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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
    Commented Feb 13, 2011 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
    Commented Feb 13, 2011 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
    Commented Feb 14, 2011 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
    Commented Feb 16, 2011 at 3:36
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    @FranckDernoncourt - FYI - thanks to your marking 2 questions as dups of this one, I closed those and moved their answers to here. For pretty much exact dups, I'm using the 'merge' function more often than just closing. Much appreciated.
    – JTP - Apologise to Monica ♦
    Commented Mar 2, 2019 at 12:18

8 Answers 8

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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
    Commented Feb 13, 2011 at 11:16
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    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
    Commented Feb 13, 2011 at 12:06
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    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
    Commented Feb 13, 2011 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
    Commented Feb 14, 2011 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.
    – user296
    Commented Feb 16, 2011 at 15:58
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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
    Commented Feb 16, 2011 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
    Commented Feb 17, 2011 at 16:58
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    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
    Commented Jan 10, 2013 at 21:07
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The same reason a company would offer coupons. I'd guess they're just doing it as a way to entice people to do their investing with them. Since it is any ETF I doubt they are being compensated by the ETF companies, as is sometimes the case (iShares does this with Fidelity, for example). And they still get the commission on the sale.

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How do they make money by selling these ETFs?

They don't. They are hoping that you'll open an account with them to buy these ETFs and will then also buy other products of theirs that are profitable to them. This kind of product is called a loss leader.

What's the catch?

You have to sign up for an account with them. That's about it.

This article on The Motley Fool by Jordan Wathen sums it up nicely, looking at Fidelity's FZROX. He asks (and answers) both of your questions practically verbatim. To summarise:

The hope is that after opening an account with Fidelity -- or better yet, moving your million-dollar account to the brokerage -- you'll decide to place stock trades ($4.95 each) or put some of your money into its other mutual funds, which actually have management fees.

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    Great point on the no-management-fee funds, but I bet they do make money in management fees on funds that they don't charge a transaction fee for.
    – D Stanley
    Commented Mar 1, 2019 at 21:44
  • @DStanley oh, good call - I assumed OP was talking about the former because they are relatively new and noteworthy. I missed that it was regarding all no-transaction-fee funds.
    – CactusCake
    Commented Mar 1, 2019 at 22:01
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Firms that offer commission-free securities are getting paid somehow, otherwise they wouldn’t do it. Consider the commission free ETFs as a loss leader to get you through the door. While the securities are commission free, the broker is making money on the expense fees. The broker might also make money from other services:

  • early redemption fees on the ETFs if not held 30 days
  • they earn money on the cash balance in your account
  • they might make a market and collect the bid/ask spread
  • you might do trading that incurs a commission
  • you might use their fee based asset management
  • you might purchase an annuity from them
  • you might use margin borrowing in your account
  • you might short stocks and pay their borrow fee
  • they might receive payment for order flow for trade routing
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Craig W's on Why might a brokerage firm stop offering a particular ETF commission free? gives one example of how a broker can make money with commission-free ETFs:

From Forbes (mirror):

TD Ameritrade receives remuneration from certain ETFs (exchange-traded funds) that participate in the commission-free ETF program for shareholder, administrative and/or other services.

In other words, TD Ameritrade is now enforcing a pay-to-play for their so-called commission-free exchange-traded funds. They are willing to forego their $6.95 trading commission in favor of remuneration directly from the ETF vendors. Because Vanguard refuses to pay such money to custodians, they are no longer being allowed to play.

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The customer loyalty line is kinda bogus, according to my research. The brokerage is receiving money from the ETF, the ETF is paying to be promoted. Or else the brokerage is providing a service to the ETF:

"Charles Schwab & Co., Inc. receives remuneration from third-party ETF companies participating in Schwab ETF OneSource™ for record keeping, shareholder services and other administrative services, including program development and maintenance."

Also see this discussion of the issue: Why might a brokerage firm stop offering a particular ETF commission free?

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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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