Wednesday, 1 March 2017

Brokerage/ETF price wars, and implications for the cost of capital

The Wall Street Journal reported this morning that Fidelity has announced a reduction in its online trading commission rates from US$7.95 to US$4.95 a trade. This move follows Charles Schwab's decision several weeks ago to cut its commissions from US$8.95 to US$6.95, and in response to Fidelity's decision, Schwab announced yet a further reduction in rates to US$4.95 as well. This emergent price war among discount online brokerages has sent the share prices of Schwab, TD Ameritrade, and E*Trade into a tailspin (and rightly so).

It remains to be seen how far this price war has to run, but it could be a fairly long way, as these brokerages still charge considerably more than disruptor Interactive Brokers (your correspondent's primary broker), which allows you to trade US stocks for as little as 1c per share due to the platform being fully automated. It would appear that the cost of trading is on course to continue to trend steadily towards zero over time.*

These moves come alongside the now much-discussed trend towards investors moving funds out of high-cost, actively-managed funds and into low-cost, passive index vehicles - some of which charge less than 10bp. Active management fees are also trending down - partly in response to growing competition from passive vehicles (e.g. the WSJ reported just yesterday that Paul Tudor Jones has reduced his base fees from 2.75% to 1.75%). In short, the wrecking ball of capitalist competitive forces is finally being brought to bear on the world's archetypal capitalist institution - the stock market - and resulting in a long-overdue squeezing out of excessive fees/rents.

So here is an interesting question and potential implication from the above that I have never seen anyone posit or discuss: does the falling cost of trading and investing mean that the gross (pre-fee) cost of capital ought to fall, and hence market valuations rise?

In answer - in theory at least - is a resounding yes. Investors' net returns are comprised of gross returns less management fees and other trading costs (ignoring tax). In theory, stock prices should reflect the capitalized value of net returns, being the returns actually realized by investors, not gross returns, so if fees and trading costs are in the aggregate declining, the gross cost of capital ought to decline in sympathy.

We see this theory in action quite clearly in the case of listed investment companies (LICs), which very frequently trade at a discount to NAV. This is rational. If the expected gross return of an LIC is say 8%, and fees and costs are say 1%, then a 1/8 = 12.5% NAV discount should be (and generally is) applied. This discount ensures that the net return to the investor is equivalent to the gross return of the fund, with the entry-point discount offsetting the impact of costs. If fees were to decline, it would be logical to expect this discount to narrow.

Analogously, if the cost of both trading and accessing investment vehicles such as ETFs are falling significantly, logically stocks ought to trade at somewhat higher levels than they have in the past. How much so is up for debate, but it could be as much as 10% or more. I have never seen this issue identified/mentioned by anyone in the investment community, let alone analyzed. There is an academic paper waiting to be written here (if anyone cares to plagiarise my idea, please go ahead).

That's the theory at least. In practice I'm somewhat less confident it will make too much of a difference. The world of stock markets and finance is messy and often does not work the way theoretical academic models say that it should. It's an interesting issue to ponder, however, and is yet another potential justification for the declining cost of capital I have recently discussed.

Comments/thoughts welcome.


*Incidentally, one of the bull theses on Interactive Brokers the stock (IBKR US) has been that its pricing has been only 1/8th of competitors, and so it has latent pricing power. I think the more likely outcome is that competitors' prices decline towards IBKR's levels. In addition, longer term, automation is likely to become more widespread, and so it is quite possible commission rates fall further still. I'm a huge fan of IBKR as a customer, and cannot recommend them highly enough, but I can't quite make the numbers work as an investor in their (expensive) stock.