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It’s all over the news – US broker firms are offering removing fees for trading. Interactive Brokers then Charles Schwab then TD Ameritrade – as the broker war escalates, they are all dropping fees to survive and their share price is taking a beating.
If you didn’t notice at all, that may be a good thing – following the financial new too closely usually makes you tempted to change your investments based on what the market is doing. Nearly everyone doing that will lose out over the long term. Just keep putting your money in month after month and you will beat everyone sweating over the Financial Times.
How can these companies offer free trading? It’s part of trend in declining fees that’s been rolling for a while now. There’s plenty of new upstart broker firms that have been offering zero-fee trading as a way to lure investors over to their platform.
It’s not just trading. Some index funds are becoming free by dropping their management charges and robo-advisors become free by dropping their platform fees.
How brokers make money from you
So how do they survive? Should we start expecting free Cokes and Teslas? Is profit so 2018? Surprisingly, these brokers make more money in other, subtler ways. They are removing the fees that cause investors the most obvious pain and which investors use to choose a broker or fund. That’s not going to help them though, because all the other brokers have gone free almost overnight.
Brokers make money from your cash deposits – you put some cash in your broker account and they charge you a poor rate of interest while you figure out how to invest it. Then they lend it out to others for a higher interest. Charles Schwab makes 57% of its revenue from doing this, so it doesn’t care about trading fees! 57% of revenue from something you barely notice – that’s a good business model.
Sometimes robo-advisors will robo-decide that you need to keep part of your portfolio in cash to reduce risk, especially if they feel a downturn is coming. Or if they make their money from lending your cash out! You’ve been warned.
The brokers have some other ways to squeeze money out of their platform. Some companies pay to get access to your orders and sell to you what you want to buy. This keeps the price differences between buy and sell fairly tight by inviting in willing buyers and sellers, so is probably no bad thing for us.
Brokers also hope that once they’ve lured you in, you might still generate some fees for them. They may lend you money ‘on margin’ to invest in shares, charging you interest. They may lend your shares out to others, keeping some of the profit and sharing the rest with you. And you might be tempted to invest in non-free mutual funds or start trading complex options, which will more than offset the loss they make from your free share trading.
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So is your trading going to be free?
This fee slashing is great for American customers but not so much for you. American residents can happily buy and sell US-listed shares and US-domiciled (i.e. where the registered office of the fund sits) funds.
If you are not a US citizen or resident, then you should not be buying US-domiciled funds, Exchange-Traded Funds (ETFs) or (many) stocks from US stock exchanges like the NYSE. You need to find UCITS ETFs that are domiciled in Ireland and listed on the London Stock Exchange (LSE) or other European exchanges.
Then you will pay half the withholding tax on dividends that US-domiciled funds are charged (15% vs 30%). And, most importantly, your beneficiaries won’t get slapped with a 40% estate tax on your US-domiciled cash, shares and funds worth over $60,000 when you die. With Irish-domiciled funds, there’s no estate tax at all.
The other problem is that there are very few brokers globally that can be bothered to accept expats, due to tough anti-money laundering regulations. So if you see an offer for free trading, it’s likely they won’t accept expats or it’ll be for US-listed shares and funds only.
I’ll let you know if that ever changes. The LSE charges a stamp duty tax on share trades though, so trading is unlikely ever to be free while the tax is still around. But hey, we are still getting very cheap trading, and it’s insanely cheap compared to the monster fees you will get slapped with if you are stuck in a long-term savings plan or insurance plan with a savings component.
The fees for buying and holding an Irish-domiciled ETFs are like a pesky mosquito compared to the shark-like savings plan fees that are eating literally half your body.
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