Cheap Is Great, But Free Will Cost You
Whenever a company offers something at no charge, that means the price is hidden and out of sight.
Bloomberg, October 17, 2018
There is a basic, fundamental foundation upon which all economics is built: everything has a cost. Colloquially, we know this as the phrase “no free lunch.” Economics is neither that obvious, nor straightforward, and the nuance is that while everything has a cost, at times, it can be hidden from view.
On the internet, “There ain’t no such thing as a free lunch” is best known by its acronym, TANSTAAFL. Popularized in the 1960s by sci-fi writer Robert Heinlein,1 it enjoyed a resurgence a decade later when Milton Friedman used it for the title of his 1975 book, “There’s No Such Thing As a Free Lunch.”
What is a “free lunch”? Quite literally, it dates to the post-prohibition 1930s, where we are reminded by William Safire that a free lunch was a bartender’s enticement to get you to buy drinks; the economic lesson is “you are paying for that so-called free lunch.”
Which brings us to today’s discussion comparing “cheap” and “free.” “Cheap” is less expensive than dear. We understand cheap, we appreciate all of its advantages. Experience teaches us that cheap is indeed good for investors, as costs compound over time, acting as a drag on returns.
“Free” on the other hand, when offered by any for-profit company, should be approached warily, for reasons clearly understood by both Heinlein and Friedman. “Free” is not without costs. Free has hidden charges, expenses. Free requires you to read the fine print, where disclosed on page 37 you learn that free can be very expensive.
“Free” in the mutual fund business is a loss leader, a form of marketing. It eventually leads to a “bait and switch,” where free is substituted by a higher cost (and in some examples a MUCH higher cost) product.
In a soup kitchen, free makes sense. Free is a core principle of a charitable organization, where it is completely rational. Any charity where the goal is to give something away to someone who cannot afford it uses free by design as the core element of creating benefits for both donor and beneficiary.
In financial services, free is bullshit.
Do you doubt this truism, obvious but overlooked by so many in their rush to pay less? Do you for an instant believe that large for-profit companies price their services at “free” because they are kind-hearted and generous and only have your best interests at heart? Can you really be that naïve to believe such obvious and absurd nonsense?
Perhaps a few examples might bring you around. And these are from companies that have a deep selection of worthwhile products and services they charge a fair price (more or less) to their clients.
RobinHood: The app millennials love does not charge any fees on trades. Named after the “steal-from-the-rich-give-to-the-poor ethos of a fictional tale, this is the classic example of there being no free lunch. As Bloomberg News2 reported this week, Robinhood derives “more than 40 percent of its revenue from selling its customers’ orders to high-frequency trading firms.” Not best execution, but simply directing the order flow to where rebates and payments will come back to the company. Note the company claims otherwise,3 but I would point out they are not a fiduciary to their clients, but instead are a broker dealer regulated by the Financial Industry Regulatory Authority (FINRA).
This, if an investor pays an extra tenth of a point on any given trade of 1000 shares, it could cost them an extra $100 versus paying an $8 charge from an online brokerage account that is not “free.” Cheap is cheap, but free can be expensive.
Perhaps most damning at all, removing any barrier to trading tends to encourage, well, more trading. An overwhelming amount of evidence shows that even when “free,” more trading tends to be very, very expensive.
Fidelity: My Bloomberg colleague Nir Kaissar explained how Fidelity “Unleashed the power of free.” They offered two index mutual funds – one tracks market cap the largest 3,000 U.S. companies (float-adjusted market cap), and the other holds the top 90 percent of stocks within various developed international and emerging countries. Both charge zero fees, and they quickly raised a few billion dollars in fresh assets.4
But as Kaissar pointed out, Fidelity has “more than 1,000 Fidelity mutual funds, including the various share classes, with close to $1.9 trillion in assets and an asset-weighted average expense ratio of 0.46 percent a year.” Those two index ETFs may be free, but the rest of their offerings are not, bringing in $9 billion dollars of annual revenue. Fidelity is betting they will find ways to monetize their zero fee customers.
Vanguard is cheap – but not free. Fidelity is free, but not cheap. Those 2 ETFs may be free, but the much of their lineup is not cheap, and is often more expensive than Vanguard or Blackrock.
Schwab: Offers its Schwab Intelligent Portfolios as a free robo-advisor for customers. As with all of the other free lunches, this too comes with strings attached. It uses its own funds, which may not be as cheap as equivalent Vanguard or Blackrock funds. But more controversially (especially to its competitors) it carries a big cash balance of about 9 percent, making money on the spread it collects in interest versus the tiny fraction it pays to customers. During a bull market, with nearly 1 in 10 dollars not participating in equities, one would expect this portfolio to underperform. But hey, it’s free!5
ETF Portfolios: There are a number of firms that will assemble an allocation of different asset classes into a single, fully diversified 1 ETF portfolio for free. However, the individual ETFs contained therein have internal charges ranging from 30 to 75 basis points. The ETF wrapper is free, but the ETF ingredients have expenses.
My disclosure: My firm charges an advisory fee, which we believe provides value to customers. We lower the fee about 15 percent after clients demonstrate “good investor behavior” over a few years (meaning, they don’t log on to their portfolios and begin to day trade their accounts). In the future, I would not be surprised if we find ways to make the cost to clients even lower, but I am positive we will never make them free.
One last reminder: Facebook is free, but not cheap. All it requires from you is endless amounts of your limited time and attention, sharing what would otherwise be private information, that has been shown to cost some people a substantial chunk of their mental health, all the while compromising some of our most sacred democratic traditions.
Gee, all of that “free” sounds pretty damned expensive to me.
1. “The Moon Is a Harsh Mistress” 1966, by Robert A. Heinlein, published by P. Putnam’s Sons, winner of 1967 Hugo Award; nominated for 1966 Nebula.
2. Robinhood Gets Almost Half Its Revenue in Controversial Bargain With High-Speed Traders, By Simone Foxman , Julie Verhage , and Suzanne Woolley October 15, 2018.
3. Robinhood published a letter from co-founder Vlad Tenev, saying “We send your orders to the market maker that’s most likely to give you the best execution quality.” They also note on their site (How Robinhood Makes Money) that margin trading service plus interest income from customer cash and stocks, plus rebates from executing brokers, plus their higher tier monthly service all generate revenues.
4. The only catch is that these ETFs are only available to individual retail investors who reside in the United States and purchase these shares through a Fidelity brokerage account.
5. Disclosure: Schwab is one of the two primary custodians RWM uses for client assets. We do not use Schwab Intelligent Portfolios for Liftoff, our own automated online investment platform (aka robo-advisor), preferring to use technology developed by Riskalyze, where myself and my partner sit on their board of advisors.
UPDATE: April 19, 2019
See this WSJ article: SoFi’s No-Fee ETF Launch Saddles Some Customers With Tax Bills
I originally published this at Bloomberg, October 17, 2018. All of my Bloomberg columns can be found here and here.