For Some Online Brokers, Uninvested Funds Can Be of Little Interest

Online brokers may charge bargain-basement commissions, but some are also skimping on the interest they pay clients on uninvested funds.
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Online brokers may charge bargain-basement commissions, but some are also skimping on the interest they pay clients on uninvested funds.

Of the nine biggest online brokers, three --

Datek

,

Fidelity

and

Ameritrade

(AMTD) - Get Report

-- pay significantly below-market taxable interest rates on uninvested cash. Two other Net brokers --

Chase Manhattan Bank's

(CMB)

Brown & Co.

and

Fleet Financial's

(FLT) - Get Report

Suretrade

-- also pay substantially below-market rates on idle cash.

The rest of the biggest Internet brokers --

Schwab

(SCH)

,

Toronto Dominion's

(TD) - Get Report

Waterhouse

,

E*Trade

(EGRP)

,

Donaldson Lufkin & Jenrette's

(DLJ)

DLJdirect

,

Quick & Reilly

, also owned by Fleet, and

Morgan Stanley Dean Witter's

(MWD)

Discover Brokerage Direct

-- follow the full-service model of automatically sweeping uninvested cash into a money-market fund, where it earns a market rate.

These brokers offer both taxable and tax-free money-market funds, giving high-tax-bracket investors the opportunity to earn tax-free income. (Fidelity will sweep free cash into a tax-free money-market fund, but investors who are taxed at too low a rate to benefit from a tax-exempt yield can't have cash swept into a taxable money-market fund, even though Fidelity runs one. They can invest in the taxable fund, but they have to give instructions to buy shares.)

Why do they do it? For profit. Brokerage firms pocket the spread between the interest they earn on margin loans and the interest they pay on idle cash, explains Greg Smith, an analyst at

Putnam Lovell de Guardiola & Thornton

. So the more they charge for margin loans and the less they pay on cash, the bigger the spread.

"Interest income is a large earnings engine for these online brokers, especially if they're self-clearing," Smith says. Self-clearing broker-dealers record on their own balance sheets customer receivables from margin loans and amounts payable to customers for cash balances.

"If they're not sweeping into a money-market fund and paying a below-market rate, they're probably making a nice spread on that," Smith says. For Ameritrade, he notes in a recent report, net interest income has accounted for 25% to 30% of net revenue in recent quarters.

Those nice spreads help the brokers keep their commissions in check. Beth Basilio, a spokeswoman for

Dreyfus

, whose online brokerage unit pays a below-market fixed rate on free cash, says: "The reason we do this is that it helps to support our low commission rate, which is something our customers are sensitive to, and we are sensitive to our customers' needs."

What difference does the rate paid on idle cash matter? A cash balance of $5,000, invested in the average money-market fund, which returned 5.04% last year according to Ashland, Mass.-based

IBC Financial Data

, would have generated $257.90 of income. The same balance in a Datek or a Dreyfus account, where uninvested cash earns a fixed rate of 3.5%, would have generated $177.85. At Fidelity, where the rates on cash vary with the amount (starting with a paltry 0.949% on amounts up to $1,000), a $5,000 balance would've generated $170.50, based on a rate of 3.358%. At Brown, which pays 2.25%, the balance would have earned $113.65.

Admittedly, the differences are small. And active traders, for instance, probably care much more about low commissions. Commissions at Datek, Ameritrade, Suretrade and Brown are among the lowest. Likewise, traders who buy stocks on margin a lot most likely care more about getting the lowest possible margin rate.

Charles Salmans, a spokesman for Fleet, which owns Quick & Reilly and Suretrade, says the differences in how the two companies treat idle cash correspond to the differences between their client bases. "If you look at the client base of Suretrade customers, they do tend to be traders," he says. "They don't tend to park cash with us, and when they do, it doesn't reside there for long." Quick & Reilly, by contrast, "tends to attract life-planner types who are not quite as active traders," Salmans says.

Fidelity's below-market taxable rates on cash appear harder to justify in this context. Its commissions are only slightly lower than Schwab's, and they are substantially higher than those of Waterhouse, E*Trade and Discover, all of which will sweep cash into a taxable money-market fund. Likewise, its margin interest rates are lower than E*Trade and Discover's, but higher than or comparable to those at Schwab (for loans up to $100,000), Waterhouse, DLJdirect and Quick & Reilly, all of which sweep.

Fidelity spokeswoman Jessica Johnson says: "We're always trying to balance the cost of doing business with the benefits we provide investors. Based on our analysis, the structure we have in place now makes sense given the wide array of products and services we provide investors."

So if your broker won't sweep your idle cash into a money-market fund, it's probably wise to calculate the cost and make sure you're getting what you're paying for.

As originally published, this story contained an error. Please see

Corrections and Clarifications.