{"id":7694,"date":"2017-07-26T10:03:02","date_gmt":"2017-07-26T17:03:02","guid":{"rendered":"http:\/\/www.wealthfront.com/blog\/?p=7694"},"modified":"2022-01-11T17:12:28","modified_gmt":"2022-01-12T01:12:28","slug":"silent-assassin-fees","status":"publish","type":"post","link":"https:\/\/www.wealthfront.com/blog\/silent-assassin-fees\/","title":{"rendered":"The Silent Assassin of Fees"},"content":{"rendered":"

A few years ago I wrote a blog post that attempted to comprehensively outline all the apparent and hidden fees that can eat away at your investment return<\/a>. This was (and still is) important because over the course of 30 years fees can actually lower your net worth by as much as 50%.1<\/sup> But as detailed as the article was, I omitted perhaps the most arcane and hidden of all the investment fees: Payment For Order Flow<\/a>, or PFOF as it\u2019s more commonly known in the industry. PFOF is both complicated and highly contested, so today I\u2019ll help unpack how it works and explain Wealthfront\u2019s position.<\/p>\n

How Does It Work?<\/strong><\/p>\n

When you place a trade to buy or sell a stock, the various exchanges through which your broker trades the stock pays the broker a very small amount of money per share for the right to execute the transaction. This fee is the Payment for Order Flow, or PFOF. Exchanges typically pay brokers on the order of 19 or 20 mils<\/em> per share for the right to execute your trade. For reference, a mil is one hundredth of a cent, so 19 mils is 0.19 cents. So while the amount made on each individual trade is inconsequential, it adds up to tens of billions of dollars in aggregate every year.<\/p>\n

The reason why the broker is paid by the exchange and not the other way around is because the exchange then sells information about your trades before they are executed in order to profit. They do this through specialized investment partnerships known as \u201chigh frequency traders<\/a>,<\/u>\u201d which use algorithmic trading methods to \u201cfront run\u201d your trade by milliseconds to make money. There is quite a bit of debate as to whether this helps or hurts markets, which I\u2019ll address later.<\/p>\n

But here\u2019s where PFOF really gets ugly. Some brokers arrange with the exchanges to get a PFOF that is in excess<\/em> of what the market normally bears and build that into the price they charge clients. In other words, you end up paying more<\/em> for the trade, and the brokers make more money. For example, the market rate for PFOF is around 19 mils, but a broker might ask the exchanges to give them 70 mils, the difference of which they build into your price. Here\u2019s how it plays out: say you pay $10 per share to work with a broker that passes along the typical 19 mils of PFOF. If that broker imposes the \u201cpremium\u201d PFOF you\u2019ll pay $10.0051 ($10 + ($.0070-$.0019)) for the same stock. That means you\u2019ll pay $5.10 of PFOF for every 1,000 shares you buy. That\u2019s a huge premium on top of the typical commission of $4.95 per trade fee. In fact, brokers who impose a premium PFOF often charge much lower commissions only because they earn an equivalent or greater amount from their premium PFOF.<\/p>\n

Paying it Forward<\/strong><\/p>\n

Because we initially followed industry convention, Wealthfront used to earn a portion of the PFOF fee from our clients\u2019 trades generated by our former brokerage partner. Specifically, our brokerage partner charged us 35 mils to trade each client\u2019s share, then credited us back half the amount they earned in PFOF (9.5 mils, half of the standard 19 mils). So our net commission per share was 25.5 mils (35 \u2013 9.5).\u00a0 But as we dug in more, we realized industry convention felt kind of slimy, so we decided to do things differently and stop pocketing the PFOF fee from our partner.<\/p>\n

But we didn\u2019t just stop taking the fee; we gave it to our clients. Bringing our brokerage operations in house<\/a> in April enabled us to deal directly with the exchanges. This allowed us to negotiate with the exchanges to give what we would have earned in PFOF back to our clients in the form of a better price. For example, if you previously paid $10 to buy a share of an ETF, you now pay $9.9981 per share ($10 – $0.0019, or less the PFOF cost of 19 mils). The cost savings you earn per share might seem slight, but the benefit can really add up over time. We are not aware of any other advisory or brokerage firm that passes on PFOF savings to its clients.<\/p>\n

The unseemly nature of PFOF has recently attracted government attention. According to a New York Times op-ed<\/a> by Jonathan Macey, a professor at Yale Law School, and David Swensen, Yale\u2019s renowned chief investment officer, Senator Mark Warner, a member of a Senate subcommittee on banking and investment, recently wrote to SEC Chairman Jay Clayton urging the full elimination of PFOF to \u201cincrease price transparency, reduce fragmentation, strengthen stability, and bring U.S. equity markets\u201d closer to the competitive mandate. In this same article Macey and Swensen shared data that showed how IEX, a new stock exchange that doesn\u2019t pay PFOF, has consistently offered lower spreads (i.e. better pricing) than exchanges that offer PFOF.<\/p>\n

Parting Thoughts<\/strong><\/p>\n

PFOF is the dirty little secret of trading, so it\u2019s very important that you read the fine print whenever you engage with someone in the investment industry. Registered investment advisors like Wealthfront are required to disclose all their fees in their Form ADV. However, brokerage firms are not required by any regulatory entity to disclose information about their fees because they are not held to the same fiduciary standard<\/a> as advisors. So whether you\u2019re working with a traditional brokerage firm or trading app, always ask about what kind of PFOF they earn and how it affects your bottom line. You should consider it a big red flag if they\u2019re unwilling to disclose that information.<\/p>\n

1<\/sup> As we explained in Fees Can Destroy Your Returns<\/a>, the sum of your obvious, nickel and dime and hidden fees can be greater than 3% \u2013 4% per year. That can represent more than half your expected gross return.<\/h6>\n","protected":false},"excerpt":{"rendered":"

A few years ago I wrote a blog post that attempted to comprehensively outline all the apparent and hidden fees that can eat away at your investment return. This was (and still is) important because over the course of 30 years fees can actually lower your net worth by as much as 50%.1 But as […]<\/p>\n","protected":false},"author":4,"featured_media":7672,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"inline_featured_image":false,"footnotes":""},"categories":[1315,1282],"tags":[1491,1296,1281,2220,1694],"coauthors":[99],"class_list":["post-7694","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-industry-insights","category-investing","tag-brokerage-fees","tag-fees","tag-investing","tag-pfof","tag-stock"],"acf":[],"yoast_head":"\nThe Silent Assassin of Fees | Wealthfront<\/title>\n<meta name=\"description\" content=\"Payment For Order Flow, or PFOF, is both complicated and highly contested, so today I\u2019ll help unpack how it works and explain Wealthfront's position.\" \/>\n<meta name=\"robots\" content=\"index, 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