by Bart Ward
For most investors working with a brokerage firm, commissions are the most obvious costs that one is concerned with. Like most aspects of investing, there is more than meets the eye on Wall Street, when it comes to accessing the costs associated with transactions. We can look at the cost of buying or selling securities as having an explicit part—the broker’s commission—and an implicit part—the dealer’s bid-asked spread, plus other costs as well.
The full service commission for trading common stocks is generally around 2 percent of the value of the transaction, but it can vary significantly. Before 1975 the schedule of commissions was fixed, but in today’s environment of negotiated commissions there is substantial flexibility. Discount brokers that do not provide the range of services that full service brokers do, have generally lower commission prices. However, on some trades, full-service brokers will offer even lower commissions than will discount brokers.
Sometimes the brokerage firm you do business with is also a dealer in the security being traded and will charge no commission, but will collect the fee entirely in the form of the bid-asked spread. This is where the term broker-dealer comes. As a broker, the firm acts as an agent and simply executes the trade on an exchange. As a dealer, the brokerage firm makes a market in a specific stock providing bids and offers. Broker-dealers can supply what is known as “firm bids or offers” which are prices at which a dealer is committed to buy or sell a specified amount of securities.
Another implicit cost of trading that some professionals would distinguish is the price concession an investor may be forced to make for trading in any quantity that exceeds the quantity the dealer is willing to trade at the posted bid or asked price. A stock that is not very liquid cannot be sold easily without dropping the price substantially or bought without raising the price. This is called the “market impact” of the trade and is affected by what the “depth of market” is for the stock. Stocks that have a deep market will be able to be sold or bought easily without much of a price movement, if any. In short a stock that has a deep market will have a high degree of liquidity.
There is another way that brokerage firms also make money. This is through their inventory positions. Many brokerage firms hold inventory of frequently traded stocks or stocks that they make markets in. Brokerage firms bring to market new issues of stocks for companies and often provide market making functions for these issues as noted above. At times they may buy or sell the stock from their inventory to a client and make the difference between what they may have bought it for some time ago, and the current market price. This is much different than just getting the spread between the bid and ask.
When a stock is bought or sold from a brokerage firm’s proprietary account (inventory) this is known as a “principal trade.” When they buy or sell a stock directly on an exchange it is known as an “agency trade.” On the confirmation that is sent to the client after the trade is executed, the firm will list whether the transaction was a principal or agency trade.
Another way that brokers are compensated is by a “selling concession” during an initial public offering (IPO). When new stock is issued by a company, brokerage firms and investment banks get into the action. These IPOs are often sold to the public “commission free.” Don’t kid yourself though; the brokerage firm will get a “selling concession” from the underwriter (investment bank) during the IPO which will allow it to compensate the broker for selling the stock to a client.
Total trading costs consisting of the commission, the dealer bid-ask spread or the price concession can be substantial. According to one study, the round trips costs (costs of purchase and resale) of trading large blocks of stocks of small companies can be as high as 30 percent. However, in most cases the trades are far smaller and can be as low as .25 percent of the value of stocks traded for large transactions made through discount houses.
In any case, there is no free lunch, especially on Wall Street. And there should not be. Brokers who are worth their salt and do a good job, should get paid. Those that do an especially good job should get paid well. I often ask the following question, “When you are going to have an operation on your heart, do you want to have the cheapest surgeon available or the best one that may get paid top dollar?” I bet you can guess which answer I get most often. Then I follow with, “Well what about when someone is going to operate on your wallet, do you want the cheapest or the best you can get?”
Quote of the Week: “The shortest and surest way of arriving at real knowledge is to unlearn the lessons we have been taught, to remount first principles, and to take nobody’s word about them.”—Henry Bolingbroke
Bart Ward is the chief executive officer of Ward & Co. Ltd. an Anoka based registered investment advisor – specializing in the management of stock and bond portfolios in companies which are listed on the NYSE.