Free Investments Can Come at a Cost

There are now plenty of ways to invest with no fees or commissions — but free isn't always cheap.

Arielle O'SheaDecember 3, 2018
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There’s a new trend in investing: free.

You can now trade stocks, own index funds and even get portfolio management with no fee.

This is noteworthy, though investors may not realize it: Nearly a third of Americans who have an investment account think they don’t pay fees, according to NerdWallet research. (It’s not hard to draw a connection to this next finding: More than half say they don’t know how to locate the fees they pay.)

In reality, virtually every investor pays some type of fee at some point, but intense competition in the industry and new technology have been driving down those costs. The race appears to be hitting bottom: In 1996, the average equity mutual fund charged an annual fee — called an expense ratio — of 1.04% of the invested amount; in 2017, the average was nearly half that. Earlier this year, Fidelity Investments introduced four index funds with no expense ratio at all.

Those funds join a growing list of options for investors who want to cut overhead to the bone: Stocks can be traded commission-free through services like Robinhood and J.P. Morgan’s You Invest; brokers are widening their lists of no-transaction-fee and no-commission funds. There are also computer-based investment management services called robo-advisors — some of which charge no advisory fee, including one from established broker Charles Schwab.

All of this is good news for investors. But it pays to be aware of the following:

An upsell may be on the way

It’s the contemporary version of a free breakfast with a side of timeshare pitch: In many cases, free investment products and services are loss leaders to lure you in the door.

In the case of Fidelity’s zero-cost index fund, the broker may be hoping you’ll need or want some advice as your balance grows — in which case the company’s robo-advisor, Fidelity Go, will prove convenient — or that you’ll diversify your portfolio into funds or accounts that do charge an annual fee or otherwise earn Fidelity money.

That’s not to say paying for advice is bad; on the contrary, good advice can actually make you money. “In the long term, a few basis points you pay for advice could make a world of difference in your overall retirement plan,” says Joe Wirbick, a certified financial planner and president of Sequinox in Lancaster, Pennsylvania.

But if and when you decide it’s time to pay for help managing your finances, you should consider the universe of services available to you — robo-advisor, human and hybrid — rather than just the options within your existing brokerage. (Learn more about how to choose a financial advisor.)

Cost is only one factor

It’s hard to overstate the impact of fees: Every dollar you pay to a commission or a fund expense ratio reduces your investment return. And because the money skimmed off by fees would otherwise be invested, the cost actually compounds over time. (Here’s more about the investment fees you should know.)

But investors blind to anything but fees are making a mistake. There is a laundry list of other factors to consider.

In the case of index funds and exchange-traded funds, that list includes performance and risk. These funds track a benchmark index. The goal is to meet — rather than beat — the market, but even so, funds that sound the same and track similar benchmarks can vary in their holdings, tax efficiency and returns.

“We’re often surprised at the return variation between different types of ETFs that should be tracking similar indexes,” says Derek Holman, a certified financial planner and the co-founder and managing director of EP Wealth Advisors in Torrance, California. That variation won’t be much, but it could be more than a slight difference in expense ratios.

With free investment management services like robo-advisors, consider how much of your portfolio is held in cash — the service is likely pocketing the interest on that allocation, or at least a portion of it, and that cash holding can reduce your return and introduce a potential conflict of interest. You can find this information in your account statement or by viewing your account online; any allocation to cash should be listed along with the other investments in your portfolio.

“They make more money the more that is allocated to cash, and they have control over how the money is allocated,” says Holman.

Unfettered access can backfire

Nobody leaves an all-you-can-eat buffet hungry. When the second slice of pie is “free,” you tend to make room. Similarly, you might find your appetite for trading increases when a commission or transaction fee is off the table.

“The indirect cost is that ‘no transaction fee’ has the potential to encourage more trading, and studies show that most people do a pretty poor job of trading frequently and managing their own money,” says Holman.

A commission can serve as a reminder to proceed carefully and gut-check your decision; free trading apps and commission-free investment lists may remove that mental barrier. That doesn’t mean you shouldn’t aim to reduce or avoid commissions, but it may mean you need to be more mindful of each transaction.

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