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Iron Capital Insights

  • Iron Capital Insights
  • October 3, 2019
  • Chuck Osborne

No Free Lunch

“There is no such thing as a free lunch.” This age-old wisdom used to be common knowledge. Today politicians go around claiming they can make everything free. College? No problem, free it is. Healthcare? Why would anyone ever need to pay for that?

Of course, we are not as dense as our elected officials seem to think. There is a big difference between “free” and someone else paying for it. Colleges are expensive to operate. Professors and administrators are human beings like everyone else, and they require these pesky things known as salaries. Most colleges take up a large amount of real estate and that costs money, even if it is just the maintenance. College isn’t free. We could make the same comparisons with healthcare.

Charles Schwab announced this week that trading in certain securities is “free.” TD Ameritrade followed suit. Is it true? Of course not! There is no free lunch. These firms announced that they would no longer charge commissions. Commission-free trades are not free; the commission is the tip of the cost iceberg. The spread is where most of the cost occurs. There is a difference between the price a broker/dealer, such as Charles Schwab and TD Ameritrade, will pay to buy a security and what price it will accept to sell the same security. That difference is known as the spread.

The easiest way to think of it is the retailer’s markup. The price of a shirt at Macy’s is more than what Macy’s paid for the shirt – that is how Macy’s makes money. Those transactions do not include an added commission paid by the customer, yet we would not consider them free, would we?

Commissions made up approximately 7 percent of Charles Schwab’s revenue. They are only cutting a fraction of that 7 percent; this is more marketing than anything else. The truth is that today’s broker/dealers are more like banks than they were before the financial crisis. Their greatest source of revenue is the spread they collect on their customers’ cash. The cash that just sits in your brokerage account is loaned out overnight to other financial institutions that need reserves. The Charles Schwabs of the world collect that interest and pass on little of it, if any. At Iron Capital, this is why we took the step of actively investing our clients’ cash into money market funds so the interest goes back to our clients.

There is no free lunch in trading and there is no free lunch in a trade war. Early this week we saw manufacturing data which showed that the U.S. manufacturing sector is in actual decline. It was the worst reading in a decade. The European Union has projected that economic growth in Europe is basically zero for the third quarter and expected to be worse in the fourth quarter. The textbook definition of a recession is two negative growth quarters in a row. We are getting close.

Right now the market is still going nowhere. There are a lot of short-term ups and downs, but over the last 18 months or so we have gone nowhere. There is one reason: Trade. This whole dispute is negotiation and if successful it will lead to a better world, but in the meantime, we have to make investment decisions, and this is the world we actually live in. So, we remain cautious and a little defensive, as that is the prudent thing to do.

Warm regards,

Chuck Osborne, CFA
Managing Director