Is Zero-Commission Trading Truly Free?

There has been much in the financial news recently about many brokerage houses moving towards zero commissions on stock trades. On the surface, zero commission trades seem like a good deal. However, firms that offer this option must get paid somehow, otherwise they would not do this.  There are a few other costs that investors should be aware of when trying to preserve a cost-effective investment portfolio.

Expense Ratios

While this is more straightforward than other costs (as it is openly disclosed), it is a cost nonetheless that an investor should be aware of. An ETF or Mutual Fund’s operating expenses such as distributions, management, marketing etc. are some of the costs of doing business. That said, this is something that an investor can minimize. Small differences in expense ratios can cost one a lot in the long run. Below is an illustration of how these small differences can add up:

Dimensional Fund Advisors, with whom clients are familiar with, recently announced they would be reducing their expense ratios for several funds, starting February 28, 2020. Below is a list of the funds:

Bid-Ask Price Spreads

Nearly every security when traded has a different price for buyers and sellers. Behind the scenes of ETFs and Mutual Funds, managers buying or selling underlying securities for a fund may face wider bid-ask price spreads for securities that do not trade as frequently, thus lowering the possibility of getting the best price when a trade is made. This cost eventually makes its way to the investor in the form of a lower return.

Turnover

High turnover in funds can lead to higher taxes in the form of frequent short-term or long-term capital gain distributions. Tax-inefficiencies of certain funds may end up costing more than gains. High turnovers in conjunction with bid-ask spreads can build up to a hefty cost and thus lower an investor’s net return.

Conclusion

Ultimately, zero-commission trades are still a step in the right direction for investors, especially for those just getting started as commissions would take up a chunk of their investment costs. Investor should be cognizant of industry-wide changes such as zero-commission trades as there are usually caveats associated with them. As the title of this blog states, zero commission trading does not truly equal free.

One of the most important duties as an advisor is to help maximize a client’s after-tax returns. Being constantly vigilant of these and many other factors that play into a client’s overall investment allocation can make a huge difference in the long run.