Keeping all of us in the dark

Kickbacks embedded in the cost of funds that users unknowingly pay for, eat into their returns over time

ROBINHOOD, the US-based stock brokerage, filed for its IPO last week and there were some shocking reveals.

Robinhood's good: 18 million users

Robinhood has changed the game and built a brand and trading experience that is accessible, self-serve, enjoyable and the envy of the industry. Every fintech, wealthtech, traditional broker, and bank looks at its clean user experience and information hierarchy as the new gold standard.

They have together created a race to provide retail access to the stock market in every corner of the globe.

In under a decade, they have grown to 18 million users with over US$80 billion in assets under custody. They have probably created quite a lot of value for their users - both from fees and by existing during a great bull market. With 50 per cent of their users being first-time investors, Robinhood has successfully democratised stock trading in the US.

Robinhood's ugly: US$720 million in transaction-based revenues in 2020

If it is free to use Robinhood, where does this revenue come from?

It's quite simple. Robinhood does not charge its users anything transparently, but instead receives payment for order flow as a kickback from the hedge funds and market makers whom Robinhood gives the right to execute its orders. This may result in less-than-good execution, because the kickback is embedded in the underlying price the user ultimately pays for securities.

It is kind of like going to a mall and comparing the foreign exchange rates across all of the booths. They all have big signs that say zero commission, but somehow their rates are all slightly different because the spreads they take vary and this is how they make money.

Who ultimately pays? The users without knowing any better, believing that they are paying zero commission and getting the service for free. This activity causes all sorts of misaligned incentives between the client and broker, and probably does not lead to good long-term outcomes. This payment for order flow (PFOF) activity is actually illegal in many places around the world.

If Robinhood makes more money on more trading volume and bigger spreads, it will create an app that incentivises users to trade more. If it wants users to trade more it needs instruments with more volatility to incite more trading behaviour. Options trading on meme stocks and crypto become perfect for its business, and unsurprisingly account for the majority of its transaction-based revenues.

Kickbacks all over the place

Last month, the mother of a colleague got fleeced with a 2 per cent sales fee when buying a unit trust. I personally think it is crazy that you can still get charged any sales fee for buying a unit trust in Singapore, but that is not the worst of it.

There is a kickback embedded in the cost of funds that you unknowingly pay for. The industry gives this many names: trailer fees, retrocessions, loaded fees, sales commission. I like to call it what it is - a kickback.

Let's say you pay 1.7 per cent in management fee for a fund. It is likely that over 50 per cent of that fee is a kickback to the distributor who sold you the product on top of any sales charge. This is paid continuously as long as you hold the fund and usually ranges between 0.5 and one per cent per annum, or around 50 per cent of the fund fees.

Fund managers have to compete against one another to pay higher kickbacks to the fund platforms, financial advisers, brokers, and private banks just so their funds can be sold. This leads to an obvious misalignment of incentives between you and the distributor, who is now focused on selling you funds that pay a higher kickback, and with more short-term performance so they can churn your account and earn more sales fees.

These kickbacks may also lead to fund managers to keep their fees high so they can afford to keep paying and incentivising distributors to sell their funds.

Many online fund platforms advertise themselves as low or zero fee, but that is because they make their money through hidden kickbacks.

Trailer fee kickbacks eating your returns

Fees compound into a great difference in returns over time. Let's say you achieved a global stock market return since 1988 and paid a typical unit trust management fee of 1.7 per cent for the exposure. You would have done seemingly well, with a 490 per cent total return.

If you had managed your costs, made sure you were not paying unnecessary kickbacks, and paid 0.5 per cent for the exposure instead, you would have earned an extra 290 per cent in returns by now, or 780 per cent in total return. That is a big difference.

Funds typically have many share classes for a single strategy. The share classes differ in fees, mostly due to the kickbacks the fund manager has to pay. On top of high fees, the perverse incentives caused by trailer fee kickbacks and sales charges suggest that no one is really on your side trying to give you suitable financial advice. It is all about extracting value without you knowing it, and giving you enough temptation so you keep playing the game.

Keeping all of us in the dark

Everyone wants to take their pound of flesh and ultimately the investor pays the price. It is extremely profitable to earn a margin which clients cannot see. I did not realise the extent of the industry's trailer fee kickback secrets until I started and a fund manager said: "Okay, this all sounds great but how much do I have to pay you to put my funds on your platform?"

Commissions that are not clearly disclosed to clients are deeply deceptive. Low or zero-fee fund platforms take their margins from the fund managers. With all this structural misalignment, it is no surprise that the average investor returns around inflation over 20 years, and one in two who has used CPF to invest ended up worse off. The financial advisory and wealth management industry must evolve.

The rise of fee-only transparency

Fee-only simply means an adviser or platform can only be paid by its client directly and transparently. This seems pretty straightforward, but is far from the industry norm.

At Endowus, we had to think creatively about how to make great funds available at low cost without becoming misaligned with our clients. We achieved this by accessing the lower cost institutional clean share-class of funds where available. Where there is a trailer fee kickback from a fund manager, we rebate all the trailer fee to the client. This means you keep more of the returns you deserve, and we remain independent to recommend the solutions that best suit your goals, rather than line our pockets in the short-term.

Our belief is that if we are paid to give our clients suitable advice, and clients have a clear understanding of what and why they are paying us, they will stay with us because it will lead to better outcomes. This will be profitable for us in the long-term.

Final thoughts

Technology can solve these foundational issues and shed light on what is so obviously wrong with an industry that runs on kickbacks.

With the scale and technological prowess of Robinhood, they have the power to change their revenue model to be aligned with their users. They are well aware of this, as currently their payment for order flow business model is showing up as a risk factor in their IPO filing: "Because a majority of our revenue is transaction-based (including payment for order flow, or "PFOF"), reduced spreads in securities pricing, reduced levels of trading activity generally... and any new regulation of, or any bans on, PFOF and similar practices may result in reduced profitability, increased compliance costs and expanded potential for negative publicity."

My hope is that the success of clients served by fee-only platforms will inspire the industry to structurally change and put client interests first.

  • The writer is CEO of, a fee-only digital wealth platform for your wealth - CPF, SRS & cash

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