Free Is Not Free

Schwab made the headlines last week when the company announced it was cutting its trading commissions to $0. While this may seem like a great deal and an obvious win for consumers, there is more to the story and cause to be dubious. Specifically, if Schwab earns nothing via buying and selling securities for its clients, then how does it actually make money? It’s a question worth asking. Let’s follow the money.

Free is natural

Free is a common strategy in 21st-century business. Chris Anderson’s book titled, “Free” was a big hit when it was released in 2009. Chris was the editor in chief of Wired Magazine for 10+ years. You can read about his book launch release in Wired here. Peter Diamandis also wrote about the free model in his brilliant 6 D’s of Tech Disruption – he calls it “Demonetized.” Offering services for free has become a common and natural part of business, accelerated by the near-zero marginal costs of distribution through technology and software.

Free is opaque

Free is a price everyone loves, but sometimes we are blind to its real meaning. Schwab’s move to cut trading costs might seem exciting at first. However, once that excitement fades and you ask the question, “But how do they make money now?”, you start to realize that the price you paid previously was actually buying you something valuable… transparency.

When things are free, be skeptical…

Technology companies have become masters of consumer psychology. In particular, they know how to find and exploit our blind spots. “Free” is a perfect example of a powerful consumer exploitation.

Instagram and Facebook are “free” – except they track everything about you (and compromise your privacy), sell your data and fill your screen with mandatory ads at the rate of one of every 5 posts. Amazon’s free shipping is another powerful example. It’s well documented that consumers prefer a $50 item with free shipping over a $40 identical item but with $5 shipping.

How do brokerage companies like Schwab make money when trades are free?

This is the key question. Since the free model reduces consumer transparency, here is an insider view. There are, give or take, four primary business models that companies like Schwab may use to generate profits without charging for trades. The first two are pretty traditional and transparent, the last two are less apparent, and less appealing, to the typical investor:

Branded investment products: Brokerage firms often sell their own firm’s proprietary products, mostly in the form of mutual funds and ETFs. These funds charge annual management fees, and sometimes sales fees or loads. Fund fees are more or less transparent in 2019 if you know where to look and what to ask. Even when they are transparent, fees can vary widely. It’s something we’ve kept a close eye on since the very beginning of Osbon Capital.

Securities lending: This is when firms “lend” your securities to short-sellers (people who want to profit from falling stock prices) for a cost. You never see it happen and it doesn’t really impact you in any direct way. You also don’t really have control over it – making it a benign way for brokerages to generate revenue and boost profits.

Cash: This is a big one to look out for and it certainly won’t show up in any of their marketing. The Schwabs of the world invest the idle cash you have sitting in your brokerage account (called a “sweep account”) in low-risk interest investments like T-Bills. They pass a portion of that interest back to you and keep the rest. Multiply small returns across billions in cash deposits across tens of millions of accounts and you have a nicely profitable business model. Except when savvy investors (or advisors) know to check what they are earning on their sweep accounts. We’ve kept a close eye on this over the past few years as rates rose. It’s something we have direct control over for our clients and it’s had a nice impact on their bottom line when large cash positions are part of the picture.

Sale of order flow: This one makes most investors uncomfortable, including me, and is controversial. Selling order flow means when you go to trade, your order is likely routed to a high-frequency trader who can then likely (legally) front run your trade and give you a worse price on execution. Michael Lewis wrote about this in “Flash Boys” in 2015. If you’re only investing $100 or $1000, then it’s not a big deal for you and you probably really like the no-commission environment. But if you’re placing a $100K trade, the price matters quite a bit and you’d gladly pay $4.95 for a trade to feel that the brokerage firm is aligned with your incentives and seeking the best price possible for your transaction. Robinhood is likely the biggest offender in this category. This is probably the best reason to be skeptical of “free” when it comes to investing.

Is free always bad?

We’re not trying to indict the concept of free stuff. Free can be a real bargain. Our point is that a price of zero often means that you are paying in some other unintentional way. The free appetizer may lead you to buying a pricier entree or extra drink. The free magazine subscription may land you on every catalog mailing list known to man. The free tire rotation may earn you a hard sell for brakes, fluids or filters you don’t need. The same rules apply in investing. We’re here to sort out the changes and act as a buffer for investors. Let us know if you have any questions or comments.