With ETF management fees near zero, and online brokerage platforms now charging $0 trading commissions, one might wonder how the discount brokerage platforms can make any money. Well, most brokerage firms make money by selling order flow to high frequency trading (HFT) firms. (They also make money on the cash sitting in investor accounts, but this issue is easier to address. Just hold cash in a higher yielding money market fund, where the investor earns the interest, rather than the brokerage firm’s cash account, where the broker earns the interest.)
But getting back to the first issue, the sale order flow to HFTs sounds non-transparent and ripe for manipulation. How much does it cost an individual investor in trade execution? There is a lot more to trading costs than just the brokerage commission. I like to think of it using this formula:
Trading Costs = Portfolio Turnover x (Explicit Costs + Implicit Costs)
Explicit Costs are brokerage commissions. Implicit Costs are the bid-ask spread and market impact. The bid-ask spread is the difference between the price the buyer bids to buy and the seller asks to sell a stock. Market impact is the change in the market price of the stock an individual is trying to buy, based on the market’s knowledge of that individual’s order. This is what the HFTs are paying for: they want to know the orders first, so they can front-run purchases of the stock, drive up the price the individual investor will ultimately pay, and collect the difference. This warrants a longer conversation, but suffice it to say that all investors pay higher implicit trading costs due to the presence of HFTs.
For index funds, their implicit costs are even more interesting. Index funds trade, or “reconstitute”, only a few days per year to keep turnover low. But they all reconstitute on the same days, and they buy stocks at the market-on-close price. In other words, they don’t specify the price they want to pay. They submit orders to buy a certain number of shares at the market’s closing price, whatever that may be. How’s that sound as a trading strategy? I’ll only go to market two days per year, the same days as everyone else, and I’ll pay any price to buy the particular stocks that I need to buy. As a result, many brokers extract significant bid-ask spreads delivering shares to index funds on reconstitution days.
Some investment firms use a more sophisticated approach to minimizing trading costs. First, portfolio turnover has a multiplicative effect, so keeping fund turnover to a minimum is key in reducing all trading costs. Second, firms like Dimensional Funds submit millions of open orders per day on lots of stocks, providing liquidity to the market. Then they wait for other funds to fill those orders, which allows them to capture, rather than pay, the bid-ask spread. Third, they actually pay trading commissions to a few brokerage firms who will work with them to build custom trading algorithms, as they have determined this is more cost-effective than paying “$0 commissions” for less efficient execution. I like investing with firms who take such a thoughtful approach.