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Rekenthaler Report

When Free Isn’t Free

The investment industry doesn’t often give something for nothing.

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No Commissions!
Travelers quickly learn to avoid “no-commission” currency exchanges that lurk outside of baggage claim areas. With the rates they charge, they could pay their customers a commission and still turn a profit. (My favorite horror story: A German tourist swapped EUR 300 to a freelance trader, for what he was told was the equivalent sum of Mongolian tugrik. He received EUR 3 worth.)

Mainstream investing is considerably cleaner. The waters are murky indeed for options traders, or those who buy penny stocks. Nor would I steer my favorite relatives toward cryptocurrencies. However, for investors who stick to the center of the road, brand-name brokerage firms, mutual funds, and banks offer far better deals than do those currency exchanges.

That said, that which appears to be free is not necessarily so.

Once, the investment industry’s sales fees were upfront. Those who bought stocks paid brokerage commissions, while those who sought funds faced “load charges.” (There were also no-load funds, for investors who did not use brokers.) Either way, the payments were immediate and open. There were complaints, because the fees were high and non-negotiable, but nobody was fooled.

12b What?
Things have changed. Because mutual fund buyers disliked paying front-end loads, fund companies began to hide them. A 1980 invention called the “12b-1 fee,” attached to “B shares,” permitted funds to extract sales payments surreptitiously, rather than bill their shareholders directly. At first, the disguise was highly effective. Many who bought B shares thought that they had avoided sales charges. Most certainly, they had not.

The news about 12b-1 fees has since spread, such that this example may seem archaic. But such fees persist. Earlier this year, I spoke to a man who had put $1 million into an “A share” fund. Because of the size of his investment, the fund waived its front-end load. No commission! Except there it was, in the form of the fund’s annual 0.25% 12b-1 fee. Should the investor hold the fund for 20 years, and its net asset value rise by 5% annually, the 12b-1 fee will generate almost $90,000.

This, to be sure, is a relatively low cost for receiving financial advice--far below the standard asset-management fee, for those advisors who levy such charges. Thus, I would not say that the investor erred. Quite the contrary; the fund has a good long-term record and is otherwise low-cost. It will likely treat him well. However, he did not comprehend the terms of the deal. He did not know how the other party got paid.

Banking It
Bloomberg’s Matt Levine relays another, more-dramatic example of how investors can misunderstand the business realities.  Citigroup (C) sold its retail customers a structured note--in essence, a tame form of derivative--that was linked to’s (AMZN) stock-market performance. The note carried neither a cover charge nor a stated expense ratio. How, then, was Citi paid?

The answer, which the note’s purchasers apparently did not realize, was in how Citi priced the security. Under many market conditions, Citi would profit more than the note’s investors. That indeed proved the case, when Amazon stock rose by 20% over the next three months, thereby permitting Citi to exercise its prospectus rights to call and retire the note. Its buyers scored a profit of 2.5%, while Citi itself collected an estimated 3.5%.

Levine can muster no sympathy. “Of course [the note] was more lucrative for Citi. If you find yourself [doing a weird deal] with a big bank, that is because the bank wants you to. You don’t need to do any fancy math--you don’t even need to read the one-page summary--to know that the bank will probably do better out of that trade than you will. It was the bank’s idea!”

Happily, things work somewhat differently in the fund industry. Few funds are priced as aggressively as was Citi’s note. Mutual fund companies do not expect to take three parts of the profits for every two parts of their customers’. For them, $0.10 on the dollar is enough. That reason, among others, is why funds have become the U.S. investment standard and bank products have not. Still, Levine’s attitude is worth emulating. Better to be overly cynical than to be unaware.

Taking Stock
Which brings me to the topic of stock commissions. As with index-fund expense ratios, they are converging toward zero.

With index funds, I fathom the math. The major fund companies continue to cut their prices because of the benefits of scale. If the assets under management are sufficiently large, the fund company can profit even with a minuscule expense ratio, because the marginal cost of serving those investors is exceedingly low. In addition, as with Fidelity’s ZERO series (Fidelity ZERO International Index (FZILX); Fidelity ZERO Total Market Index (FZROX)), such funds can be useful loss leaders. Bring the assets into the organization, and then seek to make money from them on other services.

The same logic, to an extent, holds for stock commissions. If I wish to make an online $600,000 equity trade, Vanguard will do so for $2. Clearly, the company hasn’t underpriced a cup of  Starbucks (SBUX) coffee solely from the goodness of its heart. It, like Fidelity, hopes to get a larger share of my wallet. Vanguard would like to have my entire investment portfolio, if possible.

But there’s more to the stock-trading business these days than just gathering assets. Brokerage firms can also sell their customers’ transaction data, to high-frequency trading firms. According to the investment website Seeking Alpha, the new-school broker Robinhood has been doing just that. Robinhood receives no commission at all from its customers for executing trades--but $260 from HFTs for every million dollars’ worth of transaction data that it sends.

Does this constitute “selling out” Robinhood’s customers, as Seeking Alpha would have it? Or are such data sales, which neither Robinhood nor other brokerage firms are eager to discuss, unsavory in appearance but not particularly harmful? You got me (and I suspect other market observers). I do not know that answer. But I do know that a dash of Mr. Levine’s cynicism is required.

Morningstar’s Grant Kenneway provides the final thought. “Financial advice from family and friends is free. But it tends to be very costly in the long run.” If your family is anything like mine, Grant, truer words were never spoken.


John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

John Rekenthaler does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.