Yet another nugget gleaned from reading Mike Piper's Oblivious Investor blog was his link to an explanation describing what I've always regarded as one of the more impressive magic tricks in investing: How can big brokerages afford to eliminate trading fees on stocks and ETFs which have historically been the mainstay of their revenue generation?
The article in question, by Allan Roth, provides a satisfying explanation: the brokerage business has become a loss leader for Schwab's real business, which is profiting from net interest income. That deserves a more in-depth explanation.
According to the Roth article, 61% of Schwab's profits in Q3 2019 derived from net interest. Net interest is what Schwab makes by paying next to nothing in interest on cash sweep accounts, investing the difference in higher yielding investment-grade short-term securities, and keeping the difference. A sweep account is the brokerage account where dividends, transfers, and stock sales automatically go (unless specific arrangements, i.e. automated reinvestment of dividends, demand otherwise).
I decided to examine this phenomenon firsthand by looking at the historical performance of my sweep accounts at Vanguard and Schwab.
The Vanguard Federal Money Market Fund (VMFXX) has a fee-adjusted annual 1 year return of 2.14%.
The Schwab Government Money Fund (SWGXX) distinguishes between investor shares and sweep shares, where the latter has an annual 1 year return of 1.66%.
Apparently, that difference on a scale of billions of dollars in assets is what makes Schwab profitable. Clever.
The article mentioned that Schwab offers a zero-cost robo-advisor platform called the Intelligent Portfolio. When I checked it out, I noticed a unusual disclaimer on the far right side at the top of the page:
We believe cash is a key component of an investment portfolio. Based on your risk profile, a portion of your portfolio is placed in an FDIC-insured deposit at Schwab Bank. Some cash alternatives outside of the program pay a higher yield.
This seems to support the idea that Schwab's popular loss leaders (commission-free trades on stocks and ETFs, free robo-advising service) are intended to draw business away from industry stalwarts like Vanguard while the actual money gets made through interest earned on cash held in a sweep fund.
As clients are likely to be enthusiastic about the free services, few will notice the reduced return on cash in their sweep fund.
At long last, the mystery of eliminating commissions is explained in a manner that makes sense.
Roth expands on a theory of how eliminating commissions, purchasing TD Ameritrade and offering the purchase of fractional shares comprise a three-legged stool strategy to become the dominant brokerage in the business. It makes for a fascinating read - check it out here.