What Free Trading Costs

STOCKS OF RIVAL ONLINE BROKERS WENT INTO a tailspin recently, after Bank of America announced that it would offer commission-free trading through Banc of America Investment Services to customers with more than $25,000 in bank deposits. The shares have rebounded, but their dramatic reaction suggests that this might be an offer many electronic investors and traders would jump at. But are free trades a free lunch?

Now available in 18 states, including New York, New Jersey and Florida, the offer from Bank of America (ticker: BAC) is open to banking customers with combined balances of $25,000 or more in their checking, savings, CD and FDIC-insured IRA accounts. Those who qualify are entitled to 30 free equity trades a month—but still pay the usual fees for mutual funds, options and other transactions. BofA will roll the offer out in phases nationwide by the end of the first quarter of 2007.

BofA (http://www.bankofamerica.com) is definitely the biggest but certainly not the only recent price-cutter. A new brokerage service, Zecco (http://www.zecco.com), opened its virtual doors on Oct. 9, trumpeting no-tier zero-commission trades. (The tiny broker cheekily took credit for prompting Bank of America’s offer.) And SogoInvest (www.sogoinvest.com) entered the market in July, touting $3 trades. The rough industrywide average right now is about $10 a trade, with lots of variation, based on volume, frequency, creditworthiness and account size. Other brokers say they don’t plan to cut commissions.

Cheap trades, although attention-getting, aren’t new—remember FreeTrade and Brokerage America? What gets lost in the hullabaloo about free trades is that there are many components to the costs of investing; commissions are just one piece.

When we compile Barron’s rankings of online brokers every March, we certainly factor in stock commissions as part of our “Cost” ranking. But we also evaluate options, mutual-fund and bond-trading commissions and look at rates paid for cash kept in accounts, as well as what customers have to pay to buy shares on margin.

Drilling down into the Zecco offer, for instance, we find that customers receive 1% interest—on any cash balance—on the low side. And BofA pays just 0.35% on balances under $10,000, and about 1.5% on amounts between $25,000 and $50,000. Even Interactive Brokers (www.interactivebrokers.com), which has kept trading costs low for its customers for years, pays upward of 4% on cash balances at present. (The exact formula depends on how much cash is held in an account.)

The bank, of course, hopes to win over new customers and persuade existing ones to put more in their accounts. In a statement, Liam McGee, president, Bank of America Global Consumer & Small Business Banking, says: “Customers appreciate the simplicity and convenience of using a single, trusted financial institution for all their banking and investment needs, and are motivated by the preferred pricing and other rewards it can bring.” A BofA spokesman says it’s much too early to assess customer response, but “there seems to be a great deal of appetite.”

Free trading can be useful for certain investors. If you’ve got a small brokerage account and trade in small blocks, say 100 or 200 shares at a time, you might come out ahead by paying no commission, even if you give up some execution quality. On the other hand, free commissions may not be a huge priority to investors and traders putting up wads of money. Says Muriel Siebert, president of online brokerage Siebertnet.com: “I don’t think the cheap brokers are the best overall value if you’re trading in large quantities.”

She emphasizes that people with large accounts have to look at the entire suite of a broker’s offerings, including the quality of customer service and what they’re paying on cash. “A few service niceties, low margin rates, decent returns on cash and whether they sweep your cash to a money market every day—that’s what will change an investor’s return,” Siebert states. Features like sophisticated trading tools and the system’s operability may also be important to these clients.

Steve Sanders, managing director, business development at Interactive Brokers, says, “No brokerage is in business for charity. They have to make their money somewhere.” For instance, you’ll find Google-generated ads all over Zecco.com. Sanders says, “That wouldn’t be the worst thing in the world to deal with if you’re only doing a few trades per year.”

This is not to suggest that the inexpensive brokers mentioned here are doing this—but dealers can find ways to pad their revenues by not offering the best execution, says Sanders. “A cheap broker might be slower with routing, and might route orders to get payment for order flow,” he says. In other words, the broker can get paid to send the order to a particular market maker or exchange, even if it doesn’t necessarily offer the best prices.

Sanders also points out that brokers make a lot of money on the cash in your account and can charge you much higher margin fees to make up for not charging commissions. He concludes, “I think [free trades] are more applicable to the novice sector of the brokerage space.”

There is, in other words, no such thing as a free trade.

Posted by on 11/25 at 09:54 AM

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