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18.1: Brokerages

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    79804
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    Video - Audio - YouTube

    There are three types of brokerage firms, full service brokerages, discount brokerages, and deep-discount brokerages. What can you expect to pay for each? What kind of service can you expect from each?

    Full-Service, Discount, and Deep-Discount Brokerages

    Full-service brokerage firms are companies such as Merrill Lynch and Morgan Stanley. Investors can expect personalized service as well as customized research and investment recommendations. Of course, you can also expect to pay dearly for these services. You might also receive services for which you might not expect. In the past, brokerage firms would direct their registered representatives, also known as stockbrokers or account executives, to encourage their clients to buy certain securities for which the firm would be compensated handsomely.

    Retail investors often ask how they can get the shares of an Initial Public Offering (IPO) at the IPO price. Customers of full-service brokerage firms, especially accredited investors, a fancy term for people with lots of money, are typically privy to the IPOs at the initial prices. You and I won't typically be able to purchase the IPO shares at the initial offering price.

    Every brokerage firm is different but do not expect to be treated well unless you are going to bring a substantial sum of money to your account. A few decades ago, these brokerage firms wanted you to deposit at least $50,000. Of late, many appear to want at least $500,000 and some years ago, a client related to me that the stockbroker of her parents was ready to set the minimum initial deposit to at least $750,000.

    Does all this full service necessarily translate into outsized performance? On at least one occasion, Your Humble Author encountered a situation where a client was using the services of a full-service brokerage firm. The client was recommended Class C shares of various mutual funds, the ones with the higher annual operating expenses in lieu of the front-end sales charge. The client had well over $1,000,000 of assets in the account. If you remember, with over $1,000,000, the front-end sales charges of Class A shares are waived. In this situation, the client was paying far more in annual operating expenses that was necessary. After pointing this out to the client, their response was, “I guess I should talk to them about this.” I sure hope they did and gave them hell!

    Discount brokerage firms began to emerge in the 1970’s. After much consolidation in the industry, the largest discount brokerage firm is Charles Schwab. Others include Edward Jones and LPL Financial. These brokerages traditionally left the stock picking to the investor but now have their own sophisticated stock rating and recommendation services. The commissions were much less than the full-service brokers.

    The advent of the Internet saw the emergence of deep-discount brokerage firms in the late 1990’s. These firms emphasized technology to reduce brokerage costs dramatically. Investors using deep-discount brokerage firms typically would never speak to a broker when executing transactions. However, they do have the option of consulting with a registered representative, for which they will be charged similarly to what a discount brokerage firm would charge.

    Commissions, Then and Now

    Traditionally, virtually all brokerage firms made their money from transaction commissions. Full-service brokers would charge from $70 to $100 or more per trade. Discount brokerages began with commissions at $45 per trade but then progressed to $29, $19, $13, and then below $10 per trade. Deep-discount brokerage firms started at $5 to $10 per trade. A few deep-discount brokerage firms experimented with $0 commissions. One failed and the other raised their commission to $5 per trade.

    One company, Robinhood, has been successful in charging $0 commissions and earned the love and affection of young traders as Robinhood encouraged tech-savvy younger adults to trade as often as they liked since there are no commissions. “I am trading for free!” is what you will hear from Robinhood customers. Robinhood then earned the scorn of the younger adults when, for reasons that are still subject to controversy, Robinhood halted trading of certain popular “meme” stocks that were the target of groups of traders that had banded together to push the prices up. Robinhood is now a publicly traded stock having gone public in mid-2021. As is typical with Initial Public Offerings, Robinhood is far below 50% its high stock price for the year and well below its IPO price as of April 2022.

    Wait a minute! How can a brokerage firm make any money with a $0 commission schedule? We hope you remember from chapter 3 that the deep-discount brokerage firms are receiving a kickback from the dealers and market makers who buy and sell the stocks from their own inventories. It is innocently called Payment for Order Flow or simply, Order Flow. Dear Readers, Robinhood is not free! Please refer back to our extensive discussion in chapter 3 about how Payment for Order Flow works. Order Flow is currently in the news as the Securities and Exchange Commission has been floating the idea of banning it. There is even a change.org petition to ask the SEC to ban Order Flow. Stay tuned!

    Assets Under Management (AUM)

    Over the years, commissions have received bad publicity, especially when a few brokers would “churn” their clients' accounts. A broker is guilty of churning when they encourage their clients to initiate excessive trades in their accounts for the purpose of generating commission income for themselves. As such, the brokerages have experimented with alternative methods of charging for their services. Many years ago, Merrill Lynch experimented with charging $3,000 per year for unlimited trades but they do not have that program anymore.

    By far, the most popular method to charge for brokerage services today is called Assets Under Management, commonly abbreviated as AUM. An account that is charged Assets Under Management is also referred to as a wealth management account, a wrap account, an investment advisor account, or simply an advisor account. With AUM, instead of charging per transaction, the brokerage firms tack on a yearly 1% or 2% wealth management fee. Do you remember the mutual fund F shares? These types of programs are being pushed by all the major full-service brokerage firms and many discount brokerage firms. There are several flavors of this program.

    Performance-Based Wealth Management

    The latest wrinkle to this method is the new performance-based wealth management program. With performance-based wealth management, you are only charged Assets Under Management investment service fees when your account advances past the previous quarterly total. Only pay your advisor when you make money! The advisor receives 10% to 20% of your earnings when you make money. The advisor receives nothing when you lose money or do not make anything. It is a variation of the way hedge funds charge their shareholders. These accounts are aggressively marketed to high-net worth investors.

    One San Diego-based firm that offers this model is Dunham & Associates. When the Global Financial Crisis of 2008 and 2009 hit, Dunham had to change their model somewhat since it took several years for most clients’ accounts to rise to the point they were before the collapse. Dunham altered their fee structure so they now charge much less when your account does not gain instead of charging nothing.

    Both the Assets Under Management and the performance-based wealth management models sound tempting to the potential investor. The investor pays no commissions and with the latter model, they pay no or very low fees if their account does not grow. However, the reality is that you have the potential to pay far, far more for your investment services using this method. For prudent, long-term investors who do not partake in excessive buying and selling of their investments, the Assets Under Management model will most likely be the most costliest of any option.

    Your Humble Author is an anachronism. Personally, I do not believe that these accounts are in the best interests of the clients. Prudent, long-term oriented investors will typically pay far more with the Assets Under Management model as opposed to just paying the traditional commissions. However, you will be hard pressed to find investment advisors that do not use these models. Several years ago, sitting at the table while attending an investment seminar, the topic of discussion turned to the commissions versus Assets Under Management models of charging clients. My contribution was, “I simply do not believe that the Assets Under Management model is in the best interests of the clients. Prudent, long-term oriented investors who do not engage in excessive trading are going to pay far more over the long term. I believe we are doing our clients a disservice.”

    A gentleman with perfectly quaffed hair and wearing a very expensive suit shot back with, “What are you worried about? You send them a bottle of wine on their birthdays, take them to the golf course and the steak house. They’ll love you!” I decided that it was time for me to cease any contributions to the conversation.

    As noted in the comment at the table above, the Assets Under Management model should be far more expensive for prudent, long-term oriented investors who do not engage in excessive trading. If you want to be a speculative trader and buy and sell frequently, then an Assets Under Management model might wind up being more cost effective for you. Of course, as we have done our best to impress upon you, successful frequent buying and selling of securities is difficult, at best, and downright impossible for the vast majority of us. It's not called The Loser's Game for nothing, ya' know! Thank you, Charlie Ellis!

    Anti-Brokerage Firms: Dividend Reinvestment Plans (DRIPs)

    Fed up with your broker? How about bypassing the middleman and going straight to the companies that you want to invest in? Many of the large, well-established companies offer a way for you to invest directly in their stocks via Dividend Reinvestment Plans, usually abbreviated as DRIPs. As we learned in chapter 3, Introduction to Stocks, some are totally free or very close. However, DRIPs are not perfect. How would you like having to sift through 18 different statements? Some cost-conscious brokerages such as InteractiveBrokers charge a monthly fee to allow you to keep all your DRIPs in one place. Many traditional brokerage firms also now offer DRIPs. Prudent, long-term, buy and hold investors should definitely consider the use of Dividend Reinvestment Plans. Remember: Dividends don’t lie!


    This page titled 18.1: Brokerages is shared under a CC BY-NC-SA 4.0 license and was authored, remixed, and/or curated by Frank Paiano.