A commission war has broken out among the online brokerage firms. TV and print advertising has been filled with banners touting the new low rates. Last month, Charles Schwab cut its online trade commissions to $6.95 from $8.95. Within a few weeks, Fidelity lowered its rate to $4.95 from $7.95. Schwab responded a few hours later by matching the $4.95. TD Ameritrade got in on the action by reducing its standard commission from $9.99 to $6.95, while E-Trade’s rates followed the same path, with “active traders” now offered a $4.95 commission.
What is the reason for this sudden race to the cheapest rate? The firms are seeking to accumulate assets and increase market share. For example, trading commissions at Schwab represent only 11 percent of revenue. While Schwab and others will take a bit of a hit on revenue because of this commission battle, these firms are interested in attracting assets into their own proprietary mutual funds and ETFs. The fees earned by Schwab for its asset management products are 44 percent of revenue and were growing much faster than commission revenue, which will now decline.
The firms are also reacting to a major shift in investment cash flows. Investors have been moving their money out of actively managed mutual funds and into “passive” investments like index funds and exchange-traded funds. The commission war is an attempt to grab a bigger slice of that trend. Assets in U.S. ETFs grew to $2.5 trillion from $938 billion in the last five years. At the end of 2015, 348 mutual funds and ETFs charged investors 0.1 percent or less.
The online firms are also trying to attract younger investors and compete against the robo-advisers whose technology offers low-cost portfolio management.
However, Barron’s notes that lower commission rates shouldn’t be the only factor swaying stock investors. The quality of trade executions can mean a great deal more than the commission paid. Price improvement considers whether a buy order was executed at a price lower than initially displayed to the investor, or on a sell order that the stock was sold at a higher price. Fidelity’s order system displays the price improvement received on a filled order. Consider that a 2-cent price improvement on a 500-share order ($10) supersedes a $5 commission cost. Back in the 1980s, before the advent of discount brokers, it might have cost nearly $200 in commission costs to trade 500 shares. Today, commissions have largely become immaterial.
An unintended consequence could occur if these lower commissions were to encourage investors to trade more often. Naturally, brokerage firms benefit from investors who are active buyers and sellers. But on balance, hyperactive trading is a losing proposition for investors. Rapid trading is more akin to gambling, instead of building wealth by investing in the long-term growth of a business.
Disclosure of investment costs have come to the forefront in the financial industry. Regulators are demanding that financial firms provide greater transparency in the overall expenses investors are charged, whether they are buying stocks, buying products, or managing their retirement portfolios. Reduced commission costs are just one piece of the aggregate investment-expense puzzle.•
Skarbeck is managing partner of Aldebaran Capital LLC, a money-management firm. He can be reached at (317) 818-7827 or firstname.lastname@example.org.