Understanding brokerage statements reveals the true cost of the service being provided.
Judging from the questions I receive from prospective clients, it is clear that many investors do not understand their brokerage statements and confirmations. During the bull market of the late 1990’s may people didn’t care what their trading costs were. But in a flat or declining market both visible and hidden costs can make a difference; so it is important to pay attention. Here are some things to consider when reviewing brokerage confirmations and statements for clients. Further, if they have been told they are not paying any commissions for their stock trades read this article carefully.
There are two kinds of brokerage transactions; agency transactions and principal transactions. An agency transaction occurs when the firm acts as a broker or agent. It results in the commission you see on a confirmation.
In a principal transaction the brokerage firm acts as a dealer, meaning that it sells out of, or buys into its own inventory of stock. The firm will earn a markup, a markdown, or the spread on the difference between what the stock cost the brokerage firm and what the client paid; but the amount of the markup or markdown is usually not disclosed. It can be identified by a notation on the confirmation such as “X firm makes a market in ABC stock.” So even though they are not charging a commission, they are still making money on the trade.
Many firms claim they only charge an annual “wrap fee,” and that the client does not pay any commission or other costs. But they may fail to disclose the costs their clients actually incur when trades take place. TV and print ads try to get people to focus only on the commissions they charge (or do not charge). In reality, the commission may be the smallest cost of a transaction. Whether it is a discount or on-line broker, a major brokerage firm, or an independent firm there is no such thing as a cost-free transaction. There are costs involved in every stock or bond trade.
While this cost can be passed on in the form of a visible ticket charge or commission, it can also be built into the trade, without disclosure to the investor. For example, if you assume a typical $25 cost per trade, an account with 15 trades in four companies will generate $375 in costs to the investor. If the same number of shares were purchased in four trades (one per company), the cost would have been only $100. Careful attention needs to be paid to the number of transactions and the number of different issues.
The same applies to mutual funds. You can usually move from one fund to another within a share class at a fund family without any commissions or transaction charges. You are therefore usually better off with one class of shares using one, or perhaps two mutual fund families at the most. A brokerage statement that shows a smorgasbord of different fund families and share classes could be a red flag that too much is being paid and that the investor is not receiving reduced “breakpoint” commissions available to investors in a single fund family.
Pay attention to the “solicited” and “unsolicited” disclosure on trade confirmations, too. This is a required disclosure for every trade. It tells the broker’s compliance department whether the broker or the client initiated the trade. This is important because if the broker recommends the trade (purchase or sale) the broker has to make sure it is a suitable trade for the client. As a result, they have much higher liability than if the investor chose it themselves. Think of this from the broker’s perspective. If the broker recommended the trade it was solicited. If the investor asked the broker to buy or sell the stock, bond or fund it was unsolicited. Hence, if confirmations repeatedly show the unsolicited disclosure but the client didn’t request the trade it can be another red flag.
For the most part there are many good, reputable, honest people working in the financial service profession. And there is a lot of work that goes on behind the scene. Financial service professionals and their firms deserve to be fairly compensated for their time and service. The issue is not which brokerage firm or method of compensation is better. The issue is, are investors paying a fair amount for the services they receive, and do they really understand what their total costs are?
No one can make an informed decision without full disclosure, and without a full understanding of brokerage confirmations and statements. Practitioners who have clients with questions or who discover areas of concern should consult with a reputable Registered Investment Advisor who can help them understand brokerage confirmations and statements.
