Here’s an educational post on How Discount Brokerages Make Money by Patrick McKenzie. It seems reasonable that a DIY investor understand these sources of revenue at a basic level: net interest, commissions, asset management fees, wealth management fees, securities lending, and payment for order flow.
For me, the biggest takeaway is that brokers make a lot more money quietly shorting you on cash interest than upfront from the big-banner-ad commission fees. Did you know that only 7% of Schwab’s revenue comes from commission? Meanwhile, a whopping 57% of Schwab’s revenue comes from net interest, which is the spread between what they earn on cash and what they pay you. E-Trade, 67%. TD Ameritrade, 51%. See you Are You Quietly Losing Money via Your Brokerage Cash Sweep Account?
I’ve mentioned this before, most recently in my Schwab Intelligent Portfolios review. Schwab makes a ton of money on your idle cash, and it is NOT an accident that they force you to own cash in their automated portfolios.
Right now, Schwab only pays you a sad 0.26% APY on your cash sweep. Both you and Schwab can earn much more than that elsewhere with essentially no risk, which leads to an interesting observation from the article:
Brokerage customers keep ~10% of their assets in cash. The 200 basis point spread between cash in brokerage accounts and money market funds or insured bank accounts, all of which are functionally riskless, is equivalent to a 20 bps asset management fee across the portfolio.
This is an important perspective. It’s one thing to pay a robo-advisor like Wealthfront or Betterment 0.25% annually and get some value out of it, and it’s another to effectively pay 0.20% for absolutely nothing. Add in your stock commissions, and you might even be paying more than a robo-advisor. If you keep a big balance in a bad cash sweep, you should really zap it into a top-yielding cash equivalent or buy a short-term Treasury Bill within that brokerage account. These days it’s all just a matter of clicks.
If that’s too much trouble every month, consider automatic dividend reinvestment or a one-time move to a broker with better cash sweep. My idle cash at Vanguard is in the Vanguard Federal Money Market Fund earning 2.29% with zero effort. At the very minimum, you should be aware of this hidden cost and acknowledge that it’s part of what you’re paying every month.
(A second takeaway is that the author believes that Robinhood gets more money for payment flow than other major brokers because they have a higher percentage of options trades than other brokers, and options order flow is more valuable than regular equity trades.)
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Of course, you can just lower your effective rate by not keeping much cash there, right?
If you’ve got $100k total and only $1k in cash, then you’re only paying 2 basis points, right?
I suppose if you’re actively trading and want to keep cash there, then yeah, you have to consider the opportunity cost of your cash earning such a low rate.
Yes, the main point is as a heads up to the investors who don’t know about these silent tactics. They are avoidable, but only if you know they exist.
Its interesting where they make the most money from. I never would have guessed that. I invest through a credit union, but then I keep minimal cash balances, so it’s not an issue. If we ever decide to consider using an advisor, now we have another question to ask. I am not sure I will want to keep doing the job myself, and at the same time, I am not sure I will ever fully trust anyone else to do it.
Thanks for bringing this to front of mind Jonathan. Two points:
1. Schwab still offers money markets yielding 2%+. When you combine their money market funds with their Investor checking account, IMHO, that is a good value proposition.
2. I agree that the cash inside of Intelligent Portfolios really should be SWVXX or something similar. So their “free” service is actually costing an investor about 20bps annually due to the difference in yield. That 20 basis points hidden fee is still less than many competitors.
Both good points. But also two things that the average retail investor stumbling upon Schwab’s offerings would not know about. Schwab will quietly take away money from #1 before they read something like your comment or this post and know better. At the same time, it will quietly attract new clients with #2 who see “FREE”.
Schwab won’t ruin your life, but I’d rather they just charge me upfront. Such tactics keep it from being the place where I would tell my parents or children to keep their hard-earned money. Vanguard is still that place, at least for now.
Very good advice. I closed my Schwab accounts and have Merrill Edge automatically transfer income out to credit union, because they changed their sweep funds. To my knowledge, Vanguard and Fidelity are only ones with good rates on sweep funds. Do you know of any other?
Don’t overlook the interest they earn on margin investors — 5.75% to 8.4% at Fidelity, for example. The interest alone drove me away from margin investing.
“The interest alone drove me away from margin investing”
I can’t resist observing that this is an amusing way to put it — it’s like saying “the interest alone drove me away from getting a mortgage”. Margin investing IS interest — that’s the downside of leverage.
I think we’ve all seen the consequences, usually bad, of the race to the bottom, where profits and and margins become non-existent. Whether its Schwab, Fidelity, Vanguard or whoever….I appreciate the online resources, 24 hour customer service, stability and security of knowing I’m dealing with a viable enterprise. They have to make money somewhere. This seems like a small price to pay for the benefits we receive….assuming of course you are aware that you are paying them (or smart enough not to).
Any thoughts on Wealthfront’s cash account? They advertise 2.57% APY with no fees.
Oh boy. Do tell them about security lending.
I was using Betterment as a trial for a handful of years, as well as investing on my own. Somewhere along the line, Betterment stopped giving me a return on my money and started using a weighted average return.
During the trial, I contributed monthly to my account. I was somewhat aggressive with a 70/30 split. I noticed two things… I never really seemed to get anywhere. My brokerage and my own investments always outperformed whatever I invested in the roboadvisor. I suspected my fees were eating away at my returns. Also my returns, which in the latter years weren’t transparently reported, were lower than I realized. Using Personal Capital to track my roboadvisor was an eye-opener. My returns were lower than I thought. Also I noticed Betterment changed my investments a couple of occasions, and towards the end, there were some better options, but by then I had already made the decision to terminate. The one area I wish I could have changed, is they had me heavily invested in international. You really don’t have a choice, and that’s the point. In the end, I concluded it wasn’t worth it for me.
Every anecdote is valuable and everyone of course has to make their own decisions based on their experiences and priorities.
However I’d caution against overgeneralizing your experience — in particular, International equities have indeed done very poorly in recent years, in comparison to US. However this hasn’t always been the case, and I don’t believe it will be the situation forevermore going forward, either.
During some periods, one set of asset classes does relatively better, while during other periods other sets of asset classes will reign. One is, with good reason, generally advised against chasing recent performance. I know right now it can appear as though one is a fool to invest in anything but US stocks (and tech stocks in particular), and any investments in that arena will have outperformed recently. I wouldn’t make that all-in bet for the next decade, though, personally.
Which is all a roundabout way of saying that maybe your roboadvisor account was suffering in the short term due to its diversification, but that this strategy (whether you employ it via roboadvisor, or other means), will likely outperform in the long term.