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Discussing “No Free Lunch” in Finance

Whenever a company offers something at no charge, that means the price is hidden and out of sight. Investors considering the plethora of new fund and investing service options that purport to be “free” or have no cost should be aware: there is no free lunch.

Josh and I review a prior post on this in great detail.

The cost may be hidden in a myriad of ways. Corporations are for-profit entities and they should charge for the services they provide. But sometimes they charge investors in a hidden or non-obvious way. In today’s discussion, we talk Robinhood, TD Ameritrade, Charles Schwab, Wealthfront, Betterment, E-Trade and more.

 

 

 

Previously:

Cheap is Great, But Beware of Free (Bloomberg, October 17, 2018)

Ain’t No Such Thing As A Free Lunch . . . (Washington Post, October 24, 2015)

Cheap is Great, But Beware of Free

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.

 

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1. “The Moon Is a Harsh Mistress1966, 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. Wem 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.

 

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I originally published this at Bloomberg, October 17, 2018. All of my Bloomberg columns can be found here and here

 

BBRG: Cheap Is Great, But Free Will Cost You

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

 

 

 

Today’s discussion is based on something that should  be obvious, but in our haste to save a buck often gets overlooked. The basic, fundamental foundation upon which all economics is built is simply this: everything has a cost. Colloquially, we know this as the “ain’t 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 by sci-fi writer Robert Heinlein (“The Moon Is a Harsh Mistress,” 1966), 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”? It was quite literal, dating to the post-prohibition 1930s, whereas we were reminded by William Safire: 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.”

Let’s compare “cheap” and “free.”

“Cheap” is less expensive then dear. We understand cheap, and 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 . . . Continues here

 

~~~

I originally published this at Bloomberg, October 17, 2018. All of my Bloomberg columns can be found here and here

 

 

Is Free Will a Myth?

‘Societal conditioning’ might sound like either a grim Orwellian brainwashing technique or a fancy new way to wash your hair, depending on how warped your sense of humor is. But your surroundings—from the breakfast cereal you eat to the very design of the streets you live on—might have much more influence on how you think than most have ever given it credit for. Robert Sapolsky posits that “I picked this shirt today because the culture I come from has these values and my visual color receptors told me that this shirt matches with this.” It might be far fetched to some, but consider this: if the street you’d grown up on was wide (say, a Texas highway) and at age 30 you moved to a tiny cobblestone street, you’d feel cramped in. Apply this to everything around you and you’ll get a sense of what Sapolsky is talking about.

Why You Don’t Have Free Will: Your Breakfast Food, Biology, and Culture | Robert Sapolsky

Robert Sapolsky’s most recent book is Behave: The Biology of Humans at Our Best and Worst.

Dangers of a Fact-Free America

@TBPInvictus here:

When did America lose interest in reality?

There was a time that economic releases from government agencies – Bureau of Labor Statistics, Bureau of Economic Analysis, Census Bureau, Department of Labor, etc., etc. – were deemed reliable. They were reliable because they were derived using credible collection methodologies and statistical analysis by folks who were devoted to trying their best to get it right. But no more.

There have always been challenges to  the way models were created and maintained, but discussing the plusses and minuses of various approaches to econometric modeling is a very different debate. Now, we are warming up to the concept of denying objective reality. Sure, the crazies made wild claims, but they were always debunked, as was fringe sites like ShadowStats and ZeroHedge.

Recall GE CEO Jack Welch – himself known for his expertise in faking GE’s quarterly earnings using the squishy accounting of GE Capital. He teed it all up with this tweet on a monthly jobs report:

You’ll note the date on that Tweet – October 5, 2012 – was one month before Obama’s reelection, and Mr. Welch was clearly among the opposition.

More recently, Trump repeatedly asserted that the unemployment rate is far higher than the official statistics would have us believe. Here’s Fortune in August of this year:

This isn’t the first time that Trump has questioned the validity of the official unemployment rate, or what economists at the Bureau of Labor Statistics have labeled the U-3 rate. But Trump has rarely talked about the unemployment rate in such strong terms, characterizing the employment situation report as simple propaganda meant to trick the public into believing that the economy is in better shape than it’s in.

Trump hasn’t offered any evidence for this assertion, and over the course of his campaign has claimed that the “real” unemployment rate is anywhere from 18% to 42%. Therefore, it’s evident that Trump’s talk about labor market isn’t rooted in careful analysis of government surveys.

Of course, Jack Welch is no strange to fabricated data; during his nearly 2 decades as CEO of General Electric, he learned a thing or two about how to cook the books.

But reality matters. Under Welch, the GE Capital financial helped GE manipulate its earnings every quarter. Welch’s successor had to settle accounting fraud accusations with the Securities and Exchange Commission for what was done during Welch’s tenure — all of which made his assertion the government cooked its books laughably of self-awareness.

Catherine Rampell wrote an excellent piece in the Washington Post about the virtual impossibility of running a democracy if the facts don’t matter:

“You know those unemployment rates, inflation numbers, household spending figures, health insurance coverage rates, gross domestic product growth and other stats that companies and consumers rely on when making financial decisions? Nearly half of Americans, and a supermajority of Trump voters, believe the books are cooked.”

What’s interesting here is that it seems folks are all too eager to distrust and dismiss Obama-friendly numbers (job creation, the unemployment rate), but apparently have no problem whatsoever believing the Obama-unfriendly numbers (the low labor force participation rate, the low home ownership rate). So, apparently, the agencies are cooking some numbers, but not others, which is absolutely fascinating.

So, there’s the macro of the situation. Now for a look at how that macro filters down to the micro.

I happened to come across this comment on Facebook:

screen-shot-2016-11-11-at-6-19-05-pm

Safe to say I took that with a grain of salt and set about verifying it. After all, it’s easy to see how folks living in that economic environment would be longing for the type of change Trump claims he’s going to provide. So, off to BLS.gov I went to see exactly what’s going on in Longmont, CO.

Here’s what I found:

longmont-unrate

So, Ms. Fitzgerald likely took herself to her local polling place and cast a vote for Mr. Trump, who’s surely going to do something about the 8.8% unemployment rate that is, in reality, 3.3%.

Trump is already making America great again — and all he had to do was stop lying about its economic state!

Multiply Ms. Fitzgerald by tens of millions who know what they know notwithstanding the facts and, well, we now know how the story ends.

Once again to Ms. Rampell:

“The problem with elevating yourself by tearing down the existing authoritative institutions is that once you succeed, you’ve established a road map for others to tear you down, too. There will always be someone waiting in the wings with an even juicier conspiracy theory, an even zanier hidden truth, an even more intricate data-unskewing method — and there’s no longer any authority left to debunk any of it.

This is how a democracy crumbles: not with a bang, but with data trutherism.”

We have crossed the rubicon.

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BR here:

Let me point out one small psychological addition:

Now that the election is over, expect the GOP to start seeing how fantastic the economy has become; to a somewhat lesser extent (no false equivalency here), the Democrats will start seeing more of its weaknesses:

 

imrs

Source: Washington Post

 

As Rebecca Sinderbrand, Deputy national political editor at the Washington Post noted on November 15: “that must’ve been some weekend.”