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Are No-Commission Trades Good for Investors?

Ben Johnson says investors should be on their toes for other expenses as the pricing war among brokerages continues.

Christine Benz: Hi, I'm Christine Benz from Morningstar.com. Brokerage firms are slashing their commissions left and right, but is that always good news for consumers? Joining me to provide some context around the latest news regarding brokerage firms is Ben Johnson. He's Morningstar's global director of ETF research.

Ben, thank you so much for being here.

Ben Johnson: Thanks for having me, Christine.

Benz: Ben, let's just recap for people who haven't been following this super closely. This is part of a broader trend that we've seen where fees have been coming down, commissions have been coming down. Let's talk about what's happening in the brokerage space recently with respect to commissions.

Johnson: I think it's important for us to to step back and place the latest developments in the context of the longer arc of history, which has been toward cost compression more broadly as it pertains to either asset management fees or the topic of our discussion today. Brokerage commissions, which going back not all that long in history, were measured in the hundreds of dollars to transact in a stock ... 

Benz: At a full service brokerage, right.

Johnson: A full service brokerage, and in came kind of discount brokerages, including Charles Schwab. The competition has gotten fierce among these platforms. The technology that drives this process has gotten so good that the incremental cost of trading has gotten down to basically nothing. So we've seen brokerage commissions come down more recently from about $9 a trade to about $5 a trade. And as of today, for many securities, now zero. And that applies to Vanguard for all ETFs, which was in an announcement that firm had made going back to last year; more recently Interactive Brokers, which launched a light version of its platform last week; Charles Schwab made a splash just yesterday announcing that it would no longer be charging commissions for equity in ETF trades; then TD Ameritrade followed suit after the close of trading yesterday. So it's all come to a head quite quickly. It's captured a lot of headlines, a lot of attention to pay nothing for what you once paid hundreds of dollars.

Benz: So at first blush, this seems like great news for consumers, but you really think it's important for people to take a step back and just say, "Well, these brokerage firms aren't doing this out of the goodness of their hearts. They are getting something out of this relationship that they are expecting to have with me." So you think it's really important to think about all of the costs you're paying and let's talk about that. Let's talk about some other costs that might not be as explicit as, say, fund expense ratios or brokerage commissions, but might drag on your returns nonetheless.

Johnson: Absolutely free is never free. Clients of these platforms need to be asking themselves, "In what other ways are these firms monetizing my business?" And it can take a variety of different forms that increasingly are less apparent, less transparent, and difficult to wrap your arms around. In the case of many of these large brokerage firms, what they'll do is they'll take those orders that you're making, they won't charge you a commission for it, but they'll sell that order to a third party that will execute it on your behalf.

And what happens in that transaction is that the execution, the price you get, the difference between the bid and the offer price that is around that price at which you execute, might not be as favorable. The spread might not be as tight as if you had simply paid a commission and executed directly there with the broker that you're dealing with.

There's no way for your average investor to measure that. So that begins to disappear into the ether. And you might not realize that despite the fact that nominally you're paying no commission, you're incurring some sort of opportunity costs at the back end by virtue of allowing this firm to sell your trade flow away.

There are other costs that are less apparent as well. Other opportunity costs like the yield that you earn on your cash balance ...

 

Benz: That's a biggie.

Johnson: ... in your account, which I think more recently has begun to come to the fore. And you've seen a degree of competition among many of these same firms along those lines as well, touting in their marketing materials, their yields relative to competitors. Because saving $5 on a trade means nothing if you're earning 30 bps on your cash, 0.3% when you could be getting 2% or more somewhere else.

Investors need to be on their toes. They need to be asking more pointed questions and they never should accept the word "free" at face value because nothing is free.

 

Benz: Right. You have a three-item punch lists that you think investors should look for when sizing up a potential engagement, whether with a fund company or a brokerage firm: Transparency, candor and alignment. Let's just talk through those three things. Why I should think about them when I'm engaging with some outside firm.

Johnson: Transparency is paramount. As more and more of the real cost of doing business with these platforms begins to seep into different dark corners, it's important that these firms be transparent about how they're monetizing your business, how they're taking your assets and turning that into revenue for their organization.

Being very candid about why they're doing it, how they're doing it, who these parties are that they're interacting with, and what the puts and takes might be. What's the cost and what's the benefit to me as your end client?

And ultimately, I think alignment above all else to say this is what we're doing in a way that aligns our values, our ability to keep the lights on, to create a positive client experience with your outcomes, our end client. And to the extent that those two things are synced up, that's terrific. To the extent that those are out of step, I think that's worrisome. It's important to understand, again, how am I being monetized? Is it being done in a way that's fair? Is it being done in a way that's transparent, that maximizes value on both ends of the transaction?

 

Benz: Ben, always great to get your perspective. Thank you so much for being here.

Johnson: Thanks for having me.

Benz: Thanks for watching. I'm Christine Benz from morningstar.com.