Who gets paid when you invest? (and why that matters!)
Schwab recently announced that the company would be reducing commissions on U.S. and Canadian stocks, ETFs and options from $4.95 to $0. Founder and Chairman Charles Schwab said about the decision, "From day one, my passion has been to make investing easier and more affordable for everyone. Beginning October 7, every Schwab client can trade U.S. stocks, ETFs and options commission-free. Eliminating commissions ensures my ultimate vision is realized – making investing accessible to all."
The announcement enticed other competing firms to also reduce or eliminate commission charges on stocks, ETFs and options. With companies not charging commissions on trades any more, you might be inclined to ask:
So how are they making money?
In order to clarify this often murky subject of investment compensation, let's look at:
- Who are the players involved and how do they get paid?
- Why would a firm not charge commissions on trades?
- What does it mean for you?
There are typically 3 main players that investors should be familiar with when it comes to "Who gets paid?"
The Custodian (or bank) is typically a big, regulated, adequately-funded financial institution that holds client cash and investments (i.e. Schwab, TD Ameritrade, Pershing, Fidelity). When you place a trade (either with an Advisor or online) it's processed through the Custodian who places transactions and moves the money as directed.
The custodian is typically compensated by charging fees for processing transactions (like commissions on stock trades), loaning money for the purchase of securities (like margin interest), maintaining accounts, and offering proprietary investments.
The Advisor (or financial professional) is the person/firm you've hired to give advice and make recommendations regarding your financial situation. Often times they provide other services, but for our purposes here, the advisor is the face you talk to about placing trades and making investment decisions.
The advisor is typically compensated in two ways: service fees paid by the client (like management fees, advisory fees, financial planning fees, etc.) or commissions (indirectly paid by the client from the investments recommended by advisor).
The Fund (or investment vehicle) is an exchange traded fund (ETF), mutual fund, etc., that you purchase for investment purposes. The internal costs of running that fund (trading fees, management fees, financing costs, marketing expenses) are often internally embedded (read: not often readily disclosed) in the fund, and can be measured annually by referencing the fund expense ratio. Individually held stocks, bonds, and options do not have expense ratios and do not receive additional compensation for investing in them.
Common Compensation Ranges
AUM stands for assets under management. Hypothetical ranges of compensation are general in nature and for illustration purposes only. Compensation may vary.
A Quick Example of How This Plays Out
Let's take a $10,000 investment in Fund XYZ
The advisor who recommended the fund will get paid for his part (typically an ongoing advisory fee or commission).
The custodian the advisor placed the trade with (let's say, TD Ameritrade) charged a trading fee.
Finally, the (hypothetical) ongoing costs of running Fund XYZ create an internal fund expense of 0.60%, annually, which is taken out of the fund without you even seeing it.
That's three different players, all being compensated during the investing process. For most investors, all three players are often involved at some level, and deciphering the level and type of compensation can be tricky, especially in cases where 2 or all 3 players are working for the same institution. Most of the big banks work in this kind of capacity, playing the Advisor, Custodian, and Fund company all in one.
Looking at Schwab
So why would Schwab want to eliminate trading commissions?
The short answer likely has something to do with Schwab, Vanguard, Fidelity, and TD Ameritrade (as well as others) being in a bitter fee battle, lowering fund costs, trading costs, or whatever necessary to gain market share. This has largely been to the benefit of retail investors. Thus, small and big investors, alike, can experience the same level of ease in trading by reducing one of the 3 costs we've discussed.
As Schwab (and others) continue to reduce the internal fund expenses on their ETFs (another cost point) retail customers win on two pricing fronts. We use Schwab as one of our Custodial partners, and are pleased to see reduced costs for our clients.
What does all this mean for you?
Moral of the story: There are fees you see and fees you don't see, but it's rarely ever free. When it comes to investing, it's important to know how all three levels are compensated regarding your situation. I can't say that more strongly.
You should have no problem asking your advisor to tell you how each of the three levels of compensation work together (especially if they answer YES to, "are you a fiduciary?")
If you would like help figuring out how much you're paying, please don't hesitate to reach out. Our knowledgeable consultants would be happy to review your situation without cost by calling us (805) 963-6181, or by email: email@example.com.