Sunday, July 26, 2009

Do You Know Your Broker Well?

Brokers - stock brokers, insurance brokers, bond salesman, etc. - are supposed to advise you on which securities to buy and sell, depending on your investment objectives. They offer a variety of products to help you shape a portfolio that fits your investment objectives. Brokers may seem like clever financial experts but they are first and foremost salespeople. Many brokers are paid a commission, or a service fee, on every transaction in the account they manage. Therefore, their interest is in conflict with you - the investor.

Brokers want you to buy things you don't own and sell things you own. Has an investor stuck to Berkshire Hathaway stock since 1965, they would have seen their net worth gone from $12 to $90,000. But for brokers who have recommended their clients to buy and hold would have starved. There are many forms of commissions. On a stock trade, it is a percentage of the total value of the transaction. For mutual funds, it can be an upfront commission (sales load) which are paid when you make an investment, or it can be a backend commission (deferred loan) which are paid when you take your money out. On bonds, brokers normally don't charge a commission. Instead, money is made off the "spread," or the difference between what the firm paid to buy the bond and the price at which the firm sells the bond to you.

In many cases, brokers are fine and honest people, but the system rewards them based on the number of transactions they execute and not on how well their client's portfolio performs. Even when the best course of action is to do nothing in a client's account, the commission system encourages brokers to recommend sometimes dubious trades. For example, placing secondary offerings - shares issued by companies that had already gone public but needed more capital - with clients would pay five times the normal commission. One hundred shares of JPMorgan, for example, at $35 a share paid a 1% commission for a total of $35. But the commission on the same 100 shares in a secondary offering of the same JPMorgan stock was 5 percent, or $175. Brokers could have recommended the same share a month, or even a week, ago had they thought it was a good investment. Why did brokers suddenly find JPMorgan attractive one day, when brokers weren't interested or recommending the stock the day or week before? More likely the motivation is self interest, pure and simple. However, not all brokers are commission-hungry wolves on the prowl for naive investors. Some are, others are just inept. Most are honest brokers but sadly, the brokerage industry has numerous flaws. Brokers are mostly good people stuck in a bad system.

There are mainly four problems in the system: 1) Brokers are not well-trained enough for the enormous task expected to be carried out; 2) The system in which brokers operate is geared towards volume selling, and dangling with carrots frequently and thus, weaken the fiduciary duty of giving objective advice; 3) To increase sales, firms use sales contests to get brokers to sell securities that investors may not need. Most brokers rarely, if ever, disclose to their clients how they are paid or how their bonuses are structured, even though such disclosures would go a long way to resolving the conflict of interest problem; 4) Branch managers and other supervisors who are paid commissions just like their brokers have an incentive to push everyone to sell more and turn a blind eye to questionable practices.

Behavior are often determined by rewards or compensations. It is hard to run out of space to create novel ways to use commission to motivate brokers - and take more money out of customers' pockets. One popular system is the grid. Typically, brokers receive a percentage of their generated commissions, ranging from 33 to 45 percent, depending on the volume of commission sales they bring in. As their commission sales increase, they can jump to a higher payout level on the grid. Imagine, it's December 27. Your broker's payout level is 33% and he has generated $470,000 in commissions so far this year. But if he hits $500,000 by December 31, his payout level jumps to 40 percent, applied retrospectively. To your broker, this means he can earn a windfall of $44,900 in additional compensation just by generating $30,000 in commission sales in four days. Unless a firm's ethical culture is impeccable or even rarer, the broker has an impenetrable moral compass, the temptation to sell anything to anyone, no matter how inappropriate, is overwhelming.

It is common practice for firms to lure star brokers away from his employer with large, upfront bonuses. Such bonuses can equal or exceed an entire year's pay. This sum is paid on the presumption that the broker will bring his customers with him to the new firm by telling them that his new firm offers better customer service and better research but never reveals the new firm is paying him a bundle to move. In such cases, customer accounts are bargaining chips that brokers use to increase their personal wealth, not their customers. Once the broker moves to the new firm, he must produce. Thus, the broker is more likely to push unwanted or unneeded products, especially those paying higher commissions.

Commissions distort brokers' recommendation in other ways as well. Some companies have special arrangement to sell mutual funds in exchange for above-average commissions. If your broker knows he'll get 25% more money for selling Fund A over Fund B, guess which fund he will sell you? Most large brokers also sponsor their own funds, so they may even steer you to one of those.

Brokers come in many forms. There is the full-service brokerage houses like Merrill Lynch, Smith Barney, and UBS PaineWebber. Not only do they help clients to establish their investment goals and pass on customer orders to their trading desk for execution but they also provide research from in-house analysts and give advice on a wide range of securities. For these extras, customers pay more.

Then there are the discount houses - like E-Trade, Interactive Brokers which give minimal advice or none at all. Many do not provide proprietary research although they may make available research produced by other firms. For less services, investors are charged a moderate commission or pay a flat fee for each trade. Many online brokers are discount brokers. For a $50,000 asset, customers pay a flat fee of $9.95. Anyone can open an account and sell or buy up to 5,000 shares for as little as $8 or some $9.95. Firm touts its capability to fill orders within 10 seconds in most cases. The ease and low cost of online trading lured millions and millions of investors into opening online accounts. With the online trading revolution came powerful new computer networks, called electronic communications networks, that act much like electronic stock exchanges. It serves to match buyers and sellers up in a split second. Because it involves no human intervention, they do so at a fraction of the cost of the New York Stock Exchange or Nasdaq. But investors are not fully informed and caught unaware because the revolution of online trading comes with its own hidden dangers. The first is "payment for order flow," which is a rebate or payment received by the brokerage firm from market makers. Market makers are firms who post prices to buy and sell financial products for their own account and for others.

When you place orders to buy or sell a stock, you may not think about where or how your broker will be execute the trade. Placing an order through your online broker may not necessary be routed directly to the stock exchange for execution. But where and how the trade is executed impacts your transaction cost, though you may not notice it. Just as you have a choice of your brokers, your brokers also have a choice for the market of execution. When you place your order with your online broker, your order is routed to the market of the online broker's choice. Because market makers offer a rebate or "payment for order flow" to the brokerage for your order, the chances are pretty high that your order will be routed to the market maker to match your buy order with someone else's sell order, and only the transaction is reported to the exchange. The problem with payment for order flow is that your buy order may not be exposed to a large number of sell orders, and that may deprive you of a better price. For example, you place an order for 1,000 shares with your online broker, which then routes it to a market maker, who then rebates your broker a penny for every order it gets at the market price. But another market maker or exchange not paying a payment for order flow might be able to improve the price by 5 cents, saving you $50 ($0.05 x 1000 shares). That's five times what most online brokers charge in commission. The moral is: don't be fooled into saving $5 or $10 in commission charges and only to pay far more in hidden trading costs. And you have options to direct your orders, you can request your brokers to direct it to a market or exchange that you want your orders to be executed. But your brokers may charge you a fee.

If brokers tout about their speed of execution, they must not fail to warn investors of the possibility of significant delays. Usually, trade execution is fast and seamless, but it does takes time. During fast moving market, price can change quickly. Because price is quoted for a specific number of shares, investors may not always get the price they saw on their screen or the quote given by their brokers. By the time the order reaches the market, the price could be slightly, or very different. Under the Securities and Exchange Commission's rules, your broker is obligated to get the best execution - best possible price in the shortest time - available for your order.

Another hidden trap is internalization. This happens when your broker fills your order from the firm's own inventory instead of routing it to a market maker or exchange for execution. This is just like payment for order flow except that the parent company gets to keep all the payments and the "spread" - which is the difference between the buying and selling price. For the investor, it is the same, the buy order does not get expose to a wider universe of sell orders and may get executed at a higher price than the best available price the broader market is offering.

As an investor, the responsibilities are on you. The more you understand these, the more rewarding your investment journey will be.


Frank said...

Hi Brian,
I am using on-line broker, E-Trade, to buy stock because i do not know of better alternative.
Just curious, how about you?

Berkshire said...

Hi Frank,

You can check with them where they send orders to for execution, would it be to the exchange or a market maker.

For me, I use a normal broker, UOB Kay Hian, a local broker in Singapore.

Daniel M. Ryan said...

With regard to full-service brokers: the commission model dates from the time when many brokers came from upper-crust backgrounds. The commission structure was decided in part to make back-then stockbrokers look like businesspeople, and not like idiot sons of rich fathers with pretend jobs.

There isn't enough current dissastisfaction to make an entrepreneur set up a full-service shop with brokers on fixed professional-level salaries, though. It's long been advocated, but never been followed through upon. [At least, I don't know of any shop that's tried it.] Some brokerage houses have tried an asset-based fee structure, but the only brokers who qualify are those who've fought their way out of the commission trenches. That experiment may have even been folded.

Penny Stocks said...

Best to stick with a major player like fidelity or vanguard.