The downside of discount brokers
Jonathan Chevreau The National Post Tuesday, February 22, 2000
Investors give up speed, guidance in exchange for low fees

Discount brokerages have enjoyed heady success the past few years, so much so that their sheer popularity seems to have degraded service.

In a bull market that reinforces the average investor's feeling of omniscience and infallibility, the lure of eliminating the lion's share of brokerage commissions is understandable. Fast-acting day traders are in and out of securities so quickly that "round trip" sales charges executed at full-service brokers would quickly deplete returns on all but the most spectacular capital gains.

But investors are beginning to experience the downside of minimal service and advice. Waits of an hour or two to implement transactions by telephone or to get broker errors corrected are now not uncommon at such major discount brokerages as TD Waterhouse or even Internet-based services like E*Trade Canada. In a fast-rising market like Nasdaq, multi-hour waits can add up to thousands of dollars in opportunity loss.

Dalbar Inc. recently quantified how poor the service has become. It found that in December and January, the average phone wait time was eight to nine minutes for major Canadian discount brokers. But individuals have reported waits of more than an hour.

As Bylo Selhi, the Web-based, anonymous financial commentator and advocate for the individual investor, recently commented: "It's disgraceful that the discount brokers are running massive campaigns to attract new customers when they can't service their existing ones. Where are the regulators when we need them?"

Ironically, the benefits of the traditional full-service brokerage are suddenly being rediscovered by some investors. Not only is it a lot faster to reach a live human broker or her assistant by phone -- particularly if you're a valued customer with significant assets -- but in these choppy markets, the value of advice could also become apparent.

One full-service broker who experienced renewed traffic from discount refugees says his office ended up talking these clients out of many of their trades once suitability and know-your-client guidelines were applied. Many clients have both a full service account and a discount service. If service is too slow at the discounter, they simply do a trade through the full-service office.

"We're shaking our heads over the junk people are buying," says this old-timer. "In a strong wind, the turkeys fly. In a real strong wind, even cow turds fly."

People are buying highly speculative CDNX stocks, he says, based on such flimsy reasons as a son-in-law thought it was a good idea. "Some of these stocks make Bre-X look like General Motors."

To be sure, the two types of service appeal to different markets. The "buy and hold stocks for the long run" philosophy so beloved of the Warren Buffett investment cult suits full-service brokerages nicely. With the typical $80 to $100 minimum commission, you really shouldn't be buying stocks this way in less than $5,000 chunks. A $100 commission on a $5,000 trade works out to about 2%. But a $100 commission on a small $1,000 transaction is a hefty 10%, or 20% on a "round trip" (a buy followed by a sale).

Two per cent is considered a reasonable fee, since it's in line with front load charges on mutual funds, or comparable to the average 2.1% management expense ratio (MER) that is deducted yearly from mutual fund assets.

The beauty of buying individual stocks or bonds through a brokerage -- whether full-service or discount -- is that you are not paying that MER year after year. Someone who bought most of the major stocks on the TSE and held them for years would be out only the initial one-time commission, not a bad deal.

Similarly, someone intent on buying and holding TSE Index Participation Units (TIPs) would pay a one-time commission and then be virtually free of annual management fees. Most brokers charge additional brokerage fees to reinvest quarterly dividends whether from individual stocks or participation units.

Of course, one reason why day-traders may be flocking to TD Waterhouse and E*Trade is that many have small accounts to begin with, such as less than $5,000.

The problem with market timing or frequent trading is that those commissions can quickly wipe out the gains from the underlying stocks. Of course, if you're unfortunate enough to have an unscrupulous full-service broker who "churns" your account, you'd soon be depleting capital, but that is a topic for another day.

There is some negotiation possible on full-service trades. If the trade is unsolicited -- it's the investor's idea, not the broker's -- you might get half off.

With the arrival a year ago of Charles Schwab Canada, the lines between full service and discount have blurred somewhat. Paul Bates, Charles Schwab Canada president and chief executive, says he isn't so sure the backlash from the discount wait times is going to cause people to rediscover full service brokers.

"People choosing to be self managed do it because they want control over the process as much as they want lower cost," he says.

At his firm, clients can choose from a cut-rate pure electronic discount brokerage, an intermediate "broker-assisted" pricing model that does not dispense advice, and a full advisory service. The average commission will work out to $40, $60 and $100 for transactions going these three ways. The advisory clients can pay the traditional commission or pay an annual fee of 0.85% of assets up to $500,000, with a flat fee of $39 per transaction.

But because the firm has a $20,000 minimum asset level, the firm has been able to provide the necessary infrastructure to keep wait times down, Bates says.

One increasingly popular alternative is for Canadian investors to open accounts with U.S. discount brokers and then buy stocks or mutual funds over the Internet from them. For details, go to Bylo Selhi.

 

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