Free Fund Trading?

October 19, 2006

It was bound to happen sooner or later. With Google buying startup YouTube from a couple of twenty-somethings for almost two billion smackers, other dot-com era ideas had to be in the pipeline.

On Wednesday Bank of America announced free trading for their Banc of America brokerage customers. The stocks of competitors like E*Trade (ET), TD Ameritrade (AMTD), and Charles Schwab (SCHW) fell sharply on the news. Is a price war brewing?

This bold, dot-com era move (it’s been tried before) is noteworthy to mutual fund investors because today there are so many other ETF (exchange traded fund) choices. ETFs trade on exchanges like stocks, and therefore, the same zero-commission offer would apply.

The main downside of ETFs over ordinary index mutual funds is having to pay commissions to buy and sell them. This can easily wipe out the benefits of low fund operating fees, particularly for smaller trades or with those making regular investments.

If you buy $5,000 worth of an ETF, hold it for one year and sell, a 0.25% ETF expense ratio quickly becomes 0.85% in total expenses (2 trades at $14.95 works out to 0.60% of $5,000).

Then you have to factor in the “spread” between the bid and the ask price. Ignoring commissions completely, you’d still lose money buying an ETF and selling it a few seconds later – not because the market moves but because you buy at the ask (higher) price and sell at the bid (lower) price.

Another factor rarely considered is that the market price can be slightly higher than the actual underlying NAV or net asset value of the ETF. If you wind up selling when the market price is at a slight discount, you lose even more on the trade.

The typical ETF investor is paying closer to 1% a year to trade and own ETFs when you factor in commissions, spreads, and premium/discounts – far more than a plain-vanilla index fund investor would have to swallow.

And most new ETFs today have expense ratios higher than 0.25%. Worse, most ETF investors have holding periods measurable in days, not years.

For these reasons we’re excited about Bank of America’s new deal for ETF investors. For ordinary mutual fund investors (those who buy Vanguard, Janus, American Century, and T. Rowe Price funds), the offering is less compelling – commissions for buying and selling ordinary mutual funds at Bank of America are among the highest in the business.

Like most brokers, you can buy about 1,200 funds (some parts of their website claim 1,500, others 1,200) with no transaction fee or commission (as long as you hold for at least 90 days). As BofA’s website says, “Because of our relationships with the fund companies, you can purchase No Transaction Fee Funds, or NTF Funds, without paying any sales charges or additional transaction fees”. This “relationship” is the one where higher-fee funds kick back some of the fees paid by fund shareholders (whether they own the fund through a broker or not) back to the broker.

The trouble is with the non-NTF funds – generally the cheap ones that don’t play the kickback game. If you buy a Vanguard or Dodge & Cox fund in your Banc of America brokerage account, you’ll pay somewhere between $45 and several hundred dollars per trade (you get a 10% break for online trades – big whoop). Putting $5,000 into a Vanguard or Bridgeway fund will cost you $45. It’s worth noting that many cheap funds like T. Rowe Price and Janus now have special higher-fee classes and are available for NTF at brokers like BofA.

There are a few other catches:

Clients need $25,000 in combined assets at Bank of America (one of the top 5 banks in the world) in order to use the new system. This DOES NOT INCLUDE money in the brokerage division – you must have this balance in CDs, checking, savings or money market accounts with Bank of America, not Banc of America Investment Services (the brokerage arm).

This can be tricky because checking, savings, and money market accounts at Bank of America (like most big banks) pay paltry rates of interest.

Park $40,000 in a BofA money market and you’ll earn an unimpressive 2.37% a year (I earn 5.05% on my online savings account at HSBC – with no minimum to boot). You’re giving up $500 a year on a $25,000 balance – enough to pay the trading commissions at your regular discount broker. Don’t lose $500 to save $14.95 a few times a year.

The best way to qualify for the free trades is to park $25,000 in a Bank of America CD. While they currently tease you with a 5%, 7-month high-yield CD, you can expect to consistently earn a full 1% less than competitive CD players. In other words, you’re tossing away about $250 a year parking CDs at BofA compared to say, NetBank or E*Trade bank (or many others).

On the flip side, if you already park $25,000 in low-yield checking, savings, and CD accounts at other big banks (Citigroup, Chase), there is no lost income if you switch – which is what they really want you to do at Bank of America anyway. This move is really more of a threat to Citigroup than to TD Ameritrade.

You can’t trade more than 30 times a month and get free trades. Bank of America isn’t interested in stealing active traders from online brokers (or losing money on the accounts, which is what would happen if a day trader had a zero-commission account – it would be like giving free, all-park passes to kids at Disneyland).

The brokerage industry claims you’ll get better execution (speed and price) than you’ll get at Bank of America, though this claim is hard to prove. Whether your ETF trade goes through in 2 seconds or 2 minutes is irrelevant to a non-active trader accustomed to ordinary mutual funds, which only allow trading at the end of the day.

Bottom line: If you primarily invest in ETFs, stocks, and mutual funds that trade without transaction fees (check the list below), and you trade fairly often (say, more than 30 times a year), you can do well taking advantage of Bank of America’s free trade offer. Others will do much better at a low-fee broker like Firstrade where you can buy any ordinary mutual fund for free (including Vanguard), and trade ETFs, closed-end funds, and stocks for just $6.95.

The offer is currently available in the Northeast, but Bank of America will be rolling out the service across the country in the next few months.