If you ever see the word “FREE” emblazoned on a financial services advertisement, or you hear someone telling you that they don’t pay any costs in the financial services world, feel free to roll your eyes sarcastically. In fact, my preference is that when you see the word “FREE” in regard to anything in the realm of money, you get extremely skeptical. Furrow your brow and get ready to dig into the fine print because if you find something that is truly “FREE” that is in any way related to Wall Street, you will need to take the time to understand exactly how fees are extracted.
But wait – have you seen anyone tout free trading? Well, now that does exist, but let’s peel back the layers of that onion to uncover exactly what that means for your account and expenses you may think you’re avoiding. As you will soon understand – even free trading is not totally free.
Typically, when you see an advertisement for “free trades,” it is normally from a company that is trying to sell their product and will not charge a fee to acquire their own product or sell their own product. For example, if you have an account at Vanguard and you buy a Vanguard ETF product, they will not charge a fee to buy or sell one of their homegrown Vanguard Funds. It is the same with Schwab when you buy and sell their branded Schwab ETFs at no charge in or out. Additionally, there are many other ETF products that do not charge a trading fee. For example, Schwab offers a limited lineup of their own index funds, so to supplement that product offering to Schwab customers, there are more than 500 other ETF investments that can be bought or sold at no cost.
So, does that mean no cost trading means free? Of course not! Remember the first paragraph? Nothing in the investment world is free. Those “free” ETF investments all have internal costs measured by expense ratios. What is an expense ratio? It’s the percentage of assets paid to run the fund. For example, an expense ratio of 1.00% is a one percent cost to hold an investment, meaning if you have $100,000 in an investment with a 1.00% expense ratio, you are paying $1,000 per year. What may be surprising is that you won’t actually see those expense ratios coming out! Rather, the investment company reduces the price of the investment you hold. So, unless you or your advisor look up the fees in your investments, you would never actually see the money come out.
Even though ETF investments can often come with free trading, you now know they aren’t free – but they aren’t typically expensive either. In fact, Schwab and Vanguard offer many ETF investments that cost .03% and .04% respectively. This means that for every $100,000 invested in an ETF with those low costs, it would cost $30 to $40 per year! Even though that is not quite free, it is extremely cost effective.
This helps explain why stock trades are not yet quite free. You will see plenty of offers of some free introductory trades when you open a new account, or $4.95 trades, but free for life hasn’t happened yet in the individual stock world. Why? Well, if you buy and hold a stock, there are no internal fees to pay or share. So, buying $100,000 worth of Netflix stock and holding it will not benefit Schwab or Vanguard. Compared to buying and holding $100,000 worth of an ETF that they own or partner with. Those little annual fees inside the ETF create enough revenue to make a free trade possible.
Be aware that not all ETF investments are inexpensive, so make sure you know the costs before investing. ETFs are subject to market fluctuation and the risks of their underlying investments, and are subject to management fees and other expenses. ETF shares are bought and sold at market price, which may be higher or lower than their NAV, and are not individually redeemed from the fund.
Michael Carlin, AIF®