Online Trading: Watch Out for Hidden Costs

Brokers are adding fees, but also offering more advice

When is a $29.95 brokerage trading commission not really $29.95? When you trade online at Charles Schwab (SCH ). In March, the San Francisco-based broker tacked on a $3 "order-handling fee" for all stock trades, effectively raising its $29.95-per-trade commission to $32.95. Yet in the "Schwab commissions" section of its Web site, the firm still advertises the old commission rate, mentioning the handling fee in a footnote but not saying how much it is.

If the bear market has sidelined you or you're trading online for the first time, you may experience a case of sticker shock. The online brokers have suffered mightily, and many who were in business two years ago are no longer here. With online trading volume down 50% or more from the bull-market highs, the Web brokers that remain are remodeling their businesses, adding more investment products and advice. They're also slapping customers with additional fees, and some are raising commission costs as well.

So investors shopping for an online broker need to be more discriminating than ever. Before you choose, ask yourself some questions: How frequently will you trade, and how much money do you have to invest? Are you more interested in mutual funds? Does financial advice matter more to you than trading fees? Your answers will determine which online broker is best for you (table).

If you haven't traded online in awhile, you may have already discovered the much-loathed--at least on investor message boards--"inactivity fee." The terms vary by broker, but the fee is levied on accounts that trade infrequently. Ameritrade's $15-a-quarter inactivity fee hits clients who don't trade at least four times every six months. "There is a cost to take care of brokerage clients who are not doing enough business with you," says Joe Moglia, Ameritrade's CEO. "We're happy to have those clients, but we don't want to pay for them out of our own pocket."

Online Trading: Watch Out for Hidden Costs
You can usually avoid these fees if you have enough money invested with the firm. Brokers can profit from a large account even if it's inactive, because they collect a percentage of the management fees in the mutual funds and money-market accounts the client owns. As a rule, the higher a firm's overhead costs are per account, the more money it will require to avoid the inactivity fees. At brokers with a lot of bells and whistles, the bar is set fairly high. Schwab, for instance, charges $30 a quarter for accounts with less than $50,000, while at Ameritrade (AMTD ), clients need only $2,000 to avoid the fee.

While brokers are now penalizing inactive investors, they have been rewarding active ones with cheaper trades. Last August, TD Waterhouse split its customers into tiers: Choice, Premier, and Premier Select. Choice customers, who trade less than 18 times per quarter, saw their commission jump from $12 to $14.95. There was no hike for Select customers, who make from 18 to 36 trades. Premier Select clients, who trade 37 or more times, pay only $9.95. "Previously, our active customers were carrying the costs for the inactive ones," says Stuart Rubinstein, a marketing vice-president at TD Waterhouse. "This pricing system is fairer."

Of course, cost isn't everything. One of the perks of going with a pricier firm such as Schwab, Quick & Reilly, E*Trade (ET ), or Fidelity is that they offer personalized advice. Advice at full-service firms such as Merrill Lynch (MER ) is not available to online-only clients. All will give you a quick portfolio review for free. Getting more detailed advice costs more. Schwab's 430 U.S. branches can give you a financial plan, analyzing your asset allocation based on your investment goals. Costs range from $250 to $500, depending on your portfolio size.

Fidelity has cracked the advice nut in a different fashion. The firm offers a comprehensive online tool called PortfolioPlanner, which aggregates the information for all your financial accounts, even non-Fidelity ones, and helps you design an asset-allocation plan based on a risk questionnaire. That's free online or at Fidelity branches. If you don't want to manage your account, you can sign up for Portfolio Advisory Services for an annual fee of 1.1% of assets.

Breadth of product is also a key consideration for some investors when choosing an online broker. The lowest-cost brokers--BrokerageAmerica, Brown & Co., Interactive Brokers--offer a limited product base: stocks and options and sometimes mutual funds and bonds. But at most of the bigger firms you can also buy annuities, initial public offerings, and privately managed accounts. At E*Trade, for instance, you can invest in a managed account, which is customized to your specific investing needs, for a fee of 1.5% of assets. That's significantly lower than the 1.89% average fee for managed accounts. Schwab and Fidelity offer no-load annuities with below-average fees.

Although no broker offers everything, Scottrade seems to have a good balance between cost, products, and service. It charges only $7 for a stock trade, and there's no transaction fee for some 1,738 no-load mutual funds, including those run by some low-cost companies such as Vanguard and T. Rowe Price, which normally don't participate in no-transaction-fee programs. In addition, Scottrade levies no inactivity fees and has no plans to add them, says Bruce Morton, the company's marketing director. You can get help with a trade and other information on the phone or at one of 185 walk-in offices, but Scottrade does not offer financial advice.

If you really want to get the full-service broker treatment at a bargain basement price, a smart strategy is to invest with more than one broker. "Many of our clients have two accounts," says Andrew Sycoff, CEO of BrokerageAmerica, which only charges $5 per trade. "They get their advice from another broker but trade with us." Setting up an account with BrokerageAmerica requires a minimum investment of $1,000 so it is easy to maintain, especially since the firm charges no inactivity fees. And if you place an order for more than 1,000 shares of a stock, you don't pay a commission.

The reason BrokerageAmerica can charge nothing for big orders is an important cost consideration in itself. Many brokers not only profit from the transaction fee on a trade but also from the spread between the buying or "bid" price for a stock and its selling or "ask" price. They can do this by acting as a marketmaker. So if a stock's bid is $10 and the ask is $10.10, the firm can profit by selling the stock to a buyer for a few cents more than the midpoint between these two prices, $10.05, and buying it from the seller for a few cents less than that midpoint. The difference in execution costs between brokers generally amounts to a few pennies per share, but on a big order they add up.

The narrower the spread, the lower the execution cost will be for the investor. Using software provided by Transaction Auditing Group (TAG), a Northport (N.Y.) company that analyzes brokerage execution, we looked at trades of 100 to 500 shares on Nasdaq 100 stocks for March, 2002. We found Merrill Lynch offered the best execution. Its spreads were 84.1% of the widest quoted spread. Fidelity was a close second at 84.3%. Schwab at 93.4%, Morgan Stanley at 94.9%, and BrokerageAmerica at 98.8% were not as good.

Some brokers are not marketmakers but send orders to outside firms to be executed. About half of the Nasdaq stock orders at Scottrade and Ameritrade, for instance, go to Knight Securities, where the spread is 91.1%. At most online brokers, you do not get a choice as to which marketmaker fills your order. One significant exception is Interactive Brokers, which has a trading system that allows you to compare prices for stocks at different marketmakers and send your order to the one with the best price. With $1-per-trade transaction fee, this firm offers the best deal for the cost-conscious.

Yet Interactive Brokers offers only stocks, futures, and options trading, and provides no advice and very little human interaction. Moreover, to receive the data feeds for the marketmakers, you have to pay the firm a $10 monthly fee.

As with every online broker, there's always a tradeoff. So you have to decide which features are most important to you and choose the broker that best fits the bill.

By Lewis Braham

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