Modern Robin Hood is No Hero

Last week, I wrote that that frenetic trading of a handful of stocks was affecting our portfolios, albeit moderately. I noted that GameStop was the largest holding in the S&P 600 small-cap index, which meant that we owned it through the index fund that tracks that index (and a few other places: for more, click here).

Last week, GameStop stock fell -80 percent, but it didn’t hurt us too badly since the S&P 600 index rose by 5.4 percent. That’s a better outcome than I would have expected, but it’s a signal of the rally’s strength last week. While it doesn’t matter, I can’t help but wonder what the performance would have been if GameStop kept riding higher. Either way, I’m happy that GameStop is no longer close to the top ten holdings.

Although we probably haven’t seen the end of this saga yet, there are a few important points worth highlighting.

For starters, it’s good to have your money with a reputable firm. Almost all of the money that we manage is held in custody at Charles Schwab, which we’ve been using since the inception of the firm. We use a few others but we like the mix of service, technology, cost, and safety that we get from Schwab.

Interestingly, we can thank Robin Hood for some of the low cost at Schwab. Although Schwab is a pioneer in discount trading, there was still an explicit cost to trade on their platform. I think it was $29.95 when we started Acropolis and was $4.95 until it went commission-free in 2019.

Although the previous cuts in commissions were due to competition from other, similar firms, the cut to zero was a response to Robin Hood, who launched with zero commissions.

Does that mean that it’s ‘free’ to trade at Robin Hood? Nope. Nor is it ‘free’ to trade at Schwab. Brokerages make money from a variety of sources, most notably on cash. At Schwab, the net interest revenue on cash accounted for more than half of their revenue in 2020 (the filing can be found here).

The next largest revenue line item is ‘asset management and administration fees,’ which largely what they earn on their ETFs, mutual funds, and money markets. That accounted for 30 percent of their revenue.

The third line item is ‘trading revenue,’ and is 12 percent of revenue. I didn’t read the entire annual report, but the trading revenue largely refers to what the industry calls ‘payment for order flow.’

When we send an order through their platform, Schwab directs the order to other brokers to find the best price, which is also known as ‘best execution.’ In that process, other brokers are willing pay Schwab for the orders, which raises the question: is Schwab sending the order to the broker who gives them the best price, or to where Schwab can get paid the most?

Obviously, this is an important question, which is why Schwab details how their process works and why they believe that it is a benefit to investors. On their website, Schwab reports that they get better prices than the national best bid and offer on 91.8 to 95.8 percent of the trades of S&P 500 stocks, depending on the size of the trade. There are a ton of details here.

Robin Hood may provide the same level of transparency, I didn’t look. The same with other brokers like Merrill Lynch and UBS. This is an industry-wide practice that’s been going on for decades. I first learned about it in 1995, when my first employer was looking into it (the firm we talked to was Madoff Securities, but that’s another story).

A well-known book by Michael Lewis, author of Moneyball and The Blind Side covered this in great detail, and after I read it, I decided to hire a third-party firm to determine whether we were getting good execution. And, I’ve written about it extensively over the years, most recently, here.

What we found in the five years that we’ve had this analysis is that we pay ‘the market’ about $8-12,000 per year in market impact across the entire firm. That’s right, in 2018, we executed almost 29,000 trades worth over $1 billion, and the market impact was about $12,750.

In other words, we run a tight ship, and I’d be willing to bet that the same trades at Robin Hood would have lost a lot more to the market even though they were ‘free.’

We generally do this analysis in the first quarter, and when we get the numbers, I’ll do another article on the subject. It’s a great insight into the nuts and bolts of trading that we take very seriously, even though it’s probably under-appreciated by clients.

Although this post is already a little long-in-the-tooth, I want to say that the other big takeaway from the Robin Hood affair was that they had to raise $2.4 billion in new capital to remain operational.

In their press release, Robin Hood said that it was to fuel customer growth, but the reality is that regulators said they needed to raise the money to cover the risk that occurs between when a trade takes place and when money is exchanged for shares.

I’m young enough that I don’t really remember brokerages going belly-up, but I heard stories about a few in St. Louis that did. I don’t think Robin Hood will have that much trouble, partly because they have the backing of some of the largest, most powerful, and well-funded venture capital firms in the world who want to protect their investment.

But it sure is nice to know that the custodian that holds all of our money (our clients, and our own) didn’t even think of raising capital during the GameStop frenzy. In fact, Schwab didn’t even restrict trading in the stock, unlike Robin Hood.

Part of what I said about Schwab at the top is that we appreciate the safety of having our money there. Although it’s true that anything to happen to anyone at any time, Schwab is well-positioned to absorb almost any shock. I viewed the 2008 financial crisis as an important test since other big brokerages suffered when they took risks that went sour, while Schwab kept above the fray.

I’m not a shill for Schwab, and sometimes they frustrate me. But, they are a great firm to work with, and what we witnessed in the last few weeks is a great reminder of this important partnership.