From Charles Schwab launched the first true discount brokerage in 1974, the trend has been toward lower and lower commissions and trading fees, peaking in 2019 when virtually all major retail brokerages moved to commission-free trading.
It now appears that the trend is reversing. Loyalty investments recently announced plans to introduce a $100 “surcharge” on certain ETF Transactions. It is not, strictly speaking, a negotiating commission, but for all intents and purposes it is one. And $100 isn’t exactly cheap, especially for small orders. Hypothetically, you could buy a single share of an ETF for $50, then pay a 200% commission on that purchase in the form of a $100 surcharge.
Most investors won’t notice a difference because the fees are levied (at least for now) on just nine ETF issuers, none of which are in the top 50 by market share. These are smaller, more obscure ETFs that you probably wouldn’t buy anyway. In the current state of affairs, the Affected ETF Issuers are Adaptive, AXS Investments, Cambiar, Day Hagan, Rayliant, Regents Park, Running Oak, Simplify Asset Management and Sterling Capital.
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But it has implications for investors, and the incident speaks volumes about the brokerage industry’s “pay to play” incentive structure.
Let’s dig deeper.
Why does Fidelity charge extra?
Mutual funds have always paid for the privilege of being available on brokerage platforms. Either by sales charges or 12b-1 feesMutual funds have traditionally incentivized brokerage firms to offer their offerings and individual brokers and securities advisors to sell them.
A sales charge is a commission charged on an investment. For example, if a mutual fund charges a 5% load, you’re really only investing 95 cents on the dollar, with the remaining 5% going into the broker’s pocket. Loaded mutual funds have really fallen out of favor. Recent search of the Investment Company Institute found that 92% of mutual fund sales in invested dollars went to no-load funds.
Another industry trick is the 12b-1 tax. This is actually a commission that the broker receives for each year that the client continues to hold the fund. In theory, this incentivizes the broker to hold the fund instead of managing the account in search of new commissions. But it’s still money that comes out of the investor’s pocket and goes into the broker’s pocket.
ETFs have long been touted as cheaper alternatives to traditional mutual funds, and this is mostly true. There are no charges for ETFs because they trade like stocks and thus benefit from free or near-free trading commissions at most brokerages. And because ETFs are often index funds and have very limited trading fees, they can charge very low internal fees. The expense ratio on the popular iShares Core S&P 500 ETF (IVV) is simply 0.03%for example, which means that for every $1,000 you invest, you only lose 30 cents in fees per year.
And this is where pay-to-play comes into effect.
Despite the fact that ETFs trade on stock exchanges just like stocks, some brokers have set up “maintenance arrangements” in which ETF managers share a portion of their management fees with the broker for the privilege of trading. ‘have the ETFs available from the broker. In the case of Fidelity, the company asks for 15% of the fees collected by the managers. For ETF managers who did not accept the offer, their ETFs are subject to the $100 surcharge.
What does this mean for investors?
It seems that no matter how many fiduciary rules With regulators in place, brokers and managers will always have incentives to act against the interests of their investors. Management fees on mutual funds and ETFs have really come down over the past few decades, so much so that a large ETF like IVV can only charge 0.03% and still make a profit for the manager.
But if Fidelity’s decision marks the start of a new trend in the industry, then it is likely that the overall cost to customers will increase from this point on. In ETFs, managers now have to pay a share to the broker, they now have less revenue to cover their costs and pay their staff. From a practical standpoint, this probably means they will have to charge higher fees.
Here again, Fidelity’s decision initially affects only a small number of relatively specialized players. But another unintended consequence is that this decision strengthens the large existing players in the sector and penalizes the new ones. This potentially reduces the options available to the investor and reduces competition.
Overall, the takeaway is perhaps that the big, decades-long trend toward lower and lower fees for investors may finally have reached its end. This of course doesn’t mean we’ll return to the days of ridiculously expensive fixed commissions before 1974. But at the margin, it means a little less money in investors’ pockets.
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