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I just noticed TD Ameritrade has program where you can trade from a list of ETFs with zero fees.

Sounds like it could save me a bit of money, but my cynical side wonders how they make money off such a program...

Is it a loss leader? (They entice me to have an account there, and then make money off the other trades I make?)

Or do they simply want to grow the size of their asset base -- what is the mechanism by which they make money on the funds that I have in my account?

Edit: in case it wasn't clear in the original question above, this is an ongoing program for free ETF transactions -- not a one-time deal for some number of free trades when you open an account. I have had an account there for years and I'm eligible to participate -- it's not a program explicitly designed just to gain new accounts.

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@bstpierre: even if you limit this questino to TD Ameritrade that offers a nice variety of products, please, note that some brokeage has marketing traps where they offer only some sort of products like from one affliate and just SWAP, hope you know the shortcomings with such case. –  user1770 Feb 13 '11 at 11:18
    
@hhh - I did read the fine print, and the gotchas with this program are reasonable. You can't short-term trade, and the list of eligible funds doesn't cover everything. –  bstpierre Feb 13 '11 at 20:20
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bstpierre: Please, read this thread [1]. Before making your investment decision check twice whether the funds use synthetic replication. I checked the list of funds, couldn't find any such fund, but I would still search over prospectuses just in case. [1] bogleheads.org/forum/viewtopic.php?t=61220&mrr=1286542430 –  user1770 Feb 14 '11 at 9:59
    
@bstpierre: you either know things or not. I seriously suggests you to review this thread again. Please, let me know if you cannot undertand something in my reply. The topic is extremely important. It is used from search engines to finance and you seriously should study it if you don't know. Enough. –  user1770 Feb 16 '11 at 3:36

3 Answers 3

up vote 7 down vote accepted

Banks often offer cash to people who open savings accounts in order to drive new business. Their gain is pretty much as you think, to grow their asset base.

A survey released in 2008 by UK-based Age Concern declared that only 16% of the British population have ever switched their banks‚ while 45% of marriages now end in divorce. Yip, till death do most part.

In the US, similar analysis is pointing to a decline in people moving banks from the typical rate of 15% annually.

If people are unwilling to change banks then how much more difficult for online brokers to get customers to switch?

TD Ameritrade is offering you 30 days commission-free and some cash (0.2% - 0.4% depending on the funds you invest). Most people - especially those who use the opportunity to buy and hold - won't make much money for them, but it only takes a few more aggressive traders for them to gain overall.

For financial institutions the question is straightforward: how much must they pay you to overcome your switching cost of changing institutions? If that number is sufficiently smaller than what they feel they can make in profits on having your business then they will pay.

EDIT TO ELABORATE:

The mechanism by which any financial institution makes money by offering cash to customers is essentially one of the "law of large numbers".

If all you did is transfer in, say, $100,000, buy an ETF within the 30-day window (or any of the ongoing commission-free ones) and hold, then sell after a few years, they will probably lose money on you. I imagine they expect that on a large number of people taking advantage of this offer.

Credit card companies are no different. More than half of people pay their monthly credit balance without incurring any interest charges. They get 30 days of credit for free. Everyone else makes the company a fortune.

TD Ameritrade's fees are quite comprehensive outside of this special offer. Besides transactional commissions, their value-added services include subscription fees, administration fees, transaction fees, a few extra-special value-added services and, then, when you wish to cash out and realise your returns, an outbound transfer fee.

However, you're a captured market. Since most people won't change their online brokers any more often than they'd change their bank, TD Ameritrade will be looking to offer you all sorts of new services and take commission on all of it.

At most they spend $500-$600 to get you as a customer, or, to get you to transfer a lot more cash into their funds. And they get to keep you for how long? Ten years, maybe more? You think they might be able to sell you a few big-ticket items in the interim? Maybe interest you in some subscription service? This isn't grocery shopping. They can afford to think long-term.

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I initially doubt this answer because I thought there had to be some sort trap, checked the ETF list and cannot see a trap, good choice over Vanguard, iShares and a nice variety of products. Not just SWAP-products (seen this type of promotion where a brokeage only allowed commission-free to SWAP-products). Not bad. –  user1770 Feb 13 '11 at 11:16
    
Have you ever thought how much it might cost a small local business to get one new customer for every set of colour brochure drop? Each brochure costs a few dollars, distribution, design and very low hit-rate. Even a "cheap" campaign can cost $50-$100 per new customer. How much do you think a broker would pay to gain new assets under management of $250,000 for a single new customer? –  Turukawa Feb 13 '11 at 12:06
    
Hope my edit makes this clearer - mostly they're buying a market base. I think their intentions are unusually honest. They're telling you how much you're worth to them and you get to decide if you agree. Much better than buying an advert during the Super Bowl. –  Turukawa Feb 13 '11 at 21:56
    
Yes, it does make it clearer. I'm naturally suspicious of a "good offer" from a financial company. I was looking for evil intentions, but it doesn't sound like there are any here. (And I suspect they're mostly losing money on me.) –  bstpierre Feb 14 '11 at 19:16
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BTW, credit card companies don't make money just off your interest. They make it off the transaction fee that they charge the merchants. That's how they fund credit-card reward programs. –  fennec Feb 16 '11 at 15:58

AFAIK, It's also possible that the ETF company is paying Ameritrade for every trade you make.

Even if your brokerage doesn't make you pay a fee to trade ETFs, the company that created and runs the ETF is still making money when you purchase and use their ETFs.

See "What motivates each player?" at Yahoo Finance.

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Thanks, this is what I was looking for. Do you know that this kickback really takes place, or is it just a theory? I think this is how their no-fee mutual fund trades work -- they get a kickback from the fund. –  bstpierre Feb 16 '11 at 20:25
    
@bstpierre this is just my theory. It's either that or they consider it a loss leader to get your deposits with them like a retail bank would give you a toaster for opening an account. –  Michael Pryor Feb 17 '11 at 16:58
    
ici.org/policy/regulation/fees/ref_12b1_fees would be a link about the fees that a fund may pay a fund supermarket to be carried without a transaction fee. –  JB King Jan 10 '13 at 21:07

what is the mechanism by which they make money on the funds that I have in my account?

Risk drives TD Ameritrade to look for profits, Turukawa's storytelling about 100,000$ and 500$ is trivial. The risk consists of credit risk, asset-liability risk and profit risk. The third, based on Pareto Principle, explains the loss-harvesting. The pareto distribution is used in all kind of decentralized systems such as Web, business and -- if I am not totally wrong -- the profit risk is a thing that some authorities require firms to investigate, hopefully someone could explain you more about it. You can visualize the distribution with rpareto(n, shape, scale) in R Statistics -program (free). Wikipedia's a bit populist description:

In the financial services industry, this concept is known as profit risk, where 20% or fewer of a company's customers are generating positive income while 80% or more are costing the company money.

Read more about it here and about the risk here.

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