The zero-commission brokerage war is a wild development for investors. There is real danger here, but real opportunity, too — for those who know what to do.
To put it another way, some investors will benefit greatly from the zero-commission brokerage war. Others will look back and wish it never happened. This “May Day Part II” event (you’ll read what that means shortly) could wind up being a terrible thing for your retirement — or an incredible and game-changing thing. It depends on you — and some incredible tools we’re building. (More on that shortly, too.)
How can the same development be wonderful for some investors, but terrible for others? It’s about a combination of transaction costs and behavioral impact, and the habit adjustments that ripple out from the zero-commission brokerage wars that have already engulfed the online brokerage space.
Here is the bottom line:
- Stock commissions at zero will open up incredible new opportunities for investors with the tools and discipline to execute a strategy.
- For investors who lack discipline, or who lack a strategy in general, the temptation will be greater than ever (via zero commissions) to treat the stock market like a video game or a slot machine, with a resulting impact as disastrous as it sounds.
In case you haven’t heard about the zero-commission brokerage war, Charles Schwab — the giant discount broker and asset manager with more than $3 trillion in client assets — dropped a bomb on the brokerage industry last week.
Schwab announced that, instead of charging $4.95 for stock trades, it would charge zero, because the trend to zero felt inevitable so why not get ahead of it.
The stock prices of the publicly held online brokerages — Schwab, TD Ameritrade, Interactive Brokers, E*Trade — all dropped 10% or more on news of Schwab’s “going to zero” move. Billions of dollars in market cap evaporated as Wall Street analysts were caught by surprise.
The zero-commission brokerage war effectively means that, for all online brokers, the price for stock trades is zero across the board. Nobody can charge more and stay competitive, unless the relationship is based on something else (like wealth management or custom advisory).
The brokers can go to zero because stock commissions are not their main profit source. Schwab, for example, historically earned nearly 60% of its revenue from “cash management” — the interest income skimmed off the top of idle cash sitting in brokerage accounts.
The way this works is that, whenever you have unused cash in your brokerage account, Schwab (or whomever) will pay a rate of interest on that cash balance, but with a hidden catch. The catch is that Schwab pays a lower rate to customers than the rate it earns from the bank; the difference goes to Schwab’s bottom line.
For the online brokers, cash management is a big business — a really, really big business. It is such a big business that Schwab could theoretically charge zero for everything else — all the advice, all the financial products, all the services, all the “stuff” — and still make a living off net interest income via idle balances.
The zero-commission broker wars were a long time coming. In the 1970s, broker commissions and airline tickets both had a fixed price set by the government. It was illegal to charge less than the regulated rate. Then, in 1975, brokerage commissions were deregulated. The brokerage industry dubbed this event “May Day” — like the international distress call — because deregulation was seen as a disaster for the cushy and comfortable fixed-commission brokerage industry. That is why we suggest that Schwab’s announcement, in early October 2019, should be dubbed “May Day Part II.”
In 1978, airline ticket prices were also deregulated, taking a page from the brokerage industry. For brokers and airlines alike, deregulation ushered in a new era of price competition that continues to this day. Now that stock trades are at zero, the next logical step could be options trades going to zero.
It’s also likely that one or more of the smaller fish online brokers — TD Ameritrade or E*Trade for example — will be gobbled up by a larger fish, or otherwise fail to survive.
For investors, the trouble with a zero commission structure is the strong temptation to overtrade. With stock commissions literally at zero, it’s easy to think the whole cost of trading is zero. But that isn’t true.
The broker’s commission is only one component of real trading costs. It’s a meaningful component, to be sure, but it’s not the most important one.
Another trading cost component is something called “slippage,” which represents the price gap between the available buying price and the selling price.
In highly liquid and heavily traded stocks, slippage will be low — say one or two cents. In more thinly traded stocks the slippage can be substantial. And in thinly traded penny stocks, the slippage can represent 25% of the share price or more!
There is also a psychological component to trading costs — and this could be the most dangerous thing of all, in terms of where the zero-commission structure becomes a danger to the average investor’s financial health.
An investor who thinks ““Why not trade more, heck, it’s free!” could be tempted into treating their nest egg funds like a mountain of quarters to be pumped into a slot machine or video game. If the pattern becomes self-reinforcing, that investor becomes their own worst enemy, with bad results multiplying as the bad decisions pile up and the frenzied activity accelerates.
On the positive side, a world of zero commissions offers real opportunity, too — amazing and powerful opportunity as we shall soon see. Make no mistake, taking stock commissions to zero is a beautiful thing for the prepared investor. We can confirm this via the counterintuitive fact that the stock prices of the online brokers all tanked.
Why do tanking share prices confirm a real investor benefit? Because the fact that Wall Street has downgraded the entire online brokerage space, wiping out many billions in market cap, shows how profit expectations for the brokerage industry have been sharply reduced.
By Wall Street’s harsh judgment, in the form of a stock price verdict, the online brokers will profit less — which means their customers are getting more. The billions that Schwab and others used to earn from stock-trading commissions — not their main profit source, but still a hefty sum — will now stay in investors’ pockets.
This, in turn, makes it easier and more cost-effective to deploy smart and powerful investment strategies, like purchasing the best-in-class individual security components of an exchange traded fund (ETF) instead of buying the whole ETF.
Consider the fact that an exchange-traded fund (ETF) is more or less a basket of stocks. (There are other types of ETFs too, obviously, but we are sticking with stock-based industry or sector ETFs for this example.)
When you buy an ETF, you are buying the whole basket of stocks represented by that ETF in the form of a single transaction.
This is good because it is easy, but it is less than optimal in an important way: Because it is a basket, some of the stock components within that ETF basket will be stronger performers, and other components will be weaker performers.
In fact, some of the stocks in your preferred ETF might be stone-cold winners, while the others are duds. So why not just buy the strongest components of the ETF — the stone-cold winners as selected from the basket — and take a pass on the duds?
Why not treat the ETF like an “a la carte” dining menu, where you pick and choose among the best names, rather than buying the whole menu?
The answer is that, at least in the past, it was more expensive to run multiple transactions via the purchase of individual securities, versus the lower cost of a one-shot ETF buy.
For example: It used to be that buying, say, GDXJ, the junior gold stocks ETF, resulted in one broker transaction charge, whereas buying seven individual securities out of the GDXJ basket — the best-trending names — would result in seven separate broker charges.
And then, when the positions were closed out, the pain of that seven-fold transaction increase was felt yet again. Ouch! A pile-up of broker commissions made the “best-in-class components” strategy less valuable.
Now, though, the brokerage transaction component has gone away, thanks to the zero-commission brokerage war.
This greatly increases the attractiveness of the “best-in-class components” strategy, buying the best performers from an ETF rather than buying the whole thing.
There is a little more risk of slippage this way, but if the stocks selected are liquid (you wouldn’t do this with penny stocks) that slight slippage is more than made up for by the advantage of being in stronger names on the whole, and staying for an extended period with those best-in-class names as they trend.
This makes the zero-commission sea change genuinely exciting. The easier it becomes to transact at little to no cost, the easier it becomes to execute smart investment strategies that focus on building custom baskets of the best-performing names, almost a kind of “roll your own ETF.”
Over the course of a full investment year, the added gains here could be huge. Lowered rotation costs across dozens of positions — or hundreds of positions over a five- to 10-year time frame — could mean double-digit performance improvements over time.
Pulling the best components out of an ETF could also be huge. Let’s say you did research on an industry or sector, and the ETF you selected was a winner and rose 25%. That 25% rise would represent a basket of winner components and dud components. The winners alone might have done far, far better!
The zero-commission brokerage war is thus a giant threat and a giant opportunity at the same time.
- It is a threat to investors who lack discipline, lack a strategy, and will be tempted to take a “video game” approach to their investing.
- But it is also a huge opportunity for investors who understand how to craft and deploy powerful investment strategies that let them zero in on the absolute best-performing equity strategies — like the best-in-class component strategy — bypassing the inferior ETF baskets presented to them by the market.
You might be wondering at this point: “Where can I get my hands on strategies like that?”
The answer is “right here.” We are going to build them for you, and build the tools, too.
The zero-commission brokerage war literally just started: Schwab kicked it off with a bang last week. (They weren’t the first to go to zero, but they are the biggest and the standard bearer.) Meanwhile, we were already in the process of ramping up our research capabilities and new feature development capabilities.
Now, with the urgent clarity created by this best-in-class opportunity, born of the zero-commission brokerage war, we are kicking our research and tool development efforts into hyperdrive. We’ve never been so motivated. We’re ready to crush it.
We already have some of the most razor-sharp minds in the financial and technology world focused on unpacking the details of laying out these strategies, building them into new feature sets, and delivering them to you — the individual investor — with the goal of helping you not just survive the next bear market (whenever it arrives), but helping you dramatically improve your results as an investor, no matter the environment.
It’s an incredible time to be an investor. It’s an incredible time to be rolling out these strategies and tools. And it’s all coming your way soon — in fact if you’re reading this, you already have a front-row seat.
| Richard Smith, Ph.D.|
CEO & Founder, TradeSmith