Let me start out by saying I am very cost conscious and frugal. I try to save any unnecessary dollar spent I can. It’s been embedded in my bones from a young age and its part of why I always knew finance was the right field for me. I think saving money is a great thing and the overall expense saving investors have realized in finance over the last few decades has been a hugely positive thing for investors. What used to be costly and only accessible to institutions or very wealthy people like buying the S&P 500, is now accessible by someone with some small change and a smart phone for close to free. These advancements and the rise of index funds and lower to zero commissions has been a great thing for investors but it has sparked a whole cult group of wanting everything in finance to be free.
It doesn’t take long to find a sleuth of evidence showing how important and impactful fees are on investor returns. Index funds have grown at a breakneck pace due to the proof in the putting that most active managers under-perform their benchmarks net of fees. The hedge fund 2 and 20 fee model is coming under pressure for the same reason. It’s this mounting evidence that has ignited fee compression in the entire industry of finance rock bottom expense ratios, cheaper financial advice, free commissions, tighter bid ask spreads, and more. However, the mindless chase for lower fees has some hidden drawbacks.
Rock bottom financial advice
Robo-advisors, bill by the hour, and other fee arrangements have made financial advice more accessible to a wider audience. Having access to some professional financial advice is better than no financial advice but how about the audience of people that already had access to begin with? This is were I’d like to defer to one of my favorite quotes of all time “price is what you pay value is what you get” – Warren Buffett. Just because you pay more for advice doesn’t make the advice better advice but you are likely to get more service when someone has more skin in the game. Buffett is an extremely cost-conscious person, one of his biggest holdings is also Coca Cola. The CEO of Coca Cola James Quincy got paid over $18,000,000 last year. Why doesn’t he vote his shares to try and pay the CEO $1,000,000 instead? If someone is skilled at their craft and they are underpaid relative to the field chances are you aren’t going to retain that talent. The other thing is compensation and the size of a problem tend to be correlated, bigger problems bigger pay. A CEO of a local restaurant chain may have to sign off on financials manage the direction of the company and do a lot of the same things James Quincy has to do but he isn’t getting paid $18,000,000. If the two CEO’s make the same mistake, the mistake may be the same but the size and scale are vastly different.
Say we compare a $5,000,000 to a $100,000 investment portfolio. The cost is going to be substantially more for managing the larger portfolio. Just like Coca Cola bigger problems and more at stake is correlated to higher costs, not necessarily because the function being that different. An investor may find flat fee advice that is the same cost on both portfolios, but if someone is getting paid the same on both portfolios what is their incentive of treating the two clients any different? This links back to Coca Cola if you want to attract top talent and a higher degree of service you have to expect to pay more.
Robinhood and the zero-commission movement
Most brokerage firms were already charging single digit or low double digit commissions for placing stock trades before Robinhood came on the scene. Robinhood came on and attracted a new wave of young investors due to being the first no commission broker and it had a convenient user-friendly phone app to trade stocks. It didn’t take long for Robinhood to explode in account openings because who doesn’t love free?! Saving commissions is great but Robinhood has not been without its challenges as the company still needs to make money. Selling trade order flow to other brokers is common practice though questionable. Robinhood makes the most profit on selling the order flow of option trades it’s no wonder the phone app a “free service” has made it as easy as possible for unfamiliar investors trading things they should not be involved in. Multiple glitches later a massive trade outage during the pandemic, a fine for hundreds of thousands of trades not at best trade execution, a glitch allowing investors unlimited leverage, not true FDIC insurance, and an investor suicide from losing money in options something they didn’t understand. Saying Robinhood has had some growing pains is an understatement. Saving the $5 for a trade is great and Robinhood pushed the rest of brokers to lower commissions but investors have paid the price in other less transparent areas.
Zero expense ratio mutual funds
Vanguard started the razor thin expense ratio movement with their funds and you don’t have to look far to see investors have loved it. Vanguard manages over $6 trillion in assets today and has grown it’s assets faster than any money manager. The index movement has been so powerful it even spawned the new term Boglehead investors named after John Bogle in the finance lexicon meaning slang for an individual that is a passive investor hunting for low fees. Fidelity took it a step further to outdo Vanguard and launched their zero expense mutual funds, that’s right zero! Isn’t that better right? I think this is where many investors get short sighted, having a lower expense ratio of .03% is great but at that point you need to look at every other detail affecting performance. Are the tracking errors the same or a wider margin, how and what does the mutual fund do with securities lending proceeds, trade execution, what is the average capital gains distribution. All these factors can affect performance more than the expense ratio but investors obsess instead over the .03% they are saving.
Free markets tend to drive costs down through time, just look at computers. However, businesses remain in business for profit. Just as most people wouldn’t show up to work if they didn’t get paid, businesses wouldn’t open their doors either. So when your getting stuff for next to free in the race to zero you have to ask yourself a few questions either the business is unsustainable and going to go out of business, you’re not going to get a very good product or service, or they are using other ways to make money from you that you may not be aware of. After all, there is no such thing as a free lunch.
