8 Facts to Know About No-Commission Trades

Debbie Carlson

More firms are announcing free trade options.

Major brokerages such as Interactive Brokers, Charles Schwab and E-Trade, among others, recently announced that they would stop charging commissions to their clients who trade stocks and exchange-traded funds. Anytime people can pay less or nothing to invest, it helps them boost returns by keeping more money. Market watchers say brokerage houses' decision to drop certain trading fees is part of a trend of lower investment costs in general over the years such as falling expense ratios. But brokerages aren't offering free trading services because they're altruistic. These companies are fending off competition from newer online brokerages. Here are eight facts you should know about free trades.

Brokerage firms are looking to retain clients.

Scott Coyle, CEO of Click IPO, which allows investors to buy individual initial public offerings, says these bigger firms likely made the move to retain clients as they may have seen customers transfer to newer platforms like Robinhood, which has been offering free trades for about seven years. If the more established brokerage firms see less attrition in their customer base, they not only keep those customers but can now recruit newer customers with the added lure of free trading. "These broker dealers that have been around much longer have more robust platforms, they offer a lot more things than some of the newer free-trading firms do," he says.

Mutual funds are not included.

The brokerage firms touting their free stock and exchange-traded fund trades were silent about mutual funds. That's because mutual funds aren't part of the no-commission deal, says Kevin Dorwin, managing principal at wealth management firm Bingham, Osborn & Scarborough. "Mutual funds, for the most part, are still priced much higher because they're harder for the brokerages to administer. And I think a lot of people use mutual funds, so they're not really saving on that at this point," he says. Fees vary widely by brokerages and the type of mutual fund but they can cost between $20 to $40 to trade. Many brokerage houses are also allowing people to trade options commission-free, although option traders may still need to pay a fee of 65 cents per contract.

The average investor may not save much money.

Trading fees and expense ratios for stocks, ETFs and options have dropped over the past several years, which benefits investors overall. The trend of lower expense ratios for ETFs and mutual funds has helped average investors. But this move by brokerage houses to eliminate trading commissions may not save the average person who doesn't trade a lot, Dorwin says. "Most ordinary people don't trade so much for that to be a huge benefit. The people who do truly win are those who trade frequently, and that's not always a great strategy for individual investors," he says.

Free stuff isn't always a good thing.

Todd Rosenbluth, director of ETF research at CFRA Research, says if people don't have to pay a commission to trade, it could entice more trading. "The key takeaway to me is just because something is unlimited, it doesn't mean that investors should take full advantage of it," he says. The downside to no-cost trading may mean people will trade more than they do now, which means they could be moving in and out of the market and trying to make short-term calls because there's no cost to do so. "It's a lot harder to time the market and you're a lot better off having time in the market," he says.

Brokerages make money in other ways.

Jim Besaw, principal and chief investment officer at GenTrust, says it was easy for brokerages to offer free trading since the money earned on commission by many of the custodians wasn't a large portion of revenue. They make more money on other services, he says. Payment for order flow, which is the pay that firms receive for directing orders to different parties to execute trades, can generate revenue particularly in low-liquidity markets, he says. Firms also make money on securities lending programs, when investors loan stock to other traders who want to sell short the security. Investors and brokers are supposed to split the revenue earned, but the divide isn't always clear. These money-generating activities are fine. But Besaw says it's not easy for customers to easily figure out these costs as some brokerages are less transparent than others.

Watch cash sweep accounts.

Besaw says cash sweep accounts, which is where brokerages deposit investor cash until investors deploy it into another investment vehicle, are a top money-generator for firms. That's because firms often pay low interest rates on these cash deposits or move these funds into a in-house money market mutual fund, with a high expense ratio. "In many cases, that's a much higher number than the other fees," he says. "If a client has 5% or 10% of their money in cash, in many cases, the custodian's paying them 1% less than they should. So the custodians really making 1% on that 10%, which is 10 basis points, which are pretty big numbers." Investors can avoid this by not letting their money sit long in a cash sweep account.

Investors may make better fund choices.

Before eliminating trading fees, some brokerages had a list of ETFs they offered for no-commission trading and Rosenbluth says fee-conscious investors often gravitated to those without considering other investing aspects. "Now the whole universe is open," he says. Investors can now sort through ETFs based on expense ratios, liquidity, performance and other factors without being influenced by trading fees associated with the funds. It may also encourage better portfolio maintenance. Investors who use a broadly diversified strategy with five or six ETFs might be more likely to rebalance that portfolio regularly because there isn't a cost to buy and sell those positions, he says.

Investors may be less likely to liquidate accounts.

Rosenbluth says he's heard discussions that axing trading fees may increase demand for highly liquid, ultra-short-term bond ETFs during volatile times. These ETFs have maturity and duration of less than one year, such as iShares Short Treasury Bond ETF (ticker: SHV), which has a yield of 2% and an expense ratio of 0.15%, a cost of $15 for every $10,000 invested. With no trading fees, investors could move to these safer ETFs, rather than liquidate all their holdings and stuff it in a low-interest bank savings account. Investors may return to the stock market quicker when they feel like taking more risks since there's no cost to trade, he says.

Facts about no-commission trading:

-- Brokerage firms are looking to retain clients.

-- Mutual funds are not included.

-- The average investor may not save much money.

-- Free stuff isn't always a good thing.

-- Brokerages make money in other ways.

-- Watch cash sweep accounts.

-- Investors may make better fund choices.

-- Investors may be less likely to liquidate accounts.



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