Outside-IN

Cheap is great; free will usually cost you

In the financial services industry, free simply doesn't exist. It can't

Oct 17, 2018 @ 12:25 pm

By Barry Ritholtz

There is a basic, fundamental foundation upon which all of economics is built: Everything has a cost. The effort to get around this concept is described informally by the phrase "there's no free lunch."

What is a free lunch? The notion historically springs from the saloon owners' offer of free meal to customers. Of course, the price of the lunch is included — hidden if you will — in the cost of the drinks.

Which brings us to today's discussion of "cheap" versus "free."

"Cheap" is simply less expensive than dear. We understand cheap, and appreciate all of its advantages. Experience teaches us that cheap is good for investors, as costs compound over time and act as a drag on returns.

"Free," on the other hand, when offered by any for-profit company, should be approached warily. "Free" rarely means costless; it invariably entails concealed charges and expenses. Free requires you to read the fine print, where you learn that free can be very expensive. "Free," in some areas such as mutual funds, is a form of marketing, a loss leader. It can also be a set up for a bait and switch, in which a free product is swapped out for a higher-cost substitute.

To be sure, some things really are free. In a soup kitchen, the meals are free. Free is the core principle of charity, where the concept of imposing the costs on the beneficiary would upend the entire equation. There is a cost, but it's the donors who bear it.

In the financial services industry, free simply doesn't exist. It can't, because the goal isn't to give away products or services — it's to make money.

Do you doubt this truism, which often is overlooked by so many in their rush to pay less?

Perhaps a few examples might bring you around — and these are from companies that have a deep selection of worthwhile products and services for which they charge a fair price (more or less).

Robinhood Financial: The mobile-app broker is a favorite with millennials for its free securities trading. The name obviously evokes the idea of stealing from the rich to give to the poor (or, in reality, the young, well-educated and upwardly mobile.) As Bloomberg News reported this week, Robinhood derives "more than 40% of its revenue from selling its customers' orders to high-frequency trading firms."

In other words, it sells trade orders to businesses its customers may not themselves feel great about doing business with themselves. The company claims otherwise.

Here's the key point to remember: This business model may not ensure that customers get the lowest price. Those firms that buy Robinhood's orders need to make money themselves and thus take a tiny slice off each transaction — money that would otherwise stay in customers' pockets. That's why those firms are able to justify paying for orders in the first place. Cheap is cheap, but free usually has a cost.

Fidelity Group: My Bloomberg Opinion colleague Nir Kaissar explained how Fidelity Investments "unleashed the power of free." The big mutual and exchanged-traded fund company recently began offering two no-fee ETFs: one tracks the 3,000 largest U.S. companies by market value, and the other holds the top 90 percent of stocks within various developed international and emerging countries.

As Mr. Kaissar pointed out, the company has "more than 1,000 Fidelity mutual funds, including the various share classes, with close to $1.9 trillion in assets and an asset-weighted average expense ratio of 0.46 percent a year."

Those two ETFs may be free, but the rest of the offerings are not, bringing in $9 billion of annual revenue. Fidelity is betting that once it gets zero-fee customers in the door, it will find a ways to sell them something that makes money for the firm.

Charles Schwab: The discount-brokerage firm offers its Schwab Intelligent Portfolios as a robo-adviser for customers at no charge. As with all of the other free lunches, this too comes with strings attached.

It uses its own funds, which may not be as cheap as equivalent Vanguard Group or BlackRock Inc. funds. But more controversially (especially to its competitors) it carries a big cash balance of about 9% of assets, making money on the spread it collects in interest versus the tiny return it pays to customers. During a bull market, with almost one in 10 dollars not invested in equities, money held in the robo-adviser probably will underperform. But hey, it's free!

One last point: It isn't just in finance where we see the free-lunch calculus. All it takes is a quick look at the internet.

Facebook and similar social-media platforms are free, but not cheap. Facebook, for example, uses what would otherwise be private user information to help advertisers target consumers — and that's not to mention findings that heavy social-media users have higher rates of life dissatisfaction and that Facebook contributes to compromising some of our most sacred democratic traditions.

And let's not even get into Google, which probably knows more about more people's web habits than any company on earth. How do you think it managed to generate $110 billion in revenue last year?

All of this free stuff turns out to be really expensive.

Barry Ritholtz, founder of Ritholtz Wealth Management, is a Bloomberg Opinion columnist.

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