You Will Be Investing For Free In 5 Years

by: Herbert Moore

Fund, trading, and advisory fees will fall to zero sooner than you think.

When European merchants embarked on trips to the East Indies in the early 1600s, they sought external capital to finance the voyages. The forming of the East India companies soon followed and for the first time individuals began investing in a company rather than in a single voyage. Called "joint stock companies," these organizations gave investors access to the equity of the company rather than simply any reward or gain from a single voyage.

While joint stock companies laid the framework for modern investing, the advent of mutual funds in the late 1920s created another large shift. With mutual funds, instead of investing in single securities, everyday investors could now pool their resources to diversify their risk. Investors no longer had to research individual companies and undertake the time consuming process of transacting shares. Rather, they could pay for and rely on the acumen of a professional manager to give them access to companies deemed worthy of investment.

As the economy boomed in the 1920s, Americans piled into the market in droves. This was the first time anybody besides the most affluent began participating in the market. While the stock market crash and the Great Depression left many penniless, what was left was a system in which almost anybody could invest directly through mutual funds or through an investment advisor. Undeterred by high trading fees and expenses, investors continued to flock to the market. This influx saw average trading commissions hover around $40 and mutual fund fees rise from 1.14% of assets in 1979 to 1.36% in 1999.

Today, while some have chosen lower-cost alternatives, many investors still rely on investment advisors to pick their investments, and in turn rely on the investment choices of the managers of the recommended funds. Those that do are subject to three primary fees: mutual fund or fund fees, trading fees, and advisory fees. However, over the past few years an increase in fin-tech companies have brought increased automation and scalability to the industry. As these technologies mature and new ones are introduced, advisors, brokerages, and fund managers will be able to keep pace with all levels of demand. As a result, not only will investors of all asset levels have access to high quality financial advisory and services, but the primary fees associated with investing will also be driven down to zero.

Fund Fees: The rise of passive investing and the fall of fund fees

Why investors will shift to passive investing:

Passive investors believe that over the long run the prices of stocks and bonds will reflect the true value of those securities, so they set up long-term strategies to capture the performance of the entire market. Comparatively, active investors believe the market is inefficient, so they bet on individual securities they believe are currently either over- or under-valued to exploit the inefficiencies for short-term gains.

Which strategy is better? Mutual funds, the largest sampling of professional active managers, have performed dismally compared to their underlying indexes. The most recent study by Standard & Poor's published in September 2013, showed that, depending on the specific market sector, 71% to 93% of domestic managers underperformed their relevant indices over the previous three years. This does not include the additional effect of tax consequences, which Morningstar estimates to add an additional 1-1.2% in annual cost to the investor's portfolio. Exchange-traded funds (ETFs) on the other hand, give investors a very low-fee way of tracking those indices, and have thus outperformed mutual funds.

A very low-cost index is going to beat a majority of the amateur-managed money or professionally-managed money. -- Warren Buffett

Passive investing through ETFs has two primary advantages that have helped it enjoy higher performance: minimal trading/fund fees and minimal tax consequences. As outperforming the market is ultimately a zero sum game, the average performance of all active investors will equal the market before fees and taxes. If you add in fees and tax consequences, the average performance of active investors will be less than the market. Further, research has shown there is no persistence of returns - mutual funds that outperformed in the past have no better chance of outperforming in the future than a randomly selected fund. This renders a strategy of picking the fund with the best historical performance useless. Finally and unsurprisingly, individual active investors tend to do even worse than actively managed mutual funds, most likely due to time constraints and access to the same level of tools/research.

As a result, investors have begun to vote with their money by moving into passively managed investment strategies. Below is a chart recently published by Bank of America that shows the upward trend of passive funds at the expense of active funds.

Passive investment has claimed market share from actively managed mutual funds:

Why passive fund fees will fall further:

As investors continue to be stymied by the performance of active management, they will increasingly shift to passive funds. The continued flow of assets into this area will introduce new competition for those assets in the form of new funds, and fund managers will compete by further lowering fees. Indeed, we have seen fees fall drastically with many ETF sponsors offering funds with fees of less than 0.10%. The ETF business is hugely scalable, so as assets get bigger and bigger, ETF sponsors will be able to drop their prices further.

ETF sponsors will afford to do this by offsetting the lost fee revenue with proceeds of their securities lending business and by scalability with a larger asset base. Securities lending is complex, but for ETF sponsors it means being able to lend out the underlying securities of the ETF for a fee - iShares has a good description of it here. In fact, iShares is already able to offset much of its management fee with securities lending revenues - for example, iShares Small Cap US Equity ETF IWM has an expense ratio of 0.20% but earned 0.20% in securities lending in 2013, meaning that the effective fee was zero.

Vanguard's head of retail Investments, Nick Blake, has also weighed in on this, saying that "in theory, we could pay investors to invest in us [as] stock lending can [create] a negative TER [total expense ratio] …There will always be a fixed cost in there, but if volume is big, the total expense ratio can come right down."

Even if securities lending cannot make up for all ETF expenses, competition could put such downward pressure on expense ratios that they fall to an almost inconsequential annual fee. This can already be seen in the largest ETFs such as VTI and VOO, which have expense ratios of just 0.05%. These ETFs are able to offer low fees because of the enormous amount of assets invested in them ($300B and $155B respectively), and they are forced to offer ultra-low fees because of perfect competition within those sectors. As we see more investors move to ETFs, it will only perpetuate this trend: ETFs will become so large that a seemingly meager basis point will still be meaningful revenue, and ETF sponsors will be forced to move their fees to effectively zero to compete in a perfectly competitive market. Even without securities lending, this could mean that ETF fees across the largest market sectors could become effectively zero at 1-5 basis points.

Trading fees: Zero is inevitable

Investors are also increasingly benefiting from lower trading fees. Whereas brokerage firms charged close to $40 per trade through the 1980s and 1990s, online brokerages now charge less than $10. With scalability, the marginal cost to a broker for processing a trade becomes zero, and brokerages will be able to offer free trading by focusing on other revenue streams.

Processing a trade costs a brokerage (virtually) nothing

Trading commissions consist of a clearing fee (though if the broker self clears there is no clearing fee), an exchange fee, and any markup by the broker to cover the cost of the platform, customer service, etc. Of these, the exchange fee is the only inescapable cost, while the others are simply markups charged by a clearing or brokerage firm. The actual costs of clearing a trade through an exchange are minimal at just fractions of a cent. The NYSE, one of the more expensive exchanges, charges $0.0025 if you are taking liquidity with a trade, and rebates $0.00150 if you are providing liquidity. While the brokerage and clearing infrastructure can be expensive to create, at thousands or millions of trades, the cost per individual trade becomes negligible to the firm. An external brokerage and clearing firm like Apex (clears for smaller online brokerages like TradeKing, Zecco, Firstrade and others) charges just pennies per share on anything over 100,000 trades per month, giving a proxy for how much the internal trading infrastructure costs at scale.

Brokerages will be able to generate revenue and profits from other activities

In addition to trade commissions, brokerages earn money through the spread of the cost of their borrowing and rates charged on margin lending (lending investors money to buy securities) and through the spread earned by facilitating the transaction between lender and borrower in securities lending. While these interest rate spreads can be driven lower by competition (and indeed they already have), when it comes to retail clients, it is the price of their trading commissions on which brokerages typically compete: $9 per trade, $5 per trade, etc. Ultimately in a bid to win customers they will reduce the headline commission price to $0 (makes for a great headline) while focusing on revenue from interest rate spreads.

Portfolio management: Fees are on their way to zero

By now you're probably seeing the trend: scale coupled with automation can bring costs down to basically zero. How does this play out in the traditionally human capital-intensive portfolio management industry?

Portfolio management is scalable

It shouldn't be surprising that, at its essence, portfolio management is easily scalable. After an advisor has put his or her best thought into creating a well-diversified portfolio for one client, why wouldn't the same strategy work for another client with the same risk tolerance/time horizon/investment goal? Even a traditional "brick and mortar" advisor with a smaller client base (say <100) will see different clients with similar profiles; an advisor can have models for an aggressive portfolio, a conservative portfolio, a long-term portfolio and select or adapt the most appropriate strategy for his or her assessment of the client.

The difficulty for most brick and mortar financial advisors is that each client portfolio has to be monitored to ensure it stays in line with the original modeled allocation. Further, contributions and withdrawals have to be processed, dividends have to be re-invested, accounts needed to be billed, etc. While each task is small, their traditionally manual nature requires the advisor to dedicate significant time to overseeing each client. Fortunately, there have been new online tools emerging over the past decade to help these advisors with automating everything from modeling to billing, which has significantly streamlined their processes.

New online investment advisors take advantage of automation to leverage scalability

We are now seeing the emergence of online alternatives to the original status quo in the form of online-only financial advisors. While they require more upfront work for the company in regards to portfolio modeling and building the infrastructure, this creates incredible automation and scalability. For example, the traditional relationship building process, in which a client had to schedule an office visit, spend 30-60 minutes explaining their preferences and goals, and then fill out paperwork just to start, can often be completed in less than 10 minutes online. Rather than answer these questions in person, an online solution can recommend a portfolio tailored to each client's investor personality and goals. Similarly, the daily activities such as deposits, withdrawals, dividend reinvestments, and more can be automated. The automation allows each online advisor to properly manage each individual client, which results in almost limitless scalability.

As a result, the marginal cost of investment management approaches zero fairly rapidly. Whereas a brick and mortar investment advisor can have a marginal cost of hundreds or even thousands of dollars per client, for an online advisor, after the fixed costs are sunk for the modeling and infrastructure, there is virtually zero marginal cost for each additional client. Similar to ETFs and brokerages, competition will ultimately drive advisory prices down to the marginal cost of servicing an additional account, which is zero.

Is there anything that can't be automated?

While many of the aspects of investment advisory will decrease drastically in cost, the human element simply can't be scaled. A sizable percentage of the population will still pay a premium to talk to a human being. This privilege will continue to be enjoyed exclusively by larger investors, because with smaller clients the business proves unprofitable for the advisor and the fees will overwhelm the clients' portfolios.

Services such as managing trusts, larger estate planning, and the treatment of legacy holdings will prove more difficult to automate and scale, because there isn't a large market of individuals who require these services, and among those that do, there is rarely a "one-size-fits-all" solution. These functions will increasingly become the primary focus of brick and mortar financial advisors as they face increasing pressure on their 1%-2% management fees.

Where does this leave the industry?

The primary uncertainty is how fast investors will adapt to and demand the no-fee and lower-touch solutions.

Investors will always want some degree of hand-holding whether they're well versed in or brand new to the markets. However, they will have to make a choice between paying significant fees for the personal attention and paying virtually no fees for automation. Some clients will still prefer to deal with a person, even if the value proposition of a no-fee financial advisor coupled with no-fee products is undeniable. Whether he or she chooses a traditional or an online financial advisor, the client will benefit from the downward pressure on fund fees and the elimination of trading costs from trading platforms and brokerages.

Traditional advisors will retain their clients and will likely take on new clients, albeit at a slower pace. The online financial advisory business will grow tremendously as it attracts smaller clients, and those clients, affected by the same inertia as those with brick and mortar financial advisors, will remain with their online advisors while their assets grow. The new, online investment advisory business will not be a winner-take-all industry. Instead, it will begin to resemble the current investment advisory landscape of competitive top-tier firms, but without the smaller independents due to the larger startup costs.

Ultimately, all this means that the everyday investor will be able to invest for his or her retirement and short-term goals at virtually no cost. Given the recent advances in online financial advisory over the past few years, I'm confident this industry will undergo these changes within the next five years.

Disclosure: I am long SPY, VTI, IWM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.