What Wall Street Doesn't Want You To Know
Feb 26, 2016
You’ve heard it before: “buy and hold.” If you’ve tuned in to Truth or Skepticism, you’ve heard Tom Sosnoff and Dylan Ratigan debate passive versus active investing. One of the most common ways to passively invest is buying a no-load mutual fund that mirrors an index. Firms that manage these funds may not charge a “load” but they charge expense fees.
It’s not true. Mutual funds buy and sell products to create a portfolio. Funds are specific about the mix of products they can own. They might also have limitations on types of products they own. For example, funds might be barred from owning junk bonds or stocks under a certain price.
Let’s assume for a moment you own a no-load fund mirroring the Dow Jones Industrial Average. Creating and maintaining that fund requires a lot of trading as people buy shares of the fund and redeem (sell) them. Also, as companies are added or removed from the Dow, funds have to adjust their portfolio to mirror the index.
Trades required to keep a fund current have an associated cost. Someone is paying for those trades but who that “someone” is might surprise you.
On Wall Street, there is a common practice known as “payment for order flow.”
Here's how it works: In March 2015, Apple was added to the Dow, replacing AT&T. To maintain balance with the Dow, funds had to buy shares in AAPL and sell shares in T. Those trades cost commissions, right? Have you ever done a trade and not been charged commission? Me neither.
Guess what, your no-load fund charged you too but they call it an expense fee. Wait it gets SO much better.
When your fund buys Apple and sells AT&T, someone is taking the other side of those trades. Chances are, the firm running your fund is not the one doing so because of the risk exposure. To mitigate that risk, your fund company may use a third-party to execute trades. Not only do third-party firms execute those trades but they actually pay your fund company for those trades!
This business model between brokerage/fund companies and third parties is very much like the model used by casinos and “high rollers.” Casinos entice gamblers to gamble at their casino. They may offer free food, a free room, or other perks like a free round-trip flight. The cost of these “comps” are nominal compared with how much money the casino may potentially make once that high roller sits down at the tables. They are essentially buying business.
The truth is, expenses associated with transacting all those trades often do not even exist. But your fund company charges a fee as if they do. In reality, your firm may be paid for their business while at the same time, charging you an expense fee. Passivity does indeed pay, just not for retail customers.
If you don’t believe me, ask yourself this simple question: How do no-load fund companies make money? This isn’t exactly an industry known for being unprofitable.
Josh Fabian has been trading futures and derivatives for more than 25 years.
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