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The Muscular Portfolios Newsletter — No. 21 — Nov. 30, 2019
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‘Free’ commissions actually aren’t
 By Brian Livingston
Brokerage firms such as Charles Schwab, TD Ameritrade, E*Trade, and Fidelity Investments made headlines last month by dropping their commissions from a few dollars per trade to zero. Lower commissions are good for individual investors, but hidden costs and fees imposed by these same brokerage firms can ding you more than the trading commissions ever did.
Here’s what you need to know:
- InteractiveBrokers.com (IB), a specialized service for professional traders, set off a wave of zero-commission moves when it cut its commissions for stocks and exchange-traded funds (ETFs) to zero in late September.
- This was followed by a series of similar announcements, first from the giant Charles Schwab Corp., then TD Ameritrade (TDA), E*Trade, and Fidelity.
- The truth is that these brokerage firms never made much money from their “discount” commissions. The real profit is in collecting money-market interest rates on investors’ unallocated cash, while paying those same investors as little as one-tenth as much interest in “sweep accounts.”
- Schwab can make “2% at today’s rates,” columnist Jason Zweig wrote in the Wall Street Journal. By comparison, he said, Schwab’s clients are “earning between 0.12% and 0.55% on those balances.”
- Schwab reported a record-breaking profit on its $2.71 billion of revenue in the third quarter of 2019. “For Schwab, net interest revenue made up 60% of overall revenue during the September quarter,” WSJ’s Lisa Beilfuss writes. “As a percentage of total client assets, cash rose to 11.4% — the highest since February.”
- Schwab isn’t the only one. “Ameritrade and E*Trade generate about 60% of their top lines [gross revenues] from net interest or equivalent revenue — taking dormant cash in client accounts and lending it out or investing it in securities,” according to Telis Demos.
A lot of cash is sitting in some clients’ accounts just because a brokerage requires it. In Chapter 17 of Muscular Portfolios (BenBella Books, 2018), I wrote about the “Intelligent Portfolios” that Schwab launched in 2015.
I quoted Barron’s writer Alexander Eule as saying, “The firm mandates that all portfolios have at least 6% in cash at all times; its most conservative portfolios can have as much as 30% — an unusual construction for an investment portfolio.”
Besides being a drag on performance — cash doesn’t give you market-like returns — the dollars in your sweep account are earning a pittance while the brokerage is making 2% or more on your money.
Another source of costs for individual investors is the fee that brokerage firms charge ETF sponsors merely to list their products in the brokerage’s lineup. “Sometimes, the cost is as high as 0.4% of asset per year,” Lewis Braham wrote in a May 25, 2015, Barron’s cover story. “Obviously, spending that much on distribution is detrimental for investors in the funds.”
At the time Muscular Portfolios went to press, I wrote in Chapter 17 that TD Ameritrade “charges you 0.64% per year to hold PDBC,” a commodity index ETF that’s used in portfolios such as the Mama Bear and the Papa Bear. “The ETF sponsor’s website shows that PDBC’s annual fee is only 0.60%.” (The expense ratios have declined slightly since the book’s publication.)
A difference of 0.04 percentage point may sound small. But it would ding you $40 per year on a $100,000 account. That $40 dwarfs the $6.95 commission that TD Ameritrade formerly charged to buy and sell some ETFs. And, of course, any such hidden fee is infinitely larger than the $0 commission TD Ameritrade charges today.
There are other hidden costs, which warrant a thorough examination of every broker’s finances. My hope is that large, mainstream publications will investigate each brokerage firm and produce a complete comparison. At that time, I’ll summarize the findings for you here in the newsletter.
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Figure 1. Despite the new trend toward $0 commissions, major brokerage firms may not operate in your best interest, so to speak. Photos by (from top) Ken Wolter, Jonathan Weiss, Roman Tirespolsky, and Peter L. Gould, all with Shutterstock. Collage and posterization by author.
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The upshot: Don’t change brokerage firms
The differences between what we used to call “discount” commissions and today’s zero commissions are not big enough to warrant you moving your funds from one brokerage firm to another. If you’re happy with the firm you’re at, stay there for now.
As shown in Chapter 19 of Muscular Portfolios, the formulas of the Mama Bear and the Papa Bear require only nine portfolio changes per year, on average. (That’s nine ETF sales and nine buys, for a total of 18 trades per year.)
“Bargain brokerage firms,” such as two that I recommended in the book, are still useful:
- Robinhood.com has charged $0 commissions since 2012. However, the firm offers only a phone app. There’s no website on which you can place trades. Another concern is that Robinhood doesn’t reveal how much revenue it makes from “payments for order flow.” Many brokerage firms sell client transactions to middlemen like Citadel Securities and Wolverine Securities that actually execute the trades. A Seeking Alpha article by Logan Kane charged recently that Robinhood collects almost 10 times as much per transaction as firms like TD Ameritrade and E*Trade. This can possibly cause a slightly less favorable fill price every time an investor trades. (Fidelity and the Vanguard Group are two brokerages that claim not to accept payment for order flow. But you needn’t worry about the efficiency of your fills if you use Robinhhood only for a “starter portfolio” of less than $10,000, as my book recommends. The haircut would be just pennies a year — if that — on a simple, annual rebalancing strategy, such as the Baby Bear Portfolio.)
- FolioInvesting.com has offered $0 commissions on stocks and ETFs in “trading windows” since 2000, if you purchase a membership, which currently costs $29 per month. (I myself pay this fee, which is well worth it, since it has given me $0 trades since 2001 in all of my various accounts: IRA, Roth, SEP, and taxable. I also hold a taxable account at IB.) Without a membership, Folio’s window trades are $3 each. That fee was the lowest in the industry until the latest race to embrace zero commissions. If you happen to make 18 trades a year while following a Muscular Portfolio, the $3 fee would add up to $54 annually — a small 0.054% rounding error in a $100,000 account.
Folio runs a very user-friendly website with live telephone support. It’s also by far the easiest platform to use. You simply enter XYZ 33%, for example, and Folio’s computers automatically figure out the number of shares your portfolio needs to buy. No hand calculations!
There are differences between brokerage firms, to be sure. Robinhood’s $0 commissions no longer give it a competitive advantage, when so many other firms are offering $0 trades as well. In this new zero-dollar world, Fidelity may become attractive for individual investors. The firm has been running full-page newspaper ads stating that it pays a generous 1.58% on certain sweep accounts, whereas Schwab pays only 0.12%. (Numbers as of Oct. 10.)
In response, Robinhood has announced a sweep account paying 2.05%. That higher interest rate on unallocated cash may or may not outweigh the “order flow” mystery that I mentioned earlier. Don’t let an appealing headline make you fall for a firm that may be costing you in many other ways.
The bottom line is that you shouldn’t move your funds from a brokerage firm you like simply because of heavily publicized $0 commissions. The other services and benefits that a broker provides are far more important, now that commissions are so low everywhere.
So what should you do with your extra cash? You won’t need much, if any, if you’re following a Muscular Portfolio. The Papa Bear, for example, never switches to cash. (Ten-year Treasurys are always preferable, even in times of interest-rate hikes, Mebane Faber showed in a 2013 white paper; see Figure 19.) The Mama Bear does occasionally switch one position to cash, but only rarely and never allocating more than one-third of the portfolio to it.
If you have an actual need to hold cash — perhaps to meet an upcoming tax payment — don’t leave your money in a broker’s sweep account. Instead, buy a stake in a money-market ETF, such as iShares’ SHV. It holds ultrasafe T-bills that mature in less than one year. It’s currently yielding 2.23% after fees. That’s better than Fidelity’s or Robinhood’s much-publicized sweep accounts.
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What if Schwab acquires TD Ameritrade?
On Nov. 25, Schwab and TD Ameritrade announced that they plan to merge. The Schwab brand will continue, but TDA is expected to eventually disappear. (The merger might be blocked by antitrust regulators, however.)
Numerous commentators have noted that Schwab unleashed its $0 commission policy just a few weeks before disclosing its price for TDA. Schwab’s shares dropped about 15% in the days after the zero-commission announcement, but TDA’s stock sickeningly collapsed almost 30%, possibly making it a cheaper acquisition target. (Both share prices have since recovered, thanks to the Nov. 25 merger news.)
Schwab holds $3.85 trillion in assets for 12.2 million brokerage accounts. That includes almost half of the “custodial services” (managed accounts) that are handled by registered investment advisers in the US, according to industry estimates. Acquiring TDA will require Schwab to absorb another $1 trillion in assets and 11 million client accounts, possibly harming service and support.
In 2021, Schwab will begin six transfers into its own bank of $10 billion a year from TDA’s $110 billion of client cash. That will certainly boost Schwab’s revenue from money-market interest!
The merger is just one more reason to remain with any brokerage firm you’re currently using. Let the dust settle and allow the journalistic gears to grind until we see who truly offers individual investors the best deal — all things considered.
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News from the leading edge of investing
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Most market timers fail, Hulbert study shows
If you were choosing a market-timing guru in January 2000, you had less than 1 chance in 34 of picking someone who would outperform a simple risk-reduction rule as basic as the old chestnut, “Sell in May and Go Away.” Mark Hulbert reached this shocking finding based on his real-time tracking of 244 timing strategies for 16 years. The worst timers actually lost 20% to 86% of your money, as shown in the above graph, while the Wilshire 5000 broad-market index gained 91%. MarketWatch
The best books on personal finance
Eve O’Rourke has compiled a guide to the most valuable books on investing. It includes Morningstar’s 30-Minute Money Solutions, Dave Ramsey’s Total Money Makeover, Robert Kiyosaki’s Rich Dad Poor Dad, and (we’re proud to say) Muscular Portfolios. Your Guide to Beneficial Personal Finance Books
Marijuana stocks are still stinking the place up
I warned on Feb. 11 that major cannabis stocks shouldn’t be purchased “unless you like watching your money go up in smoke.” By Oct. 11, the shares had lost 50% to 75% of their value. My follow-up column reported then that, although the bong bubble had dramatically popped, the shares were “still in the ozone” at ridiculously high valuations. (Heads-up: The four stocks jointly fell even further between Oct. 11 and Nov. 29. The worst one went down another 32%.) MarketWatch
How you can get the best possible rate of return
The Steve Pomeranz Show devoted an NPR segment to “Three Easy Ways to Dramatically Increase Your Investment Rate of Return.” It includes a 10-minute discussion of Muscular Portfolios and how to keep more of your money by not paying any fees to anyone. Hear the podcast or view it as text. (Click “Read the Entire Transcript Here.”) The Steve Pomeranz Show
Use your New Year’s resolutions to make more money
With Jan. 1 coming up, service magazines are focusing on financial goals. Better Homes & Gardens tells how to “Save More Money Without Feeling Deprived.” (My strategy comprises B&H’s Section 6 of 11.) And Woman’s Day posted an entertaining slide-text series on hastening your early retirement by cutting your expenses $100 a month — painlessly. (The steps I recommend are the first 5 of 8 slides.) Better Homes & Gardens, Woman’s Day
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Give your loved ones
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“The investing book of the decade. ... Investors will be profiting from these methods for ages to come.”
—HUGH TODD, CEO, ETFScreen.com
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