The Silent Assassin of Fees
A few years ago I wrote a blog post that attempted to comprehensively outline all the apparent and hidden fees that can eat away at your investment return. This was (and still is) important because over the course of 30 years fees can actually lower your net worth by as much as 50%.1 But as detailed as the article was, I omitted perhaps the most arcane and hidden of all the investment fees: Payment For Order Flow, or PFOF as it’s more commonly known in the industry. PFOF is both complicated and highly contested, so today I’ll help unpack how it works and explain Wealthfront’s position.
How Does It Work?
When you place a trade to buy or sell a stock, the various exchanges through which your broker trades the stock pays the broker a very small amount of money per share for the right to execute the transaction. This fee is the Payment for Order Flow, or PFOF. Exchanges typically pay brokers on the order of 19 or 20 mils per share for the right to execute your trade. For reference, a mil is one hundredth of a cent, so 19 mils is 0.19 cents. So while the amount made on each individual trade is inconsequential, it adds up to tens of billions of dollars in aggregate every year.
The reason why the broker is paid by the exchange and not the other way around is because the exchange then sells information about your trades before they are executed in order to profit. They do this through specialized investment partnerships known as “high frequency traders,” which use algorithmic trading methods to “front run” your trade by milliseconds to make money. There is quite a bit of debate as to whether this helps or hurts markets, which I’ll address later.
But here’s where PFOF really gets ugly. Some brokers arrange with the exchanges to get a PFOF that is in excess of what the market normally bears and build that into the price they charge clients. In other words, you end up paying more for the trade, and the brokers make more money. For example, the market rate for PFOF is around 19 mils, but a broker might ask the exchanges to give them 70 mils, the difference of which they build into your price. Here’s how it plays out: say you pay $10 per share to work with a broker that passes along the typical 19 mils of PFOF. If that broker imposes the “premium” PFOF you’ll pay $10.0051 ($10 + ($.0070-$.0019)) for the same stock. That means you’ll pay $5.10 of PFOF for every 1,000 shares you buy. That’s a huge premium on top of the typical commission of $4.95 per trade fee. In fact, brokers who impose a premium PFOF often charge much lower commissions only because they earn an equivalent or greater amount from their premium PFOF.
Paying it Forward
Because we initially followed industry convention, Wealthfront used to earn a portion of the PFOF fee from our clients’ trades generated by our former brokerage partner. Specifically, our brokerage partner charged us 35 mils to trade each client’s share, then credited us back half the amount they earned in PFOF (9.5 mils, half of the standard 19 mils). So our net commission per share was 25.5 mils (35 – 9.5). But as we dug in more, we realized industry convention felt kind of slimy, so we decided to do things differently and stop pocketing the PFOF fee from our partner.
But we didn’t just stop taking the fee; we gave it to our clients. Bringing our brokerage operations in house in April enabled us to deal directly with the exchanges. This allowed us to negotiate with the exchanges to give what we would have earned in PFOF back to our clients in the form of a better price. For example, if you previously paid $10 to buy a share of an ETF, you now pay $9.9981 per share ($10 – $0.0019, or less the PFOF cost of 19 mils). The cost savings you earn per share might seem slight, but the benefit can really add up over time. We are not aware of any other advisory or brokerage firm that passes on PFOF savings to its clients.
The unseemly nature of PFOF has recently attracted government attention. According to a New York Times op-ed by Jonathan Macey, a professor at Yale Law School, and David Swensen, Yale’s renowned chief investment officer, Senator Mark Warner, a member of a Senate subcommittee on banking and investment, recently wrote to SEC Chairman Jay Clayton urging the full elimination of PFOF to “increase price transparency, reduce fragmentation, strengthen stability, and bring U.S. equity markets” closer to the competitive mandate. In this same article Macey and Swensen shared data that showed how IEX, a new stock exchange that doesn’t pay PFOF, has consistently offered lower spreads (i.e. better pricing) than exchanges that offer PFOF.
PFOF is the dirty little secret of trading, so it’s very important that you read the fine print whenever you engage with someone in the investment industry. Registered investment advisors like Wealthfront are required to disclose all their fees in their Form ADV. However, brokerage firms are not required by any regulatory entity to disclose information about their fees because they are not held to the same fiduciary standard as advisors. So whether you’re working with a traditional brokerage firm or trading app, always ask about what kind of PFOF they earn and how it affects your bottom line. You should consider it a big red flag if they’re unwilling to disclose that information.
1 As we explained in Fees Can Destroy Your Returns, the sum of your obvious, nickel and dime and hidden fees can be greater than 3% – 4% per year. That can represent more than half your expected gross return.
Nothing in this blog should be construed as tax advice, a solicitation or offer, or recommendation, to buy or sell any security. Financial advisory services are only provided to investors who become Wealthfront Inc. clients pursuant to a written agreement, which investors are urged to read carefully, that is available at www.wealthfront.com. All securities involve risk and may result in some loss. For more information please visit www.wealthfront.com or see our Full Disclosure. While the data Wealthfront uses from third parties is believed to be reliable, Wealthfront does not guarantee the accuracy of the information.
About the author(s)
Andy Rachleff is Wealthfront's co-founder and Chief Executive Officer. He serves as a member of the board of trustees and chairman of the endowment investment committee for University of Pennsylvania and as a member of the faculty at Stanford Graduate School of Business, where he teaches courses on technology entrepreneurship. Prior to Wealthfront, Andy co-founded and was general partner of Benchmark Capital, where he was responsible for investing in a number of successful companies including Equinix, Juniper Networks, and Opsware. He also spent ten years as a general partner with Merrill, Pickard, Anderson & Eyre (MPAE). Andy earned his BS from University of Pennsylvania and his MBA from Stanford Graduate School of Business. View all posts by Andy Rachleff