Shani Jayamanne: Hi, and welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into account your personal situation, circumstances or needs.

Mark Lamonica: So, Shani, Will recently got back to Singapore, which is really exciting.

Jayamanne: Yeah. I mean, I follow Will on Instagram, and I saw some of his pictures and it looked incredible.

Lamonica: Interesting. Will does not let me follow him on Instagram. But I'm going to a place that I think is less exciting, but you might think is more exciting. I'm spending the weekend in Canberra.

Jayamanne: Yeah. I mean, I've lived in Singapore and Canberra and would probably choose Canberra, just because I hate humidity, but…

Lamonica: You hate humidity?

Jayamanne: Yeah.

Lamonica: I'm going to Canberra in the winter. You hate the cold. We took a walk for 5 minutes during our catch up today, and you turned around and came back in the building.

Jayamanne: Yeah. Anything below 20 degrees I'm not really happy with.

Lamonica: Okay. Well, I don't know the exact temperature, but Canberra is going to be colder than 20 degrees this weekend.

Jayamanne: Yeah. So, I really like Canberra, and I've given you some tips, but you've chosen to ignore all of them.

Lamonica: I have not chosen to ignore them. I've been overruled. Your tip was about going to get laksa.

Jayamanne: Yeah. I think about this laksa every day. Every day when I wake up, I'm thinking about this laksa. So, if you go to Canberra, go to Dickson Noodle House, have the laksa. It will change your life.

Lamonica: Okay. Well, speaking of changing your life, picking in the right broker can change your life, right Shani?

Jayamanne: Yeah. Like, giving the people what they want.

Lamonica: Exactly. Everyone keeps asking how do we pick a broker?

Jayamanne: Yeah, this is one of the most requested episodes that we've had, and we've avoided it so far.

Lamonica: Yeah, and it makes sense, right, because when you start investing, there are so many different choices and that can be overwhelming.

Jayamanne: Yeah, that's right, Mark. And we will spend some time exploring different options and considerations in this episode, but we want to frame this conversation first and talk a little bit about why we don't think that your choice of broker is make or break. And Mark, you got work a great note on Morningstar Investor about this recently, so maybe you can get it started.

Lamonica: Okay. Well, I started talking about squash. And the reason I was talking about that, and I think we've talked about this earlier in the podcast, it's been a while. But yeah, I play every Wednesday against my 81-year-old squash coach.

Jayamanne: Ollie?

Lamonica: Yes, Ollie? And Ollie is a little less mobile than he was back when he first started playing, but he's still able to put the ball wherever he wants and that's a winning strategy. So, he constantly reminds me that the success of his approach is because hitting it away from your opponent works far better than simply hitting it hard. And what I get from that is that it's important to focus on what works and avoid what is popularly perceived as the pathway to success. And that sounds like a formula for achieving your investing goals.

Jayamanne: There's really deep, Mark.

Lamonica: It is. I'm a very deep person as you're aware.

Jayamanne: I mean. in this article, you quoted Abraham Maslow as well, and you said, if the only tool you have is a hammer, you tend to see every problem as a nail. But before we delve into that, Maslow is obviously very famous for his hierarchy of human needs, and I saw this meme a few years ago. Do you know what a meme is, Mark?

Lamonica: I do, Shani.

Jayamanne: Well, like the whole bottom of the pyramid was replaced by Internet, which I thought was quite funny. Anyway. You have a hammer; every problem is a nail. Why did you quote him and how is it relevant to picking a broker?

Lamonica: Well, it's just something I've been thinking about lately. So, the financial services industry, of course, is all about products. So, if you have an investing problem, you can try this new improved ETF, which tracks a back-tested newly created index that would turn you into Rockefeller if only you identified the mega trend of climate change back in the ice age. Want to achieve your goals? Well, you need a trading platform specializing in Malaysian small caps, where you're offered free trades in exchange for a really high FX exchange rate. And as an investor, the notion of a company selling products to try and generate profits is not exactly something that gives me pause, but as an investor advocate, I think most of these products should be avoided.

Jayamanne: And I think that the problem a lot of investors face, especially at the beginning of their investing journey, which is often when you're picking a broker, is that they aren't focused on the outcome they're trying to achieve. It seems like there's this view that the answer to the problems is picking the right product, and of course it's not. The answer to our problems is ensuring that at the center of everything you're doing is your goals and what you're trying to achieve. And when you have that perspective, the broker often becomes relevant.

Lamonica: Yeah, that's right, Shani. And perhaps this focus is because of great marketing or because the industry has made investing overly complex or perhaps a combination of both. You should spend your energy on understanding what you're trying to achieve instead of the platform that's going to get you there.

Jayamanne: And this is where wealth maximization versus goals-based investing comes in. Getting rich or having the most money possible is this nebulous goal that just doesn't work.

Lamonica: Yeah, and it's the pathway to internalizing the investing equivalent of Maslow's proverbial hammer. And what that leads to, and what logic dictates, is that you should always be in the best performing product. And we've spoken a lot about this and how that isn't the best approach because it encourages poor behavior, and it doesn't connect to your goals.

Jayamanne: And what it actually does is conform to the approach that the industry wants you to, the industry that makes money off your trading and giving into the compelling narrative of the perfectly marketed new ETF.

Lamonica: Okay. So, with that very long preamble, we will go through some considerations after we told you it doesn't matter what broker you pick, and if you shouldn't spend time…

Jayamanne: But people want this.

Lamonica: Exactly.

Jayamanne: This is what people want, and we're giving them what they want.

Lamonica: Exactly. So, now, we're going to go through some considerations to pick a broker.

Jayamanne: Yeah. And just understand obviously that it isn't a make-or-break decision that will result in a marked different outcome unless you're a day trader.

Lamonica: Yeah, yeah. And if you're a day trader, you're probably listening to the wrong podcast.

Jayamanne: Unless you want to change your ways.

Lamonica: Exactly, exactly. All right. So, before we get started, we want to be really clear about one thing. The goals of brokers and your goals as an investor are not aligned. So, brokers want you to trade more. Trading more will make it less likely that you achieve your goals. And this isn't necessarily an inherently bad thing because personal goals and the goals of companies often don't align. My goal being less fat and Cadbury's goal of selling more chocolate are not aligned. But just realize that what your broker wants you to do and what you should be doing are in conflict.

Jayamanne: And since I love studies, I thought I would quickly go through one that demonstrates why over-trading is bad out of the University of California at Berkeley.

Lamonica: If you're in the U.S., you would call that Cal Berkeley.

Jayamanne: Cal Berkeley?

Lamonica: Cal Berkeley.

Jayamanne: All right. So, this study is from Cal Berkeley. They took data from a large brokerage firm and looked at shares that people purchased and what they sold. Then they looked at how each of those investments performed. So, how did the share they sold perform versus the share they bought? In three different time periods of 84 trading days later, 252 trading days later, and 504 trading days later, the shares that were sold outperformed the shares that were bought. Over 84 trading days, the shares sold outperformed the shares purchased by 1.36%. Over 252 trading days, the outperformance 3.31%. And over 504 trading days, it was 3.32%.

Lamonica: Yes. So, the message here is pretty simple. The more you traded, the more exposed you were to that underperformance because it was measured for each trade and not each investor. So, the more you trade, the worse you do.

Jayamanne: And that means that brokers that make their money off transaction fees and want more transactions so they can make more money are not aligned with your goal and growing your portfolio.

Lamonica: Exactly, Shani. So, let's give the people what they want, as we've been saying. So, let's explore some considerations for brokers, and we'll start with saying that like most other products or services, there's a spectrum depending upon how much you actually pay.

Jayamanne: There are discount brokers, there are brokers that offer comprehensive services, there are brokers that offer only certain services, and there are full-service brokers, and this wasn't always the case.

Lamonica: As many of you would know, brokers didn't used to be a platform, they used to be a person. You would ring somebody up to execute your trades, and at the same time, you might receive an opinion on whether to complete that action. Or it might be the other way around. You might have a broker that also advises you to buy or sell certain stocks, often to their benefit as they receive clips from each trade that you made.

Jayamanne: And that was quite expensive. It was mainly percentage based and could have been up to 2.5%. You could also pay a flat fee per service, which was rarer, but depending on the broker, it could be up to $200 per trade. Definitely out of the realm of what we consider for brokerage now.

Lamonica: Yes, Shani. So, brokerage has definitely changed and evolved over the years. Once online brokers were introduced, investing became a lot more accessible. So, according to Canstar, in the last five years alone, investing $1,000 has become cheaper by 15.85%. So, the average brokerage cost in 2017 was $17.66 and now it's $14.86. For most larger amounts as well, the cost has dramatically reduced to invest.

Jayamanne: And what that means is that investors are improving their total return outcomes by lowering costs and their investments don't have to perform as well to breakeven.

Lamonica: And what Shani means by this is that when you're investing, you're starting on the back foot once you take brokerage into account. She may invest $1,000 and pay $14.86 for brokerage, but that means that you're at 98.5% of your starting value. So, to lower your starting value and the more you pay in brokerage, the harder your investments have to work.

Jayamanne: And we believe that fees should be the main consideration when choosing a broker, but we are aware that we feel that way because we have access to institutional grade research, data and thought leadership through our jobs and access to Morningstar's resources and platforms. We'll talk a little bit about this in a second, but we know that many people derive value from their brokers for extra resources that help them with the decision-making process about what they're actually going to invest in, and that means that they're willing to pay a higher price. So, let's start looking at brokers and the different type that you can have and what you pay for.

Lamonica: Okay. So, the simple way to do this is by placing brokers on a spectrum from full-service brokers to online low-cost brokers. And for simplicity sake, we will exclude stockbrokers and brokers that include a professional attached to the service. And we're going to compare one premium broker with one low-cost broker and one broker that offers international equity investing

Jayamanne: But hopefully, what this will allow you to do is understand a few of the key measures to assess brokers, depending on what's important to you. So, let's start with a full-service broker. We're going to pick CommSec because they're the most popular broker in Australia by users. And to compare, we're going to use Superhero, which is a low-cost broker.

Lamonica: Okay. So, should we start with a brief introduction to both? CommSec probably doesn't need much of an introduction. So, that's, of course, the trading arm of Commonwealth Bank. And we'll start with what we focused so far on this episode. We'll start with costs. So, take us through cost, Shani.

Jayamanne: Yeah. So, this is an easy one to compare. So, let's start with CommSec. CommSec allows trading of Australian shares and ETFs. So, to trade, they charge $29.95. They also offer trading costs of $10, but not if you're pulling it into your bank account. So, practically, it means that you're going to use the funds in an investment account to trade again. For international shares, they offer larger exchanges around the world at varying prices. The U.S. is US$19.95 per trade for US$5,000 or below; US$29.95 for trades up to US$10,000; and a 0.6% FX rate. We're not going to go into derivatives or options or anything like that. So, we'll just use the US$29.95 for trading costs and those fees for U.S. trading as a comparison point.

Lamonica: Okay. So, let's turn our attention to Superhero. So, Superhero is a relatively new offering. It was established in 2020. It markets itself as a low-cost broker offering investors access to Aussie shares, ETFs and U.S. shares. When we look at costs, they charge $5 for Aussie shares and zero dollars for U.S. shares and ETFs. They do charge on the FX though. So, for U.S. shares, it's $0.70 per $100, so not exactly free.

Jayamanne: Okay. So, for cost for Aussie shares, Superhero wins. But we always knew that was the case seeing as this is their brand. For U.S. shares, the difference in cost depends on the size of your trade. But regardless, Superhero wins on the cost front. But there's one big difference between these two brokers, and that is that Superhero isn't CHESS-sponsored. So, the securities you're purchasing are not held on a unique HIN. That sounds like a foreign language, 

Lamonica: It does sound like a foreign language, like, Sinhala, which I know.

Jayamanne: What do you know in Sinhala?

Lamonica: O.

Jayamanne: Yes.

Lamonica: It means yes, you have to tell people that. So, I know that, and I know a couple of other words that I shouldn't say.

Jayamanne: Okay.

Lamonica: Mostly because you'd laugh at my pronunciation. But anyway, let's get back to the foreign language that I understand a little bit, which is financial services speak. Okay. So, let's explain what that means and ultimately whether it should impact your decision to choose Superhero or another broker like Superhero that isn't CHESS-sponsored. So, Shani, you can explain some of this stuff. So, what does CHESS-sponsored mean?

Jayamanne: All right. So, CHESS stands for Clearing House Electronic Subregister System. It's a system used by the ASX to facilitate trades on its platform. In very simple terms, CHESS-sponsored means that the ASX registers who owns shares in a company. When you buy or sell shares through a CHESS-sponsored arrangement, the ASX knows that you own those shares directly.

Lamonica: And this leads to a HIN, which is a Holder Identification Number. Your holdings are connected to this HIN. So, holding shares in this way also means that your voting rights with the companies you hold are very clear and most traditional brokers and most brokers in the market operate on this CHESS-sponsored model. So, there's obviously an alternative, which is what Superhero does. So, what is that, Shani?

Jayamanne: All right. So, the alternative is a custodian model. Low-cost brokers like Superhero, IG Markets and Interactive Brokers operate on this custodian model, and it means that shares are held on your behalf. And with the custodian model, you have right to your assets and you can withdraw them. But ultimately, if the company goes under, claiming your assets are a little bit trickier and there may be a delay in getting the funds back to you.

Lamonica: And there are a few more downsides to this custodian model. The first and the major difference, in our opinion, is dividends and reinvestments. So, dividends and reinvestment through a CHESS-sponsored broker are completely within your control. You're able to receive your dividends in cash or reinvest them. through a custodian model, some brokers automatically reinvest dividends and distributions, and if you'd like to receive it in cash, you would have to sell, which may have tax consequences. However, with our example of Superhero, dividends are given in cash in your investment account and it's your responsibility to reinvest.

Jayamanne: One other downside that a lot of investors point to with custodians is inflexibility, if you want to move brokers. Because your holdings are commingled with other investors and there's no clear delineation, many believe that you can't move from a custodian model to a CHESS-sponsored model if you're getting sick of your broker. And this just isn't true. You're able to transfer in and out of these brokers, in most cases, without charge.

Lamonica: And this is the same case as if Superhero went out of business, you would just be able to transfer the shares to another broker once the administration was sorted. Question is though, Shani, why investors would choose a custodian model?

Jayamanne: Well, Mark, the proof is in the pudding. If we look at the cost of trade, custodian models are able to offer much lower costs because trades are done in bulk, and they can be netted. What this means is that if I'm with Superhero and I'm selling 20 Morningstar shares and Mark is also with Superhero and he is buying 20 Morningstar shares, those shares can simply be transferred to Mark without incurring any trading costs.

Lamonica: Yeah. And honestly, feel free if there's any shares you would like to transfer to me. Feel free to just do that.

Jayamanne: Yeah.

Lamonica: And I'd also question why you're selling your Morningstar shares. It's a bad sign. It's another indication that Shani is going to quit. But anyway, with this model of netting, as you can probably imagine, over a day with lots of users, there's a lot of transaction costs that are being saved.

Jayamanne: And in the case of Superhero and a few other custodian brokers, because they run on this model, they're also able to offer fractional share investing for U.S. shares, which means that due to the scale and the number of users that are on the platform, they can offer fractions of shares to own that make expensive shares more attainable for individual investors. And by expensive, I mean the actual dollar cost. For example, NVR Inc. is trading at $4359.73. Through CommSec, if I want an exposure to this company, I would need to part with US$4,300. Through a custodian, I can part with their minimum investment amount, which for Superhero is $100.

Lamonica: Okay. So, those are the main differences between the custodian and the CHESS-sponsored model. And again, like with many things in investing is based on personal preference, custodian is cheaper in most instances, but CommSec is CHESS-sponsored and offers the clear ownership of your assets, which includes choices with dividends, distributions and voting rights. But I do think one thing is important to say here that CHESS-sponsored is uniquely Australian. Like, this does not exist in other countries. So, like in the U.S., everything is a custodian model. So, I thought I'd just throw that in there.

Jayamanne: Good insight.

Lamonica: Adding my perspective as a former American.

Jayamanne: Great. So, let's move on to the next feature – data and research. A lot of investors place a heavy emphasis on data. They want real-time data. This is a feature that we understand would be important for day traders, but for long-term investors a 20-minute delay, which is a standard for most brokers, should not be an issue or a determinant of value.

Lamonica: And because it was so important, many brokers started offering real-time data for free as part of their offering to maintain market share. So, Superhero and CommSec both offer real-time data.

Jayamanne: Let's talk a little bit more about what other data and research that is offered. CommSec offer charting tools, weekly stock recommendations from industry experts and research for any stock that you're looking at. And I think that's a good time to stop and pause and talk about this research.

Lamonica: Yeah. So, we do want to acknowledge that for a lot of people, their first introduction to Morningstar is through their broker. They see our name behind the data and some brokers offer our ratings as well for equities.

Jayamanne: So, you might be looking to purchase CBA and see that we think the fair value is on the 3rd of August. It was $113.16. This fair value is based on our quantitative methodology, basically an algorithm that determines the value of a stock based on financial ratios and metrics with no input from a human.

Lamonica: Yeah. And we get this question all the time, Shani. So, why do fair values differ from the fair values on Morningstar Investor, our own product? Well, it's because ours are qualitative. So, we offer quantitative ratings for all the stocks we don't cover. But more likely than not, if an analyst covers a stock, the fair value is going to be different from the quantitative rating and what you see through your broker.

Jayamanne: So, our analyst Nathan gives CBA a fair value of $83, and as I said before, the quant rating is $113.16. We can also look at AGL. The quant rating is $11.24, and our analyst Adrian thinks it's worth a bit more at $13.13. It's not always a huge spread. So, we see like stocks with Kogan, a quant fair value of $11.38 and our analyst Johannes thinks it's worth $11.70.

Lamonica: Yeah. And we obviously see the value of human intervention. There's value in companies that can't just be derived from financial statements and ratio analysis and simply, it's a difference between what you get with a broker and what you get with Morningstar Investor.

Jayamanne: But I think that some investors do derive some value from the quant research because it provides a yardstick. And back to the comparison between brokers, that is something that CommSec provides that Superhero doesn't. So, what's missing? That's access to individual shares outside of major markets. Some investors may choose to access these markets using collective investment vehicles, and as we've mentioned before in episodes where we explored the Active Passive/Barometer Report, emerging markets and international markets might be somewhere where active managers can add value because the markets are broad and not as well covered as Aussie and U.S. markets, specifically large cap. But if direct international equity investing is something that's important to you, find a broker that allows you to trade internationally. Westpac and CMC allow you to do this. If data and technical analysis is important to you, find a broker that gives that to you. If you're looking just to trade Aussie shares and ETFs, find the cheapest broker. If a HIN and director ownership is important to you, find a broker that's CHESS-sponsored.

Lamonica: Yeah, exactly right, Shani. So, in the big scheme of things, investing has decisions that are much more important than what broker you pick, simply a vehicle that allows you to invest in those chosen securities, especially as a long-term investor that's buying and holding, it matters less.

Jayamanne: And cost ownership models, data and research, support and client services, resources, they're all different aspects of a broker service and experience that you have to consider and weigh up what is a priority for you. For me, cost matter a lot as I invest paycheck to paycheck. It's extremely important to me that I minimize trading costs as much as possible. I do this through unlisted funds, but I also invest in direct shares and ETFs. So, I have chosen to go with a broker that is low cost.

Lamonica: Yeah. And personally, I invest using Westpac. Not that there's really anything good about it, but Westpac is where I do my banking and so it's attached to my banking account and that's easy enough for me. Also, because, of course, I used to live in the U.S. I do my U.S. investing from U.S. accounts. So, I don't care about international accounts. And then, as you said, I don't need research because I work here. So, yeah, it's all obviously pretty personal. So, yeah, right down the things you want, as Shani said, out of a broker. And then, question yourself a little bit why you want those things, make sure they're actually important things. And yeah, go find yourself a broker and don't trade very much once you do. So, any parting thoughts, Shani?

Jayamanne: Please come to our conference.

Lamonica: Please come to our conference. It is the Canberra of conferences.

Jayamanne: It's the laksa from Dickson Noodle House of conferences.

Lamonica: There we go, there we go. And if anyone comes to our conference from Canberra…

Jayamanne: Please bring me, laksa.

Lamonica: …you should bring Shani laksa. And write us and tell us you will, and we will let you in for free. Does that sound fair, Shani?

Jayamanne: That sounds fair.

Lamonica: Okay. Awesome. Well, thank you guys very much. As always, any comments or ratings would be appreciated or passing this on to your friends and family.