Online Brokers: Do You Get What You Pay For?
Those TV commercials and print ads for Internet stockbrokers are enough to make a bargain-minded investor do a double-take. Stock trades for $7! No commission for trades of more than 1,000 shares of any NASDAQ stock! Wow, where do I sign up?
Before you fire your previous broker, you might ask a few questions: Can I really get good service for less than my stockbroker spends on cigars? The answer: It depends. If you're a savvy investor who chooses your own stocks, bonds, and mutual funds, then switching to an E-broker can generate tremendous savings over what you've been paying a traditional discounter, let alone one of the big Wall Street firms that prefer to deal face to face. As brokers work hard to expand their online product lines, odds are you'll get even more for your money. While online brokers once dealt only in stocks and a few mutual funds, established discounters, including the likes of Charles Schwab, Quick & Reilly, and Jack White have since significantly broadened their online offerings to include bonds, American Depositary Receipts, options, and even initial public offerings.
But online trading isn't for everyone, particularly anyone who enjoys the hand-holding a pro can provide. Even if you do sign on with a cyberbroker, be prepared to suffer through glitches and growing pains. Behind the brokers' cheap commissions are plenty of hidden fees, periodic service outages, spotty phone support, and, in some cases, clunky sites that make it difficult to confirm if, when, and at what price a trade went through.
If you're a bargain-lover like me--my wife, Lisa, and I have online accounts at Ameritrade and Schwab--those are acceptable trade-offs for commissions that have fallen by half over the past year and now average about $16. Industry insiders say a trade costs an online broker about $5, leaving plenty of room for profit. And like their traditional brethren, E-brokers earn another $5 to $10 on some NASDAQ stock trades from "payment for order flow"--a legal kickback for steering your transaction to a market maker. Since the average online investor tends to be a risk-taker, some brokers supplement their income with margin lending at a nice markup. For loans less than $5,000, Quick & Reilly's margin rate is two percentage points above the benchmark broker call rate, which is currently 7.25%. Still, even here, there are bargains. Lindner.FarSight's rate is a half-point below call.
To keep costs down, a number of cut-rate cybersites charge extra for customer service that many brokers used to provide as a courtesy. If you want to transfer a foreign security into your account at Howe Barnes Investment's Net Investor service, that'll cost you $75. When I mislaid a couple of trade confirmation slips last January while preparing my taxes, I called Ameritrade for help. My old $35-a-trade discount brokers at Waterhouse were always willing to look up the missing data while I waited. But Ameritrade's service rep told me it had a $60-an-hour research fee, plus $5 for every trade slip I want mailed to me. Michael Anderson, president of Ameritrade, says the firm will provide one confirmation for free. But "given our focus on being efficient, to have to stop to pull up somebody's records--we'll charge for that."
The moral: Inquire about a firm's fee schedule, which can usually be unearthed from deep within its Web site. I ended up digging those old confirmations out of my own files.
Commissions aside, full-service brokers have justified their steep fees not just for their advice, but also for their ability to "work" trades of small-cap stocks by finding a market maker willing to buy or sell a stock between the bid-ask spread. Savings on such trades, they argued, could more than justify the difference in commissions. No more. Regulatory reforms have improved the odds that you'll get just as good an execution through an E-broker--or any other discounter--as through a full-service firm like Merrill Lynch. Already, spreads on NASDAQ stocks have fallen by an average of 30% over the past 18 months. The prospect of a shift in coming years from fractional to decimal-based price quotes could cut costs even further.
Thanks to the reforms, trading experts now say that any investor who places a "limit order" specifying a set price between the bid-ask spread is far more likely to have it filled. "As long as you're able to enter a limit order, it shouldn't matter whether you trade through an online or a full-service broker," says University of Chicago Visiting Associate Professor Paul Schultz, whose research led to many of the NASDAQ reforms.
But with customer rolls growing so rapidly, E-brokers admit it's hard to stay ahead of demand. Ameritrade attracted 73,000 new customers in the first quarter alone. Says President Anderson: "It's all I can do to write purchase orders for enough new servers." Still, online trading can be a risky proposition for options fans and anyone else needing 100% reliability. "The online industry has been cursed with success," says consultant Julio Gomez, whose Gomez Advisors (http://www.score card.com) rates online brokers. Gomez' current top three favorites: DLJDirect, E*Trade, and Waterhouse.
Indeed, E-brokers fall short on reliability. Despite their claims that you can trade around-the-clock and from anywhere, most online brokers have been unable to keep up with demand on volatile days like last Oct. 27, when the Dow Jones industrial average plummeted 554 points and trading volume on the New York Stock Exchange exploded. While E*Trade, Schwab, and other brokers claim they were able to process every order that got through, they concede that thousands of customers couldn't get through--they were unable to log on or even get someone to answer the phone. The outages persist: Schwab was down for as long as four hours on Apr. 20, and Fidelity Investment's online system failed briefly after the Dow broke 9,000 for the first time on Apr. 3.
Most large brokers have responded to these glitches by dramatically boosting their ability to handle new business. Ameritrade has tripled its capacity recently, and some, including Discover Direct and E*Trade, are installing "fault-tolerant" systems that are better equipped to juggle demand if a single server fails. Waterhouse has gone one step further. It disconnects visitors to its Web site after 10 minutes of inactivity, freeing up the site for other customers.
For all its growing pains, Internet trading is likely to be the wave of the future. Already, E-brokers are working feverishly to steal as many of the full-service brokers' remaining advantages as possible. DLJDirect, Schwab, and E*Trade have started letting selected big customers in on initial public offerings that were once accessible only through full-service brokers. E*Trade says it will soon roll out electronic bill payment and debit cards--a move that may be intended to strengthen financial ties to customers and dissuade them from bolting for a cheaper commission.
The next frontier is Wall Street's most cherished possession--its original research on stocks and other instruments. E*Trade has begun providing, on a limited basis, some research from BancAmerica Robertson Stephens, and DLJdirect customers with large accounts can get proprietary DLJ research previously reserved for full-service clients--for a fee.
24-HOUR MATCHING. E-brokerage executives boldly predict that in the future they'll keep revolutionizing trading--slowly cutting out not just traditional brokers but market makers and other middlemen with automated matching services that operate around the clock. "A major transition is under way," says Jack White, founder of the online brokerage firm of the same name. Last fall, Jack White launched a service that lets prospective buyers and sellers of shares in small companies around San Diego--the broker's headquarters--name the price they'll accept. Once a day, the firm's software sweeps through and executes matches for a mere $5, saving both parties money. Given the investing public's love affair with online trading, such innovations are threatening to turn full-service brokers into a thing of the past.