Gallery:Step 7|Step 7: Silent Partners

Hidden Trading Costs ETF Investors Should Know About

Gallery:Step 7|Step 7: Silent Partners

How does a small investor know he is getting the best price when he buys or sells an exchange-traded fund (ETF)? The truth is that brokers may quite legally complete a trade at less-than-optimal prices and pocket the difference, and the investor may never be the wiser.

How does that happen?

Brokers often buy equity positions to trade, becoming market makers or dealers. In essence this puts them in competition with their own customers. Essentially, the brokers hold inside knowledge of trades in the hopper, and this can lead to handsome profits. Brokers can also route trades to third-parties who profit from completing transactions and who offer cash rebates called "payment for order flow". There is no assurance in either case that the customer has received the best possible deal.

At the center of these issues is the bid-ask spread, or the difference between the lowest price a seller offers and the highest price a buyer will pay. This difference or spread is what gives incentive to middlemen to complete the trade for everyone's benefit. In the era of computer networking, no one believes this spread has to be large for very liquid stocks. At the same time no one believes it will go away completely. A problem common to all stock transactions, the ask/bid issue is a separate one from the trading/net asset value premium discount issue we discussed in a recent article.

The bid-ask spread often costs 1% or more to the investor, acting much like a "load" in a mutual fund and dragging down long-term profits. It is one of the primary drains on the small investor's final returns. The good news is that the ease with which middlemen can abuse their positions is dropping for a variety of reasons, including greater competition among brokers, better technology, and stricter regulatory controls. A bit of vigilance on the part of the investor is the main ingredient to getting a fair trade.

One strategy to avoid being taken advantage of is to issue limit orders, or orders to buy or sell at a fixed price as opposed to market orders which are placed at the "best price". This removes flexibility from the broker - flexibility that can be abused.

There is a misconception that indexers need only worry about bid-ask spreads with exchange-traded funds bought or sold mid-day through a brokerage. Not true. Mutual funds also face bid-ask spread costs because they also trade securities. In addition, funds are exposed to the danger of injecting volatility with big orders that may swing the market. Partial remedies exist for funds to help mitigate both of these trading costs. For instance, Instinet, Reuters' institutional trading system boasts that it ensures anonymity, never holds positions in competition against its customers, and more rigorously seeks the best possible price.

Downward pressure on bid-ask spreads is expected as stock markets "decimalize" stock quotes, which in effect allows spreads to shrink to one penny. The Nasdaq, once criticized for keeping ask/bid increments unnecessarily large, is expected to decimalize major stocks this fall. Currently stocks are listed in 1/16ths of a dollar, while decimilazation will allow them to be quoted in pennies.

Pressure on the bid-ask spread is also coming from numerous electronic exchanges and discount brokers that market their ability to more methodically seek out the best possible price for investors. The ones who don't are being singled out in the media and by word-of-mouth.

Lastly, the Securities Exchange Commission continues to apply pressure on exchanges to decrease spreads.

Perhaps the most controversial aspect of the bid-ask spread is so-called payment for order flow. This occurs when a broker directs large amounts of orders to an independent market maker, a firm whose specialty is bringing buyers and sellers together, taking the spread as profit. Such market makers return stock brokers a cash rebate called payment for order flow. Critics decry it as a crude kickback.

"We have come out fairly strongly against that practice in the past. A broker-dealer who accepts payment for order flow is advantaging one set of customers over another, " says Deborah Mittelman, a Vice President in execution services at Instinet Corp., "They also have a free look at orders before they go to the market."

The SEC barely tolerates payments for order flow, as can be seen from an announcement on the subject his month:

"Since its growth in the 1980s in the equities markets, the Commission has made clear its concern about the practice of payment for order flow. It has repeatedly recognized that the practice constitutes a potential conflict for brokers handling customer orders, and that it may present a threat to aggressive quote competition.

At the same time, we have acknowledged that payment for order flow is not necessarily inconsistent with a broker's duty of best execution, and that it has become a feature of competition among our equity market centers. The Commission decided not to ban payment for order flow in the early 1990s. In considering the arrangements, the Commission noted that payment for order flow is, in substance, the economic equivalent of internalization."


Indeed, research by the Federal Reserve suggests that payment for order flow may actually lower bid-ask spreads. A working paper by by two Atlanta researchers on the subject can be downloaded from the Web.

Kenneth D. Pasternak, CEO of Knight Trading Group, a major independent market maker which pays for order flow, defended the practice before the subcommitte on Securities of the U.S. Senate Committee on Banking, Housing and Urban Affairs, April 26, 2000:

"It has been the subject of incessant debate because it obviously poses a potential conflict: if a market center like ours gives brokers cash rebates or other inducements, how can the investor be sure than an order will receive the best possible execution?"

".Last year, we rebated nearly $139 million to our broker-dealer clients who sent us their order flow. What our client firms did with that money is a question best answered by them, but no doubt they would tell you that, because of those rebates, their customers paid lower commissions, received more free real-time market data, and more free technical and fundamental analysis of more and more securities."

Payment for order flow may seem like a conflict of interest, he admits, but "the securities industry is rife with conflicts". For instance, firms underwrite and recommend securities at the same time. He advocates full and fair disclosure as the main solution to all such potential conflicts of interest.