THE ANNUAL DISCOUNT BROKERAGE SURVEY

Welcome to the 2011 survey of discount brokerage firms.  Information on self-styled discount brokers has been compiled for almost four years; it’s now time to publish.  This introduction contains a description of the methodology used to grade firms.  A table in the third post shows the results.  Towards the end there are posts where each broker is described in some detail using a standard format.  The third article focuses on a breakdown of the format used to describe each individual broker.

The approach, in summary, is as follows: brokers were analyzed on commission rates, additional fees and overall service.  A total of sixty-four brokerage websites were included in this survey.  If there are more out there that were missed, please let me know.  Each broker was assigned a letter grade, A through F.

Brokerage Survey Methodology

As was mentioned earlier, lists of discount brokers have been compiled here for about four years. There is one major challenging issue: comparing the members of such a disparate group of companies.  Ultimately, any approach has to be useful to the target audience: any long-term investor, defined as a person who buys and holds equities for many years.  Such people want to buy a company at the lowest total cost.  So, the target audience for this survey are those who have the following attributes: 

• A long-term perspective on investing
• That work to keep costs (commissions and other fees) low
• And who buy a small number; that is, trade somewhat infrequently: maybe a dozen times a year might be considered average. 

There are brokers where a long-term investor might assign an “F” grade, while a day trader would view the company as grade A material.

The main challenge in looking at different brokerage houses is to avoid an apples-to-oranges comparison.  When most people started investing, the main concern was likely minimizing the overall cost.  When you've only a few dollars to invest each month, one factor in the accumulation of wealth is to keep costs down.  DRIPs were perfect in this regard.  Keeping down the total cost--the commission charged for a transaction and the other costs for keeping an account with broker--is paramount.  Service is critical too.  Most long-term investors most likely want a broker that provides the best service at the lowest price.  The two main axes on which brokers were assessed are (i) overall cost and (ii) quality service.

The ranking was carried out in two steps.  First, the commission per trade was determined; brokers were clustered into groups of companies based on similariies in the base commission.  In the second phase of the analysis, the overall costs and benefit of having an account at a given firm were assessed: extra fees; the ancillary services offered by the company and the fees for such services.  Finally, the ease-of-use of the website and transparency.

Ranking the brokers by commission

The first and most obvious thing to look at is the commission: the transaction cost for buying shares of common stock of a given company.  It’s how most discount brokers market themselves.  So for the most part, it's up front and center on company websites.  With this approach, brokers tend to cluster into groups when the base commission is the major focus for a comparison.  There’s a group that will be called deep discount brokers in this survey; most of them were created in the past six or so years and offer commissions of well under $4 per trade.  The next group, most of them formed in the past decade, has commissions in the range of $4 to $7--the shallow discount brokers; the final group—almost all legacy brokers such as Schwab or TD Ameritrade—have commissions that range from $7 to $10.  The final cluster consists of brokers that charge more than $10 for a trade: there are lots of such discount brokers.  This approach, with a focus exclusively on the base commission, divided the universe of self-described discount brokers into four distinct clusters:

• Deep Discount Brokers (< $4.00 per trade)
• Shallow Discount Brokers ($4.00 to $7.00 per trade)
• Legacy Discount Brokers ($7 to $10 per trade)
• The rest of the discount brokerage world (>$10 trade)

Note that some brokers charge $3.95 per trade; these companies were all included in the second cluster: the shallow discount brokers.

So, in this first pass based on commissions alone, the groups are ranked as follows:

Deep Discount > Shallow Discount > Legacy Discount > Other discount brokers

In the next phase, the top three clusters will be examined in a little more detail to determine if the order is appropriate.

A deeper dive into the ranking

Let me digress for a moment!  Thinking as a long-term, buy-and-hold investor, I end up dividing the world of brokerage houses into two breeds: brokers for buying and brokers for warehousing.  Keeping cost down is critical for me, I don't want high transaction costs for accumulating shares, but I feel more comfortable storing these shares with a large broker: one with a stellar reputation.  When I look at my legacy broker account, the warehouses, the vast majority of the shares residing in these accounts were bought using a deep discount broker or a company DRIP program.  I then transferred them into the "warehouse."  This transfer occurred when the discount broker raised transaction costs.  So, I have two opposing impulses. The big guys, the warehouses, are expensive for trades but good for storage; the deep discounters don't offer ancillary services without charging and I don’t like storing things with the deep discounters.  Maybe it's just me, but at a company such as TD Ameritrade or Schwab, I get happier as the account gets larger; at the Zecco's and Just2Trade's of this world, I would start to worry if a large percentage of the total portfolio is sitting with a deep discount broker!  So, then it comes to a “broker for buying,” I want the lowest commission.  When it comes to a warehouse, I want the lowest charge for ancillary services.  Luckily, the deep discount brokers have the lowest commissions, but they charge more if you want anything else.  While the legacy brokers have higher commissions, they offer most ancillary services (checking writing, debit cards, certificate issuance, etc.) at no or very low cost.  Division of the world into warehouses and transaction brokers works nicely!

Which brings me to the next point: the only thing that differentiates the shallow from the deep discounters is price.  In fact, as long as there are deep discount brokers, the next tier--the shallow discount brokers--aren't likely to get my business or the business of most long-term, buy-and-hold investors.  If you want to keep transaction costs low, go to a deep discount broker.  If you want service at a reasonable price (in fact for free in many instances), use a legacy broker.  The shallow discount cluster gets caught in the middle: too expensive for purchases with inadequate (or frankly expensive) add-on services.  In examining their websites, they offer little that you can't get from a deep discount brokerage firm; in many cases, the commission costs of the legacy brokers aren't that much more than the next cluster of brokers, the shallow discounters.  Legacy brokers offer things like debit cards, bill pay, real-time quotes, issuance of stock certificates, analyst reports, checking services, etc. at no additional cost to the account holder.  The discounters often charge for these services.  The shallow discounters lose to the deep discounters based on commission rates and the legacies for their service.  They're in brokerage no-man's-land.

Given that the deep discounters beat the shallow discounters on price and that the legacies beat both of these two groups on service, I ranked the legacy broker group ahead of the shallow discounters.  The deep discounters still come out on top.  The ranking changes to the following:

Deep Discount > Legacy Discount > Shallow Discount > Other discount brokers

Now that the world is better organized, the final grades are assigned next.

Assigning the final grades

Just looking at price and service there’s a good paradigm for ranking brokers: the deep discounters win on price; the legacy brokers win on service.  The shallow discounters lose to both; the rest of the world still sits out in the wings!

The next phase is to look more deeply into the services the brokers offer, and to take a deeper diver into the fees they might charge together with the overall navigability of the website.  Aside from commissions, brokers can impose software and/or inactivity fees.  It can also base its commission on activity, which is fine for active traders, but not for long-term investors.  If a company has such fees and they're inescapable, even if it offers low commissions, the effective cost for a trade could be much higher; brokers that had such extra fees lost a letter grade.

It turned out that no deep discounters were demoted, nor were any of the legacy brokers, but some shallow discounters dropped in the ranking; the group of "other discounters" cracked in two!  At this point changing the name of the clusters to letter grades just made sense.  While they may be attractive for traders, it’s likely that very few truly long-term investors would be attracted to those firms that ended up in the F grade bucket.

Just like high school or college, brokers were awarded a letter grade ranging from A to F.  The deep discount cluster was awarded an A because it offered an exceptional commission with no extra fees.  The legacy discount broker cluster received a B grade: the commissions were, on average, higher than the shallow discount brokers, but the legacies offered vastly superior service often at no extra charge.  Almost all of the shallow discounters earned a C grade, as they offer the same service as the deep discount brokers, but at a higher price; the legacy brokers trumped them on service.  Who needs them--the deep discounters beat them soundly!

Finally, the rest of the world was divided into either a D grade or an outright F.  Companies that charged outlandish commissions and/or other fees, which was often coupled with a lack of transparency on the website earned a failing grade.  Companies that were simply expensive or that had poor service earned a D.

Summing up the grades

Companies that earned an A had flat commission rates well under $4 ($3.95 doesn't count!); they may not have offered much in the way of additional services or a great trading platform, but there were no annoying fees for things like software, inactivity, etc.  They were generally not a good choice for an IRA.

Companies that earned a B were all legacy discount brokers (around for well over ten years).  The commission rates varied from $7 to $10 a trade, but they were often negotiable.  These companies usually offered a wide and deep range of additional services at no additional cost.  For long-term investors, they were generally a good place for an IRA as they didn't charge any annual fees.

Companies that earned a C where shallow discount brokers with commissions ranging from $4 to $7; just like the deep discount brokers, they didn't offer a lot of additional services, though they sometimes had better trading platforms than their deep discount peers.  In service, they weren't comparable to the legacy brokers who all earned a B.  They didn't have those annoying, add-on fees; where they did charge an inactivity fee, it took relatively few trades to have it waived.

Companies that earned a D had commission rates of $7 or more with irritating add-on fees.  They may offer some additional services with or without extra charge.  The higher commission rate and annoying additional fees were enough to earn such companies a D grade.

Companies that earned an F generally had much higher than average fees, a difficult to navigate website or a lack of transparency.  These companies normally had additional fees, usually an inactivity or software fee that was hard to waive.

The next issue is missing information.  For some brokers, I just couldn’t find everything I needed on the company website.  Each broker with missing information was e-mailed for assistance in filling in the gaps; most responded.  I will update the information as soon as (i) I find it or (ii) the broker responds to my request.