The Compound and Friends - Everything's Free: The Impact of Zero-fee Trading (with Barry and Dave Nadig)

Episode Date: October 14, 2019

Dave Nadig, managing director of ETF.com, stops by The Compound to discuss how fee-free trading is changing the investment landscape with Ritholtz Wealth Management Chairman and CIO, Barry Ritholtz. 1-click play or subscribe on your favorite podcast app   Subscribe to the mini podcast on iTunes or Spotify    Enable our Alexa skill here - "Alexa, play the Compound show!"   Talk to us about your portfolio or financial plan here:  http://ritholtzwealth.com/   Obviously nothing on this channel should be considered as personalized financial advice just for you or a solicitation to buy or sell any securities. Please see this 3,000 word terms & conditions disclaimer: https://thereformedbroker.com/terms-and-conditions/ Hosted on Acast. See acast.com/privacy for more information. Learn more about your ad choices. Visit megaphone.fm/adchoices

Hi, I'm Barry Ritholtz. We're live from the compound. My special guest today is my friend David Nodig. He is the managing director at ETF.com. Did I get your title right? You got it right in one. All right. And the big news these days is all about free. Everything free. Everything's free. And this is great. Trading doesn't cost anything. Nothing costs. We have free ETFs. We have free trading. Is this good for the investor or is there something written in the small print that could be potentially problematic? I thought Dow's comment

today on Twitter was the best, which was now you can overreact and there's no friction. Which, you know, I think that's a very, very marked out type of very marked out comment. But, you know, honestly, if you'd go to anybody, I mean, Jack Bogle's got to be rolling over in his grave. His number one concern was the ETFs already made it too easy for everybody to express all of these dumb opinions too quickly. So, yeah, I suppose that's the one downside is that, you know, if you're going to have bad investor behavior, now you can really have bad investor behavior with no shackles whatsoever. So let's go through the list of free for a second. So Robinhood has been free from the get-go. I don't know what their business model is. Maybe it's order flow.

Pay for order flow. It's all order flow, right? And a little bit of income on cash. Sure. But that's not a lot. Vanguard announced there was free trading on ETFs earlier in 2019. Yep. Interactive Broker a couple of weeks ago said it, followed by Schwab, which then led to TD and E-Trade announcing it.

And just today. Fidelity. So who is left to charge on commissions? Well, sort of B of A Merrill Lynch, right? So now we're looking at the old line. We don't associate them with being discount brokers in the sort of 80s version of discount brokerage, but there's still a lot of money tied up in those big, more wire house-like firms. And you're still paying commissions. And a lot of those folks, you weren't paying five bucks,

you were paying 65 still, if you were doing a broker intermediated transaction. And importantly, if you want to talk to somebody on the phone, all these people are still charging. So this is really self-directed brokers, self-directed investors, and that's pretty much it. I credit interactive brokers with really cracking this wide open. And arguably, it mattered more for their clients than anybody else's. Because they're pretty active traders. That's their whole focus is that active trader market. As opposed to Schwab, which is really, and full disclosure, we custody at TD and Schwab, so we're a client of theirs. But Schwab is really more of an investment group than an active trader house.

And in fact, Schwab has become a bank. I think one of the, maybe it was the Wall Street Journal that said 57% of Schwab's revenue comes from interest on cash that's sitting around? But that's been the case, honestly, since the 70s. Really? If you look at Schwab's earned revenue off their asset base over the history of the firm, they eke out something like 25, 30 basis points on every dollar that's sitting in Schwab. How they've eked that out has changed over time. But consistently, cash management has become a bigger and bigger and bigger part of

their revenue stream. Now it's the majority. Now it's the majority. And I think what you're really going to see here is a move towards other services. And what I mean by other services, their robo-advisor platform, that? That's going to drive assets into Charles Schwab investment management products where they still eke out, you know, 10 basis points here, 25 basis points there. They have a lot of smart beta product that they're pushing. All of that stuff pays way more than they were making on commissions. So I have two questions for you, MrETF.com. What does free mean for ETFs is question one. Well, so for most investors, it's really around the corners, right? If you've got a quarter

million dollar portfolio and you're doing a five or 10 ETF portfolio, you're doing quarterly rebalances, you do the math, this saves you 200 bucks a year. Okay, who cares? Not a lot. It's not changing anybody's life. I think the interesting thing is what it means for things like direct indexing services. That was my second question. You anticipated. I'm waiting right in. So, again, full disclosure, Ritholtz Wealth Management offers a product that is powered by O'Shaughnessy called Canvas, which is a form of direct indexing. indexing. And what's fascinating about this is the biggest drag on this was how do we do this in a way that the cost is reasonable? Generally speaking, it's about the same as a regular portfolio,

but for the transactional costs. And those just went away. And they effectively have gone away. So is it possible that free ETFs have led to free commissions that ultimately benefit direct indexing and that might hurt ETFs? I 100% think that's the case, right? If you think about direct indexing, there's two models. There's the give a quarter million dollars to a firm like Parametric and they invest that in an SMA. In which case, you don't have to worry about the underlying commissions. They're paying the penny a share. They're managing that like an institutional account. The other version- But that still can add up. It still adds up, but it's not affected by this, right? They're not trading at Schwab. Right.

Then there's the other version, which is the directed trading model, which is what Canvas is doing, right? So it's still an account at Schwab or TD. When you're doing that rebalance trade or that tax lossloss harvesting trade, you've got to sell a thing and buy a thing, and there's $5 in and $5 out. And those are frictional costs that do add up over time. So that goes away. So those directed trading models for direct indexing, those just became far more efficient than they were a week ago.

That's a big shift. Yeah, giant shift. Originally, so we've been working with O'Shaughnessy. It's practically a year since we first started talking to them about this. And when we first started exploring this, it's like, well, given those frictions, this is really only good for big portfolios, $5 million. And then you go through the numbers. Because then you don't care about the $5.

Right, it disappears. And then as you work on some wholesale pricing and some institutional pricing, $5 million, and then you go through the numbers. Because then you don't care about the $5. Right. It disappears. And then as you work on some wholesale pricing and some institutional pricing, oh, you could probably do this with $1 million without too much friction. Now you could – the problem becomes fractional shares and how small a particular holding can be. The cost limitation on this, the portfolio size limitation. Does that completely go away now? I think it goes away.

I think the interesting question is going to be whether or not Schwab and everybody else here sort of backs off a little bit. And if you come in with a directed trading account and somebody like O'Shaughnessy is now directing you to buy 500 of something and sell 500 of something else. And you're doing a share here and a share there. The Schwab put a few breaks on that because really right now, now one share is literally your minimum transaction size. And there's no difference in cost between the marginal share and 1,000 shares. And to put some flesh on that bones, a million-dollar Canvas portfolio is typically going to be about 300 holdings on the equity side. I'm ballparking this. The bond side are all ETFs, so you're not buying individual bonds. So what would have been to deploy a million dollars might have cost you $1,000, maybe less on institutional pricing. So maybe it's $500, that now goes away.

Literally goes to zero. It's quite fascinating. And they're still making their money on, listen, they do stock lending. They do directed order flow. All of this is perfectly legitimate. This is what brokerage firms have been doing for years. But they're not making their money on the transaction. They're making it on the transaction business, everything that's associated.

You as an investor are not getting charged a fee, but they still find a way to squeeze a little money out of it. Right. And remember, they're still carrying the float, right? I mean, in all of these transactions, there are days here and days there where in that million-dollar account, you've got a couple days of sitting in cash for $100,000, $200,000. you've got a couple days of sitting in cash for $100,000, $200,000. That may not seem like a lot, but when they can go out to the market and earn 1%, 2%, or God knows what's happening in the repo market today, maybe you're earning 7% on repos. Who knows? It's been bananas, right? And they're paying virtually nothing to you as the investor for sitting on that cash.

That's a lot more valuable than the $5 here and there. And I do think also you have to look at where else they're going to be charging money, right? For Schwab, I think the game here is going to be their robo-advisor platform. They're going to try to push their investors out of trading and into those robos. Those robos pay effectively nothing on the cash, so they get that. And they target relatively expensive Charles Schwab fundamental ETFs, which have not five basis points, but 10, 20, 30 basis points. That's the Schwab smart beta product? Right. That's the Schwab smart beta product.

All those things are great revenue sources for them. And on top of that, they're running a bank now. I mean, I bank at Charles Schwab now. They've made it convenient. So I think this is a long game for them. People looked at the hit they took on the stock price. What was it, 10%, 15%? Out of the gate, they got hit. 9%, yeah. 9% for them, 20% for TD and others. Huge, huge hit. And it's going

to hit their revenues, right? They're going to have a couple of bad quarters. This is the long game. So let's talk a little bit about Fidelity. Why did Fidelity follow suit? I really think of Fidelity less as a brokerage firm, less as a trading shop, more as a giant mutual fund operator. Yeah. Well, you're mostly wrong. Sorry, Barry. Really? So Fibsy, Fidelity Brokerage Services, Inc., huge business, right?

They're definitely in the top three there. I think they probably have more trading volume than Vanguard's brokerage business. It's a lot of folks that have big assets parked there. A lot of that money came in because people were Magellan clients, Contra Fund clients, but they're also trading on the side. If you're a big believer in active management, chances are you believe you can do it too. So they've had- And you're more likely to be at Fidelity than Vanguard if you're a big believer.

100%. So it was a little surprising to me how quickly they did this. I expected this to happen. I think I even made this prediction on TV a couple days ago. I thought this would be a month or two. I thought it was inevitable it would happen, but I thought they'd be a little more cautious, see how the market reacted, and sort of weighed in as they saw maybe they lost a few clients. But clearly, they did the analysis and said, look, this is now a competitive disadvantage. If everybody else is free, we're going to lose

our best customers to particularly somebody like TD. TD has a big active trader component, their thinker swim platform. If they can't compete with that, they have real problems. What does this mean for the giants like Vanguard and BlackRock? For the most part, I don't think it has a huge impact. It saves them some money. If you think about it, BlackRock paid Fidelity a bunch of money to have their ETFs listed commission-free. That was a big deal a couple of years ago.

Presumably, I mean, I don't know for sure, but I would suspect that BlackRock is no longer going to write a check to be commission-free when everything else is commission-free by default. So do those pay-to-play commission-free contracts completely disappear, or do they become something else? I think that's the interesting question. If you're paying a Schwab for shelf space or a TD for shelf space right now, are you going to get something else? Are you going to get to be part of their select list? Are you going to get to be in their robo-advisor selections? If not, then what happens is those ETF companies now don't have to spend that money. That means they can either spend it on something else.

Marketing. Or they can cut fees even more. What else are we not getting? What are we not understanding about free? Because this is, you know, the first flurry of news is now faded. Now that we've had a couple of days to think about it, what's your big takeaway about this? Well, so I think you hit the first one right out of the gate,

which is I think this has profound implications for direct indexing. I think it accelerates the adoption of those kinds of strategies. I think the other piece that we're not talking about is data. And obviously we've all had the conversations about Facebook and how they're using your data. But the reality is these big brokerage firms know an awful lot about us. Schwab knows a lot about me. They've got a bunch of my money. They see where I spend my money. And I'm sure that somewhere in all those pages that I was supposed to read before I signed up, I agreed to something. And I don't

know what those somethings are, but I do worry a little bit about that because clearly if you're processing all these transactions for millions of clients, you have a lot of information. That information is valuable, not just from a marketing perspective, but from an actual investment insight perspective, right? If I could sell you, Barry Ritholtz, a feed of real time what everybody at Schwab is trading right now, that might be interesting information. Now, I don't know that they can do that. I don't know what's in their contracts. But I think that's the next shoe to drop is what's happening with your consumer information at a free brokerage. The Schwab Dataflow Quantitative Hedge Fund. Yeah. Don't know.

Could be interesting. Dave, always insightful. Thank you so much. For those of you who are watching this, be sure and click the subscribe button below. Thanks for coming by The Compound Live.