A major issue in the press in the last few years has been "Can you trust you're broker?" which was Business Week's cover story on 2/20/95. The issue revolves around full commission brokers' compensation structures that "can encourage 'churning,' excessive trading of customer accounts." The article focused on incentives "such as Rolex watches and all-expense-paid vacations" given to brokers to sell certain products. The industry has been moving away from some of the controversial compensation structures in general, and there are certainly plenty of honest brokers who provide valuable services, but the bottom line is that investors should be aware of full service brokers' conflicts of interests when they evaluate the broker and their recommendations. The broker's knowledge, experience, and reputation are obviously important elements to consider as well.
The Los Angeles Times ran an article on 4/11/95 titled "Panel Urges Alterations in How Brokers Are Paid." which effectively addressed the issue of how brokers are compensated. Here are a few excerpts from the article.
These are issues you may wish to inquire about with your broker. Some brokerage firms do now offer the choice between paying full commissions or paying a management fee as a percentage of assets, similar to money managers compensation structure. 'Flat Fee' Accounts: Read the Fine Print in Business Week (7/14/97) is an article about flat fee accounts and the possibility that brokers are biased in selling IPOs issued by their firm because the broker might receive a commission. (See also choosing an advisor)
- "Most brokers are not paid based on how customers perform, but on how many transactions, such as buying and selling stocks, they make. As a result, brokers end up getting paid more if they engage in unethical practices such as selling unsuitably risky securities that carry bigger commissions than do safer ones, and if they churn accounts, rapidly buying and selling securities just to build up commissions."
- "The committee was chaired by Daniel P. Tully, chairman and chief executive of Merrill Lynch, the nation's largest brokerage firm. Other members included Warren Buffett, the well known investor and chairman of Berkshire Hathaway Inc., and Samuel L. Hayes III, a professor at Harvard's Graduate School of Business Administration. The sole representative of small investors on the committee was Thomas O'Hara, chairman of the National Assn of Investors Corp., which sponsors investment clubs."
- "The report says that the prevailing commission-based compensation system inevitably leads to conflicts of interests with customers. It notes that in many instances, the best recommendation for a customer would be to do nothing and simply hold on to the stocks and bonds in an account. But it also says that 'the current compensation system is too deeply rooted in the near term.'"
- Key recommendations of the high-level committee appointed by Securities and Exchange Commission Chairman Arthur Levitt Jr. to change the way securities brokers are compensated:
- Eliminate higher commissions for in-house proprietary products.
- Base a portion of a brokers compensation on the amount of assets in an account.
- Disclose hidden fees and commissions paid to brokers for selling certain products.
- Severely limit contests.
- Hold branch managers more accountable.
Evidence of the problem appeared in Worth Magazine's September 1996 issue (Keeping up - page 57,58 second paragraph) which included the following: "A study by Prophet Market Research & Consulting of San Francisco has found that stockbrokers often dispense specific investment advice with little or no basic knowledge of the customer's individual needs. Prophet used 93 'mystery shoppers' who presented themselves as first-time investors to 21 brokerage firms. Prophet said that many of the brokers who dealt with its shoppers failed to inquire about even such basic matters as the income level or tax bracket of the customers. More than a quarter of the brokers provided investment advice without asking about a customer's investment history or willingness to tolerate risk, the study reports."
See also Broker Notepad and Why you should take notes from NASAA
Online trading surge slows down from News.com (10/29/98) The Trading Revolution from The Industry Standard (10/5/98) Cheap Frills Kiplingers (10/98) According to the Wall Street Journal (6/2/98 - "Why Wall Street Firms Trail in On-Line Battle") Charles Schwab has a 32% of the market for on-line trading. E*Trade is second with 12% of the market followed by Waterhouse (9%), Fidelity (8%), Datek (7%), Ameritrade (6%), DLJDirect (4%), Quick & Reilly (4%), and Discover (4%).
Online Trading: Do I Hear Two Bits A Trade? from Business Week (12/8/97)
Brokers cut commissions in Wired (10/8/97)
Smart Money ranks 21 discount brokers in its July 1997 issue. The overall winner was Waterhouse Securities displacing previous winner Jack White & Company. Firms were ranked by multiple criteria including trading costs, breadth of products, trading, responsiveness, and "Staying Out of Trouble."
Charles Schwab claims to now hold 50% of the online trading market with more than 700,000 online accounts and $50 billion in assets. Schwab has added corporate bond trading and breaking news to its web site (4/16/96).E*TRADE: Is This Investing's Future? from Fortune (3/3/97) The January 1997 issue of Institutional Investor includes an article on E*Trade in which Christos Cotsakos claims "The days of the $100,000 broker are coming to an end." E*Trade reported 94,000 active accounts growing at 7 to 10 percent per month, about 8,000 trades a day, and customer deposits of $3-7 million a day. 9/27/96 articles
- News.com article about on-line investing with numerous links.
- San Francisco Chronicle article about on-line investing.
- The Wall Street Journal ran an article titled "On-Line Investing Flourishes as Brokers Slash Commissions on Computer Trades." Highlights of the article include the following estimates
The Journal discusses "super-low commissions" as the spark for the surge. According to the article, part of the reason for the low commissions is that "roughly 40% of the revenue from an on-line trade comes from so-called payment for order flow, or a brokerage firm's profit from selling orders to other firms that actually execute the trades."
- Forrester Research estimates in a "not-yet released study" that on-line investors have 1.5 million accounts (double earlier predictions)
- By 2001, as many as 17% of households with computers will use them to trade stocks.
- Assets managed by on-line investors will account for more than 8% of total assets held by small investors.
Michael Gianturco (author of "How to buy Technology Stocks") wrote in the 8/26/96 issue of Forbes ASAP "... if you find yourself fixated by the commission schedules of the deep discounters, it may be a psychological signal that you have started to trade too much." The article "Online Stock Trading: Software For Hard Choices," discusses how "traders - not long term investors" who pay more in commissions resulting from turnover are "favored in online brokerage wars." The article discussed software and lauded Schwab's StreetSmart software and Accutrade for Windows -- according to the article, "at the moment it is the high-water mark for this technology."
The Wall Street Journal ran an article 7/17/96 about the impact of the high volume of trading on 7/16/96. Some E*Trade customers reported not being able to log into the system, receiving inaccurate information and not receiving confirmations until the end of the day. Schwab's mainframe reportedly also went down for about 15 minutes. If your going to use a web based broker you might want to investigate the brokers capacity and ability to grow and you may want to have a backup system for trading. According to the article, Schwab reported 25,000 online trades for the day with 16,000 being an average day. E*Trade reported 7,500 trades with 7,000 being an average day. Lombard reported 3,000 trades for the day with 2,000 being an average day.
If you currently use or are considering using a discount broker, you should be confident that your actions are appropriate and suitable given your investment objectives and constraints. It may be better to consult a professional than to make a mistake that you can not afford to make. (See Should you be handling your own investments?.) Keep in mind, whether you use a discount broker or a full service broker, the hidden cost of the bid-ask spread exists on every round turn transaction and remember that each transaction is a taxable event (unless its in a tax exempt account).
|Investment Banks/Full Service Brokers||Some Discount Brokers|
CS First Boston
Donaldson, Lufkin & Jenrette
Hambrecht & Quist
Wedbush Morgan Securities
Pacific Brokerage Services
Quick and Reilly
Vanguard Brokerage Services
Web Street Securities
Jack White & Company
"Sometime between the 1950s and the 1980s, the traditional broker's image in this country went from basically respectable to used-car-lot sleazy in the minds of a lot of people. That image is, of course, a gross generalization. There are, a record 103,000 brokers out there, and they aren't all sitting around thinking of new ways to cheat widows and orphans."
Tom Petruno, LA Times (2/9/97).
Last update 6/7/2000. Copyright © 2000 Investor Home. All rights reserved. Disclaimer