By Peter Mastrantuono
It was two years ago when the largest online broker capitulated to the inevitable and announced that its stock trading commission would drop to zero dollars.
One might think after “free” there is very little room for pricing innovation. But for an industry known for its financial creativity, that would be wrong.
A major online broker, Interactive Brokers, recently introduced a novel pricing structure that offers the choice to pay $0 on stock trades or pay a small commission on trades and receive enhanced price execution.
This new pricing structure raises an important question: If brokers are obligated to provide investors with “best price execution”, then what does “enhanced price execution” mean?
Best Execution
Broker-dealers are generally required to use reasonable due diligence in finding the best market to obtain the best price on a customer’s buy or sell order under prevailing market conditions.
An outgrowth of this best execution requirement is that brokers will often tout their “price improvement” on a customer’s trade. Price improvement is defined as any trade that is executed at a better price than the best quoted market price. Price improvement occurs when trades are placed with traders, securities exchanges or Alternative Trading Systems that post better, non-publicly displayed quotes.
One example provided by Charles Schwab, for instance, illustrates a $10.00 savings on a 1,000-share buy order executed at a per-share price of $25.29, or a savings of a penny a share. The savings amounts to four basis points.
Enhanced Execution
Under its “small commission, enhanced execution” pricing option, Interactive Brokers promises better execution than “best execution” and even better price improvement by routing a customer’s trade through a proprietary system that is designed to optimize price execution.
(If an investor prefers to pay no commission, then their trades are generally routed to select over-the-counter market makers for execution.)
The Value of Improved Price Execution
No investor should readily dismiss any opportunity to reduce expenses since lower costs, all other things being equal, translates into greater long-term wealth accumulation.
Using the Schwab example above, four basis points of savings on $250,000 in trading activity amounts to $100. It’s not a life-altering amount but perhaps it’s meaningful to some investors.
More importantly, however, is that investors shouldn’t lose sight of the more consequential factors behind long-term investment success, like proper diversification, good behavior (i.e., avoiding behavioral biases that undermine intelligent investing, like responding to the emotions of fear and greed), sound research and a long-term perspective (as opposed to a short-term trading mentality).
There is a Wall Street axiom that says “a portfolio is like a bar of soap, the more you touch it, the smaller it becomes.” So, yes, perhaps a four basis point savings on each trade has some value, but it’s at risk to being quickly lost from a host of much larger threats to long-term investment performance.
That’s why working with an experienced financial advisor is so valuable. He or she keeps their clients focused on the much more meaningful determinants of financial success, such as having a financial plan, creating a strategic asset allocation, managing investment risks, identifying exceptional investment managers and tracking progress toward goals.
Peter Mastrantuono is a contributing writer to MyPerfectFinancialAdvisor, the premier matchmaker between investors and advisors. Peter worked for over 30 years in the wealth management industry, focusing on retirement planning, investing, asset allocation and financial planning.
