No matter what ETF detractors say, the ability to buy and sell ETF shares without incurring a brokerage commission is one of the great investor-friendly innovations. But is it everything it’s cracked up to be?
The idea of commission-free ETF trading was hatched in 2009 when Charles Schwab began offering its brokerage clients zero-cost brokerage trades for online execution with Schwab-branded ETFs. During the first few years, quarterly asset flows into Schwab ETFs were relatively modest, averaging from $1 to $2 billion per quarter. More recently, the market strategy of commission-free trades as a way to gather investors’ assets has proven itself true. For Schwab, asset flows into its ETFs have shot higher, averaging $4.5 million to $6.5 billion over the past several quarters.
Recognizing this trend, competing brokerage firms have piled into the ETF market with their own commission-free ETF menus. E*Trade now offers commission-free trading on 133 ETFs; TD Ameritrade has 101 ETFs and Fidelity offers 91 ETFs.
Before we discuss the pitfalls of commission-free ETF trading, let’s mention one very big advantage: dollar-cost averaging.
For years, mutual fund companies have lauded dollar-cost averaging as a viable strategy for wealth accumulation. Since people are investing a fixed dollar amount on a regular basis, regardless of a fund’s share price or market conditions, dollar-cost averaging keeps investors disciplined by removing emotion.
Historically, dollar-cost averaging was only available to mutual fund investors whereas now the prevalence of commission-free trading has opened this strategy of regular investments to ETF investors. This is especially important for ETF investors with smaller increments to invest because now they don’t have to worry about commission rates negating the benefits of dollar-cost averaging. In the past, commissions represented a disproportionately large amount of the invested dollars, but with zero-brokerage costs for ETF trades readily available, previous barriers are removed.
Are there any downsides to commission-free ETF trading?
Human psychology is perhaps the biggest unknown when it comes to buying or selling ETFs with no transaction fee. Will people have self-restraint or will they turn into day traders? Really, entering a commission-free world is akin to eating at a buffet. While the food may be delicious, losing self-control can be quite easy for undisciplined types. To discourage active trading, several brokerages charge investors a redemption fee for selling their ETFs before a certain time frame.
Another potential pitfall is that fund selection on commission-free menus may be limited or offer inferior choices compared to ETFs not on the list.
For example, some ETFs on the commission-free menu may command higher annual expense ratios versus peer ETFs available elsewhere. For long-term investors, it may make sense to forgo a commission-free trade on ETFs with higher expenses in favor of a non-commission-free ETF with lower expenses. The long-term savings of lower fund expenses should more than offset the short-term cost of infrequent brokerage trades. This is particularly true for investors with large lump sums.