The Pitfalls Behind Zero-Fee Trading

After a years-long race among online brokers to slash investor costs to the minimum, in the end it only took a few days for a handful of major firms to cross the proverbial finish line. In October, Charles Schwab announced it would eliminate its $4.95 commission on all online stock, exchange-traded fund and options trades. Within a week, several big-name online brokers rolled out similar commission-free deals, including Ally Invest, E*Trade, Fidelity, TD Ameritrade and Trade­Station. Some trading fees still apply: Options traders at these firms must still pay contract fees, for instance. But those have been lowered in some cases, too.

Schwab isn't the first firm to offer free trading. Interactive Brokers launched IBKR Lite, a new online platform with free stock and ETF trades, just days before Schwab cut its commissions. And even before that, Firstrade, Robinhood and TradeZero America all offered free stock and ETF trading to customers.

A win for investors—mostly. Overall, the commission-free trend is a win for individual investors, especially those with small accounts for whom trading fees make up a larger percentage of their overall costs. But investors should resist the urge to get trigger-happy. Even with commissions at zero, "the behavioral costs"of investing aren't going to go away, says Charles Rotblut, vice president of the American Association of Individual Investors, a nonprofit investor education group. Investors who use free trades as an excuse to make frequent, emotional trades will likely erode their long-term returns, he says.

From just $107.88 $24.99 for Kiplinger Personal Finance

Become a smarter, better informed investor. Subscribe from just $107.88 $24.99, plus get up to 4 Special Issues

CLICK FOR FREE ISSUE

Sign up for Kiplinger’s Free Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

Sign up

Be wary, too, of other ways that brokerage firms may try to get money from you. Brokerages hope the move to zero commissions will allow them to attract and retain more customers and charge them for other services, such as banking, asset management, advisory services and estate planning, says Rotblut. In many cases, the service may be a good fit. Just be watchful of the fees, what you're getting in exchange for them and how they compare with what other firms charge.

Brokers will continue to charge you in ways you can't see, too. One such way is through your cash. Every brokerage firm moves your uninvested cash into low-yielding accounts called sweep accounts, the default for investor cash balances. The brokerage firms plunk those balances in short-term investments and pay clients far less interest than the firms earn on the money. Ask your broker about the yield on your default sweep account; you may be able to choose a higher-yielding account. Fidelity’s zero-commission rollout included an announcement that the firm will automatically direct investor cash into its highest-yielding sweep accounts.

There’s also a potential cost to you with market makers—the businesses (dealers or securities exchanges) that actually execute your trades. Many brokerages accept payments for routing trade orders through certain market makers. Generally, when a broker accepts payment for order flow from a third party, it’s thought to cost you on your execution price, whether you’re buying or selling shares. A number of brokerages, such as Robinhood and TD Ameritrade, do this, and the practice could increase as brokers look for ways to fill the gap left by departing commission revenues. Notably, Fidelity says it does not accept payment for order flow.

The zero-commission news wasn’t a win for the brokers’ shareholders, at least initially. Schwab shares fell 10% on the day the firm announced its zero-commission policy, E*Trade stock sank 16%, and TD Ameritrade tumbled 26%. Credit Suisse analysts say firms such as Schwab that offer more-robust services are best equipped to withstand the commission cut. But firms that logged a chunk of total revenue in commissions, such as E*Trade and TD Ameritrade, could see significant hits to earnings.