Be Wary of No-Fee Brokerage Services

Everyone loves a good underdog story.

With approximately 70% of the U.S. covered in snow right now, let's use a winter example: the 1980 men's U.S. hockey team. During the 1980 Winter Olympics at Lake Placid, the U.S. men's hockey team met the four-time defending gold medalist Soviet Union in the medal round. Against all odds, the U.S. team beat the Soviet Union 4-to-3 in a game now famously known as "Miracle on Ice." The U.S. then went on to win the gold medal by beating Finland in the finals.

More than 40 years later, and "Miracle on Ice" is still one of the most iconic moments in U.S. sports.

Unfortunately, 2020 didn't give us any significant "Cinderella stories," given that most sports were postponed or canceled for the better part of the year. Instead, most folks were left twiddling their thumbs at home during the global pandemic, but that ultimately opened the door for an unexpected comeback on Wall Street.

2020 marked the comeback of the retail investor.

Before the coronavirus outbreak and lockdown restrictions, the number of retail investors was dwindling. According to Piper Sandler, retail trades only accounted for about 13% of total trading share volume in December 2019. Fast forward a year, and that figure nearly doubled to 22.8%. Trading volume overall soared 55% in 2020 compared to 2019.[1]

The reality is that with limited forms of entertainment and stimulus checks burning a hole in their pockets, millions of individuals decided to try their hand in the stock market. Who wouldn't be tempted when you saw all of the broader indices rebounding impressively from the March 2020 lows despite the ongoing pandemic and economic fallout?

Enter the "no-fee" online brokerage platforms.

Most brokerage platforms, like E*trade, Charles Schwab, and TD Ameritrade, all experienced a boom in retail investors last year. However, the majority of the millennial crowd turned to Robinhood, which experienced a surge of three million new accounts in the first four months of 2020 alone. Robinhood attracted amateur investors with its "no-fee" trades, no account minimum, and simple trading platform.

But there's a lot of truth behind the saying, "There's no such thing as a free lunch."

Brokers like Robinhood often utilize a "payment for order flow" strategy. Simply put, the broker receives payment for executing the trade through a market maker. Typically, these payments are minuscule, fractions of a penny per share of the trade (e.g., a broker could receive $0.10 for 100 shares). But here's what's important to understand: market makers are often firms that offer the inventory of their shares to sellers and buyers. In other words, the trades aren't made on the stock exchange.

A few of the well-known market makers include Citadel Securities, Jane Street, Susquehanna, and UBS.

With the "payment for order flow" strategy, the individual investor certainly benefits from the slim-to-no transaction costs and no commission fees. The brokerage firm also benefits, as it's more cost-effective for it to direct the trades through a market maker that bundles them with thousands of other trades rather than executing the orders itself. And, of course, the brokerage firm also receives a payment from the market maker.

The latter benefit opens another can of worms. It's creating competition between the market makers to offer the best price improvement. As a result, the brokerage firm is more likely to turn to the market maker giving it the better payment, rather than selecting a market maker with the individual investor's best interest in mind. In other words, the individual investor may not be receiving the best price when the trade is executed.

For day traders or investors who purchase many shares per trade, this is undoubtedly a concern. Not receiving the best price can significantly impact their gains and/or losses in a stock. To address these concerns, the SEC now requires brokerage firms to reveal their arrangements with market makers to investors. But uncovering these reports on the broker's site isn't always the most straightforward feat.

If you're a long-term investor with a buy-and-hold strategy, the "payment for order flow" has a more limited impact on your holdings. Still, if you've considered utilizing one of the "no-fee" brokerage platforms, it's essential to understand the benefits and risks before placing your trades.

To learn more about "payment for order flow" and its impact on your investments, give us a call at Nicollet Investment Management today. We'd be happy to discuss how we execute our clients' trades and how we can help you reach your financial goals.

 Please click here for important disclosures.

[1] https://www.cnbc.com/2021/02/18/payment-for-order-flow-the-controversial-wall-street-practice-to-draw-scrutiny-at-robinhood-hearing.html