For today’s article, I want to talk about a subject matter that in the recent past has rocked the world of retail brokerage, zero commission trading. On the face of it, paying no commissions for any type of trading activity sounds like a dream come true for retail investors, but is it? I wanted to dig deep.

Musing

Before we delve into the pros and cons of zero commission trades, let me savor the chart below:

The cyan line represents cumulative time weighted-returns for my active-investment portfolio, where in I follow a contrarian value investing strategy, and  the line in orange corresponds to the same returns for S&P 500. In numbers, my portfolio has returned 38.62 %, as compared to the 26.69 % returns for the S&P 500 index thus far for the year 2019.

Back in September of this year, in the blog article titled, Value is Back, I observed the tide of markets turning towards my style of investing. The tide has since accelerated  and I am no doubt enjoying it. Beating the markets by upwards of 12 % in a year when markets are up greater than 25 % is no joke. Only if I can claim such a staggering performance year-over-year!

To showcase how hard it has been for the past 3 years for my style of investing, I want to now zoom back in time, and show how my portfolio has performed in the last 3 years.

For two years, starting from about Sept 2017 up until Sept 2019, my portfolio went into hibernation. Frustrating yes, surprising no.

Zero Commission Trades

Its never been a better time to be a retail active investor. Not only is there an abundance of information on markets handily available to those interested in the markets, it is for the most part free. And now trading has gone that route as well.  All major brokerage houses from Charles Shwab, to TD-Ameritrade, to Fidelity, to E-Trade have eliminated their fees for stock transactions.

The race to zero trade commission, in some sense started on May 1st 1975, when the SEC abolished the fixed rate-commissions, which was a staple for stock trading for the preceding 183 years. Fixed commissions, also referred to as the soft-dollars, not only produced high costs of trading, which discouraged broad public participation, but also curbed innovations in the financial services sector.

All that changed after the May Day. Upstarts such as Charles-Schwab, quickly disrupted the brokerage industry, providing a low cost transaction services, ushering the birth of the so-called “discount brokerage”.  Charles-Schwab assisted trades cost $70 on May 1st 1975 compared to hundreds of dollars at other wall-street brokerage firms.

The rise of online brokerage firms gradually reduced the fees to $14.95 per trade in the 1990 to $4.95 as recently as earlier this year. On Oct 1st 2019, Charles-Schwab became the first retail brokerage to drop brokerage fees for trading stocks, etfs and options to zero. Within days, TD-Ameritrade and E-Trade followed suit and finally Fidelity followed suit with their announcements of 0 % commission.

The early pioneer of zero commission was Robinhood. In 2015, Robinhood launched a straightforward app targeted towards millennials to allow for trading at zero cost. It soon garnered popularity among  the targeted audience. I saw this first hand at Amazon when working there. I had several millennial colleagues, who got started trading using Robinhood. Robinhood was also an impetus for me to introduce investing to my son, when I opened a brokerage account in his name and helped him purchase shares of firms he was most familiar with and interested in, such as AAPL and DIS.

As of this writing, pretty much all retail brokerage houses offer free-trading on their platform. So how does it help retail investors?

• Better returns: Transaction costs eat into investment returns. Small transaction fees, say 0.25 % to 1% of portfolio assets may  not seem to matter much. However as this article shows, these fees can add up, especially over a long time horizon.
• Invest small amounts: Investors with limited funds to invest can now think of purchasing 1 or 2 shares of their favorite stocks without incurring a significant draw down
• Multiple brokerage options: Before zero commission became a norm, the options available to retail investors were limited to Robinhood, with no frills app and Merrill Edge for those who qualified to be preferred-rewards members. Rest charged transaction cost on par with the quality and the diversity of services on offering. For example, TD-Ameritrade and E-Trade charges a premium, $9.99 per trade for their premium offerings, Charles Schwab charged $4.95 for their limited offerings. Now premium product is available to everyone without having to pay for a premium product.

Is it all rosy picture though? As the saying goes, there’s always two sides to a coin.

The obvious question to ask is how do these for-profit firms now make money, cause if they don’t, somethings got to give.. either the service deteriorates or the firm goes bankrupt.  Below, I jot down few ways in which zero-commission trades may impact retail investors bottom line:

• Increased trading activity: Studies have shown that trading more frequently leads to poor performance. No fees is a great incentive to get-in and get-out at a whim.
• Lost interest returns: Most of the brokerage firms move the uninvested cash into a default money market account that pays significantly lower interest rates relative to those can be obtained elsewhere, i.e., high yields savings accounts. This lost interest is a hidden fee and may in aggregate be more than enough to compensate for the lost transaction fees revenue for the brokerage firms.
• Bid-ask spread: You may have noticed that for every stock trading on the floor, there are 2 prices, bid, price some one wants pay for the stock and the price that someone wants for the stock. The difference between bid and ask is the spread. In general, the more liquid a stock the lower is the spread. However, in a bid to recoup some of the lost revenue, we may see brokerage firms, acting as market maker, inflate the spread and as such investors may end up paying little more to buy the stock and get little less when selling the stock. Yet another hidden fees.
• Sale of order-flow data: This is yet another non-intuitive way for brokerage houses to make money. They may sell, the order flow data to, for example, high-frequency trading firms, who may arbitrage activity around short-term trades.
• Less competition: Its quite possible that some of the brokerage houses may simply be unable to recoup the lost transaction fee revenue and may opt to merge with players that survive.

There are two sure-fire ways to make money in the markets: reduce cost and control emotions. Zero commission trades are definitely a boon to reduce cost and I sure hope emotions are also kept in check, if investors are to truly benefit from the whirl wind of changes happening in the financial services sector.

Personally, transaction costs have never been a consideration for my style of investing. I trade infrequently and in large amounts. Even so, paying no commission at all is an attractive proposition and some thing that I have already gotten accustomed to via Merrill Edge, preferred-rewards brokerage account and Robinhood.

I foresee no changes in my investing behavior. However, I do see myself moving funds around to now better avail premium product resources of TD-Ameritrade over Robinhood.

Happy Investing!

Video/Book/Article/Audio for the Week

So much good stuff to share:

• Value Investing with Legends interview with Joel Greenblatt of Gotham Funds and the author of the famous investing book: You can be a stock market genius
• Common plots of economic history, an excellent article by Morgan Housel on ways to understand the complex world of finance
• Shane Parish interview with the CEO of Blackstone, Stephen Schwarzman on the Knowledge Project podcast and the book What it takes: Lessons in the Pursuit of Excellence.
• The economist who wants to ditch the math, Noble Laureate, Robert Shiller argues for a new force that drive economics and it is not a common tool in the arsenal of economists.
• Ashwath Damodaran’s recent article, The Softbank-WeWork endgame, analyzing the WeWorks IPO fiasco.
• Planet money podcast on one man’s quest to built a perfect sperm bank