Welcome to Market Insights from Southwest Investments. Joining me today, Bart Schannep. Bart, welcome to the show.
Bart: Thank you. Good morning.
Rick: I was going to take you out to lunch and buy you lunch.
Bart: Wow. That’s going to be rare, okay.
Rick: It’s free to you, right?
Bart: No. That probably means you want something.
Rick: There you go. There’s no such thing as a free lunch, right?
Bart: No. There is no such thing as a free lunch.
Rick: However, in the news we’ve got Morgan Stanley. We’ve got these bigger behemoths, if we want to call it that, are buying up free online trading companies.
Rick: What’s going on with that? Like we said, there’s no free lunch.
Bart: That’s right.
Rick: Where are they getting the money?
Bart: Alright. I’m referencing an article. The E-Trade deal reveals the new rules of the investing game. This was in the Wall Street Journal, the Saturday/Sunday edition, February 22nd. What we saw recently was that E-Trade was recently purchased by Morgan Stanley. Now, E-Trade is one of the firms that highlights free online trading. Okay. If there’s no such thing as free, then how is it they’re offering that?
Well, it’s all about trying to gather your assets. E-Trade does offer free online trading. There are some restrictions, but basically it’s free to anybody. How do they afford that? How is that possible? Well, they hide their income. Their income is soaring. By what means? Well, primarily one is money market. Any time you leave excess cash in the account, it sweeps into their money market. Well, their money market only pays between one hundredth of one percent.
Rick: That’s 0.00.
Bart: Well, it’s 0.01 percent.
Rick: Percent, right.
Bart: Right. Up to a quarter of one percent depending on how much you have in it.
Rick: That’s less than a bank.
Rick: Right now a bank, and we’ve always told clients that we’ve spoken to that usually you only want to put very, very short-term money into your bank. Let’s invest in maybe a little bit higher performing.
Bart: Right. You have standard money markets currently paying around one and a quarter percent. You have high-yield money markets paying two percent. Okay. Well, E-Trade is putting their money at two percent and giving you a quarter of one percent. They’re keeping the difference.
Rick: That would make up a little bit of the money that they’re…
Bart: Wait, there’s more.
Bart: The other thing they’re doing, and it’s not just them. Schwab does the same. Other firms are doing the same. That is that they are making their investment recommendations in their own proprietary funds, mutual funds that they own and run. Think in terms of Vanguard. ETFs that they own and run and other investments that they’re in fact creating where they are able to collect the fees that normally would go to an outside provider.
Rick: The trading fees and their management fees.
Bart: The trading fees and the management fees, exactly. That doesn’t mean all house brands are bad. No, some could be perfectly good performers, but the reality is are you getting the house brand because it’s the best or because that’s how they get paid? The worst offender, and this is somewhat new on the market, structured notes. Let’s talk about structured notes.
Rick: Are we going to get into my favorite thing, annuities, as well? Is that…
Bart: A lot of annuities use the same philosophy. It’s all based on what’s termed structured notes, meaning you’re not really investing in a stock or a bond.
Bart: You’re investing in a derivative thereof.
Bart: That’s what you own, a derivative thereof.
Rick: Which means you don’t have it.
Bart: You don’t really have it.
Bart: You just have the promise of what it will/will not do. That promise is only backed by the issuer of that, but the issuer, generally it’s a bank. The issuer gets to collect upfront fees of anywhere from one to four and a half percent. Plus, because it’s a complicated…
Rick: Four percent? That’s a good return just right there.
Bart: They collect, not you.
Rick: Oh, they are getting it. They’re getting it.
Bart: Your dollar just went to 96 cents.
Bart: On top of that…
Rick: You mean if I put in $1,000 I’m not getting $1,000 from my investment?
Bart: On paper it looks like 1,000, but no. They’re collecting anywhere from one to four and a half percent.
Rick: Got it, okay.
Bart: On top of that, because it’s so complicated, they then also in their fees charge you to price it. The pricing, the promise.
Rick: I already know what the price is. I just paid it—
Bart: No, you know what you invested in. Yes, but it goes up and down, but only they know that because it doesn’t trade on the market. They get a fee for calculating that. Now, if you want out early, well, now that is going to cost you.
Rick: You need to be in for a certain amount of time.
Bart: Certain amount of time.
Rick: That’s given upfront and you know how much.
Bart: Then at the… It’s a fee to get out early. Then when it’s time to get out, nothing actually really matured. They then create the market of what the get-out price is.
Rick: What is it based on?
Bart: Their promise to pay. Their promise to pay. When you hear the term ‘structured notes’ and the general theme is you participate in the market up to a certain level. If the market goes down, you’re protected to a certain level, but really, how is that possible?
Only by people using, companies using derivatives, putting it together and possibly selling or leveraging some of those same underlying investments in other products. The same investment might be utilized in multiple products at the same time, betting up or betting down. Who’s collecting the fee on that? Not you.
Rick: Got it. It is similar to what I was talking about my other favorite product being annuities that it’s very complicated. There are a lot of things going on at once. It’s difficult to explain to the actual end client what they’re actually getting.
Rick: There are a lot of promises being made as far as what they’re going to get, but it is only a promise.
Bart: The big fear is if things go bad, if things go really bad, how good is the promise?
Rick: I guess that’s the risk that they’re taking. Well, thank you so much, Bart. I appreciate you explaining to us a little bit about those zero-commission trades that we’re all hearing about in the news all the time. Thank you for joining us.