How Online Brokerages Make Money Charging Zero Trading Fees

On October 2, 2019, Charles Schwab announced that it would no longer charge any trading fees. I remember my father using Charles Schwab in the 1990s and being charged $50 a trade.

Immediately after the announcement, Charles Schwab stock dropped about 9%, while firms like TD Ameritrade and E-Trade dropped by an even greater percentages. Clearly, investors in these names were not happy that these companies would be losing a significant portion of their revenue.

But when fees are cut, consumers generally win, if the firms can stay in business. Thus, the question is how will online brokerages make up for this lost revenue? Another question is what should investors on the platform do?

How Online Brokerages Make Money

After Charles Schwab announced its trading fee elimination, TD Ameritrade, the first online brokerage I opened in 1995, followed suit the next day.

So how are online brokerages going to make money or at least make up for their lost revenue? It may surprise you to know that Charles Schwab has been generating the majority of its revenues (57% in 2018) by acting as a bank.

In other words, Charles Schwab pays you a lower interest rate on your cash deposits with the firm, and earns a higher interest lending or investing the money elsewhere. For example, Charles Schwab could pay you a 0.1% interest rate on your cash and buy a 10-year treasury bond paying 1.5%. This is their Net Interest Margin (NIM) business.

By cutting its trading fees to $0, Charles Schwab is hoping to attract more customers and their idle cash onto its platform.

In TD Ameritrade’s case, it is slightly different because it doesn’t own a bank. It has affiliate partnerships with banks such as TD Bank to hold customers’ cash on deposit. The bank partner then pays a portion of its net interest margin to TD Ameritrade. Therefore, the net interest margin business profitability is lower.

Further, less than 30% of TD Ameritrade’s revenue comes from its net interest margin business. In order to stay competitive, TD Ameritrade had no choice but to also cut its trading commissions to zero, even though commissions accounted for a greater percentage of revenue.  Hence the greater percentage fall in its share price. TD Ameritrade’s #1 mission has to be to boost its net interest margin business to be its main revenue generator. Thus, I suspect it will be advertising higher cash interest rates in the future.

Besides trying to earn more net interest margin business off customers, online brokerages are hoping to generate more margin trading and options trading business. New customers might even join their money management business that invests money in mutual funds with higher fees than index funds and ETFs. For example, Schwab has an Intelligent Portfolio Premium business that costs a fixed amount to join and has a monthly fee.

What Online Investors Should Do

Free trading is great. But just as getting fries for free sounds great, if you subsequently also buy a Big Mac, a 16 oz Coke, and baked apple pie, you’ve probably spent too much on an unhealthy meal.

To take full advantage of free online trading, here’s what I think investors should do:

1) Review your historical trades. We know from the data that individual investors are the worst performers. Therefore, instead of immediately increasing your trading frequency because you can for free, review your last several years of trades and see whether you made good decisions or not. Be honest with your results.

Use the $0 trading fees to make incremental adjustments to your portfolio to match your desired risk exposure. In the past, maybe you held back on adjusting your equity exposure from 72% to 70% because it wasn’t worth paying $4.95 – $6.95 per trade. Now, commission fees are no longer a reason not to do so.

2) Do not engage in margin trading. Margin trading is how you can lose all your money in a downturn. Margin trading not only exposes you to total loss, but it also costs an interest fee to trade on margin. Please don’t leverage up at this point in the cycle. See: It Feels A Lot Like 2007 Again

3) Do not engage in options trading. The average investor has no business doing any sort of options trading. If you must dabble, then look to use options to hedge by selling covered calls or buying puts. Even then, I don’t recommend options trading unless you have plenty of time and interest.

4) Keep cash to a minimum. The money in your online brokerage account should be 95% – 100% invested in stocks or bonds. The vast majority of your cash should be invested in an online bank with a much higher interest rate or in a special cash fund with your online broker that pays a higher interest. Alternatively, your favorite digital wealth advisors such as Personal Capital and Betterment have created high yield cash products to attract more users and provide more value and synergies as well.

5) Question the fees of their mutual funds. If you elect to use a digital wealth advisor platform on an online brokerage account, then you should ask them to generate a sample mock portfolio based on your investment goals and risk tolerance. Then you should analyze the funds they are putting you into by analyzing the composition, the historical returns, and the fees. If the portfolio isn’t made up of index funds and ETFs, then the funds will most certainly be more expensive.

6) Set up a punt portfolio or a teaching portfolio. For those of you who have the time and the means, you can now set up a punt portfolio to see if you can actively beat the market. Given there are no fees, your punt portfolio can be as small as $1,000. If you’ve always wanted to be a daytrader, here’s your chance to get it out of your system. I personally have roughly 25% of my public investment portfolio in active funds and individual stocks.

You can also set up a teaching portfolio for your children or your friends to show them how to buy and sell securities, highlight how difficult it is to time the market, and more. Because my dad explained to me the stock ticker section of the newspaper in high school, I became interested in a career in finance. My career in finance ended up being quite lucrative, and without it, Financial Samurai would not exist. Therefore, you never know how far a little education will go with your children.

Make Sure You Eat For Free

Please stay disciplined when it comes to building your after-tax investment portfolio for passive income.

Take advantage of $0 trading fees by making minor asset allocation adjustments to your portfolio that you formerly would have let drift due to the fees. But remember, the more often you trade, the higher the likelihood of worse returns.

Finally, don’t forget about the tax consequences of trading. If you hold a security for under 12 months, you will pay short-term capital gains tax, which is equal to your federal marginal income tax rate. The more you trade, the more trade reconciliation you’ll have to do come tax time as well.

Enjoy the race to zero fees. Now if only the real estate industry would hurry up and cut its commission fees to zero. That would be a cataclysmically positive event for the economy!

Related:

How Much Savings You Should Accumulate By Age

Readers, how will you be taking advantage of online brokerage trading fees going to zero? Will you do anything differently with your portfolio?

The post How Online Brokerages Make Money Charging Zero Trading Fees appeared first on Financial Samurai.

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