Prior to 1975, investors were charged a fixed commission on every transaction. It didn’t matter if you were an individual buying 100 shares of stock or an institutional investor buying 10,000 shares, you paid the same fixed rate to the stockbroker who handled the transaction. There was no negotiation or discounting.
On the other side of the transaction, stockbrokers executing orders in those days were paid hefty commissions. Many stockbrokers are still being paid hefty commissions today, even if they are not always readily apparent. The cost to the investor far exceeds what it would cost to execute online orders. Charles Schwab and some other online brokerage firms have a zero-commission rate.
All that changed on May 1, 1975 — known as Mayday. Mayday is perhaps the most significant date in the annals of investing, when the Securities Exchange Commission (SEC) instructed the brokerage industry to end fixed-price brokerage commissions and established the practice of negotiated commissions on stock trades.
Mayday, and the technological innovations that came in its wake, dramatically reduced the commissions rates to the investor and democratized investing as no single event before or since has done. Investors were free to choose whatever stockbroker offered the best prices.
Wall Street didn’t like what was happening. Brokerage industry spokesmen warned of impending doom once commissions were deregulated.
John Bogle, founder of Vanguard Group, said, “People spoke to what they believed was their own self-interest when they didn’t even realize they were wrong about what was in their best interest. Until commissions were deregulated that day, it was fixed-rate capitalism, not competitive capitalism.”[1]
Mayday is often described as a form of “deregulation.” It was a curious kind of deregulation, eliminating private-sector rules rather than governmental ones. In any event, the transformation it brought to the financial industry was not immediately obvious. At first, brokerages tended to keep their commission rates intact. In fact, the initial response of some firms was to raise the rates they charged small investors.
Over time, though, the changes would prove dramatic. Commissions, which had averaged over 80 cents per share in the early 1970s, dropped to approximately four cents per share by the turn of the century. While some well-known brokerage firms lowered their rates, deregulation of commissions paved the way for discount brokers who lowered commissions even more. Later, internet trading furthered that trend.
Individual investors could now conduct stock trades independently of a stockbroker and at a much-reduced cost per trade. Charles Schwab introduced online trading in 1996 and dominated the industry, later joined by upstart online discount firms like Ameritrade, E-Trade and Scottrade. Trading costs continued to plummet. In 1998, Schwab charged $60 per trade; by 2006, that cost had dropped to just $14; today, that cost is zero. The pioneering discount firm eventually converted its business model to rely more heavily on asset management.
The emergence of discount brokerage and online trading resulted in a significant increase in trading activity. According to a May 2000 CNET article, the average Charles Schwab customer averaged one trade per quarter during the 1990s. In the first quarter of 2000, that had nearly tripled to 2.8. As years passed, that trend continued. Ameritrade saw its average client trades per account climb steadily from 11 in 2005 to 12.9 in 2009 and then to 17.4 in 2014.
It became apparent that investor trading was increasing in response to faster technology and reduced costs. A 2015 article chronicled the upsurge: “The trend is clear. As technology has gotten faster, investors have traded more. When it’s both cheap and convenient to trade, the likely outcome is…more trading.”[2]
Consequences to the Investor
The new, more competitive environment might have been an unmitigated victory for investors except for the fact that the legacy Wall Street brokers were unwilling to continue reducing commissions without extracting something to offset the loss of income, paving the way for the Charles Schwab, Fidelity and Vanguards of the world.. They found that something in the form of transaction volume and less obvious fees. The more trades investors made, the more money that flowed into brokerage coffers. It was a whole new ballgame, being played in brand new ballparks, but investors were too busy “taking advantage” of the lower trading costs to notice that they had exchanged high commissions for high volume. While discount brokers made up for lower commissions by generating higher volume, major brokerage firms started the trend and replaced commission income with new product charges.
In his 2004 Berkshire Hathaway Chairman’s Letter, Warren Buffet noted,
“There have been three primary causes why investors didn’t earn juicy returns despite a multi-decade bull market: first, high costs, usually because investors traded excessively or spent far too much on investment management; second, portfolio decisions based on tips and fads rather than on thoughtful, quantified evaluation of businesses; and third, a start-and-stop approach to the market marked by untimely entries and exits. Investors should remember that excitement and expenses are their enemies.”
Another consequence of Mayday was the abuse of the term “discounted commissions” by brokerage firms. The term was employed to convince investors they were getting a significant reduction but in many cases, these were phantom discounts. One company whose name I will withhold used what I thought was a highly unethical approach. They allowed their brokers to put the term “discount commission” on confirmations while only discounting the commission one percent!
Another aspect of the impact of Mayday related to over-the-counter (OTC) trading. OTC securities were traded in some way other than on a formal stock exchange, such as a dealer network. This arena is subject to less transparency and regulation and so unsophisticated investors might not be aware of the difference. In the years following Mayday, OTC securities could be purchased by brokerage firms using a transaction called a principal trade. The advantage was that investors purchasing these securities from a broker would not see a commission listed on the trade confirmation. Many brokerage firms marketed OTC securities aggressively because they could charge higher commissions.
That was, in effect, the dawn of concealing commission charges. It’s also one reason why closed-end funds became popular for firms to underwrite as it provided an additional source of income since CEFs are issued at prices above its actual net asset value. Investors were told if they bought a new issue closed-end fund by a certain date, they would pay no commission. Bond funds also achieved popularity about the same time and for the same reason: Investors could make a $10,000 bond fund transaction without paying any commission. The appeal of these products was obvious. What was not as obvious were the upfront costs to investors.
Other firms tried to entice investors by offering discounts on commission rates they had previously raised above previous posted NYSE commission rates. So, while ostensibly offering say, a 20 percent discount, they were actually charging investors similar commissions and, in some cases, higher than they had in the past.
Individuals were treated very different than institutional brokerage (i.e banks, mutual funds, insurance companies and large corporations, etc.). Prior to Mayday, it didn’t matter which brokerage firm, mutual funds, banks, and other entities directed business to because the commission rate was the same everywhere. Once commissions rates were deregulated, brokers realized they couldn’t continue to live off of commissions indefinitely and so created new, packaged products — such as new issue insurance products, unit investment trusts, and new “B” and “C” class shares that disguised the costs to retail investors — to maintain and in many cases increase their profit margins. This led to a large number of stockbrokers and registered representatives, who were living off directed business, to leave the industry because they weren’t capable of selling these proprietary products to their clients.
I remember people at the time telling me they had purchased this product or that and didn’t have to pay a commission to their broker. But when I examined their trade confirmations, I would inevitably see they were listed as principal trades, one of the most expensive kind of transaction for retail investors.
I saw other, equally distasteful practices occur during this period. One such event prompted me to leave the brokerage firm I was with back in the 1970’s as a result. Our firm merged with another and with it came what I considered to be a highly disreputable executive. At the time, I was quite young and doing most of my business in municipal bonds. The new executive asked my advice on why and how I did so much municipal bond business. Back then the top tax rate was 70%, so tax-free municipal bonds were highly attractive to wealthy clients. I told him I only traded in AA or AAA rated bonds, looking for the highest available yield. After the executive digested everything I said, he told me I was doing everything wrong. He suggested I do what he started to do, which was to sell BAA bonds by emphasizing the “AA” while whispering the “B” when talking to clients. Using that verbal sleight of hand allowed him to claim investors must have misunderstood him once they discovered they had purchased BAA, not AA bonds. The yields on BAA bonds were naturally higher, since they were lower-rated issues, but the higher coupons appealed to investors, and by deliberately mumbling the “B” when he sold them, he was doing a landslide business. He also decided the best way to make even more money for himself with municipal bonds was to buy them on margin. Buying on margin means borrowing money to purchase the bonds. Margin rates back then were very lenient, as much as 90% on government and municipal bonds. $100,000 of bonds can be purchase with a $10,000 down payment.
The typical commission rate on new issue bonds was one percent in those days. His strategy of buying bonds on margin allowed him to make ten times the commission. Some equally unethical brokers were generating commissions of as much as four or five percent on secondary market offerings. He also told his clients they could write off the interest, which meant they were making tax free interest while simultaneously writing off the interest on the margin loan. A dubious practice, you can only write off marginable interest if you used the proceeds to generate taxable income, I left the firm because of this person and the management that condoned his practices. I later learned he had been barred from the business.
I mention this as an example of how some brokerage firms treated their clients back then. Unfortunately, making money for the firm came first. Making money for their brokers came second. Clients came third. Obviously, not every brokerage firm regarded their customers this way, but in my opinion, the client must always come first.
Earlier I quoted Warren Buffet about
why investors underperform. You will be amazed to learn of the low average
returns a typical investor earns due to excessive fees and bad market timing. In
the next chapter, I’ll dive deeper into why not only unscrupulous salespeople
are to blame but why some investors also have themselves to blame.
[1] Jason Zweig, “How May Day Remade Wall Street,” The Wall St Journal 1 May 2015.
[2] Brian Richards, “Investors are trading way too much,” CNNMoneyInvest 4 May 2015.
