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. This article will discuss how online brokerages make money charging zero trading fees.
Immediately after the announcement, Charles Schwab stock dropped about 9%, while firms like TD Ameritrade and E-Trade dropped by 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 Charging Zero Trading Fees
After Charles Schwab announced its trading fee elimination, TD Ameritrade, the first online brokerage I opened in 1995, followed suit the next day. E*Trade has also eliminated trading fees.
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. The S&P 500 and the NASDAQ are at all-time highs. Valuations are expensive. I’d much rather invest in lagging rental properties instead.
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 in the brokerage.
The money in your online brokerage account should be 95% – 100% invested in stocks or bonds or other investments. 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. The chart below shows how CIT Bank has the highest cost of interest-bearing deposits. Savers should take advantage.
Alternatively, your favorite digital wealth advisors such as Personal Capital and Betterment have created new high yield cash products to attract more users and provide more value and synergies as well. But their savings rate will change depending on the conditions.
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. I invest in big tech names and other names that I think will outperform.
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.
If you have children, I highly encourage you to put them to work and open up an Roth IRA. It’s great to contribute to a Roth IRA with earned income at a low or zero percent tax rate.
Within 20 years, they could become millionaires if you combine the Roth IRA with a custodial trading account and a 529 plan.
Make Sure You Eat For Free
Please stay disciplined when it comes to building your after-tax investment portfolio for passive income. Your taxable investment portfolio is what will generate passive income. And passive income is what is necessary to retire early or live a life of freedom.
Take advantage of $0 trading fees by making minor asset allocation adjustments to your portfolio. 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. Short-term capital gains tax 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!
Wealth Management Suggestion
Sign up for Personal Capital, the web’s #1 free wealth management tool to get a better handle on your finances. In addition to better money oversight, run your investments through their award-winning Investment Checkup tool to see exactly how much you are paying in fees. I was paying $1,700 a year in fees I had no idea I was paying.
After you link all your accounts, use their Retirement Planning calculator. It pulls your real data to give you as pure an estimation of your financial future as possible using Monte Carlo simulation algorithms. Definitely run your numbers to see how you’re doing.
I’ve been using Personal Capital since 2012 and have seen my net worth skyrocket since. Optimize your finances wisely.
Note: Congratulations to Robinhood for going public. Although Robinhood has really screwed over a lot of its platform investors in the past by shutting down trading on its site, at least its founders and employees are now rich!
How online brokerages make money is a Financial Samurai original post. Join 100,000 others and sign up for the free Financial Samurai newsletter here.