Author – Spencer Turkal
“My custodian/broker went to no-fee trading so therefore I don’t pay any fees”.
We hear this from time to time to which my usual response is:
“Ah, I didn’t realize that (insert big custodian/broker dealer) was a non-profit!”
While I typically try not to be sarcastic, sometimes it is the simplest way to get a point across. At the end of the day these companies need to make money and those that are publicly traded have a legal obligation to maximize profit so while it may appear that fees are going away for investors, there must be something else at play here.
If you don’t recognize the word “custodian” that’s okay, think of a custodian like a bank vault for your investments. When you invest in stocks, mutual funds, or Exchange Traded Funds (ETFs), you don’t physically hold those things in your hand. Instead, they’re kept safe by a custodian, a financial company whose job is to safeguard your money and make sure everything is accounted for. The three largest by Assets Under Custody (AUC) are Charles Schwab, Fidelity and Pershing. All three of those companies are also broker-dealers, meaning that you can buy and sell stocks, bonds, funds, etc. on their platforms without a third party. Now, let’s break down how these companies make money:
Fees: The Most Visible, Yet Often Underestimated Cost
Expense Ratios
Expense ratios are one of the fees that you pay for investing in mutual funds or ETFs (both of which are funds that hold several stocks/bonds and often hundreds or thousands of stocks/bonds). They are expressed as a percentage of the amount that you have in the fund. For example, a 1% fee on $100,000 in a fund would be $1,000 per year. One of the attractive features of ETF is that they typically charge low fees, for example between 0% to 0.10%. Mutual Funds often charge between 0.50%–1.50% and sometimes even more. The higher price is due to the fact that Mutual Funds are typically actively managed by the fund company and since they are not publicly traded like ETFs, have more operational expenses (if you are wondering, our opinion is that these aspects do not warrant the higher fee, but we will go through that in a future article). It is important to note that these are the fees associated with investment funds, and this article largely focuses on custodians and broker-dealers. The fact of the matter is that most large custodians/broker-dealers have their own funds that they will emphasize on their platform. Charles Schwab and Fidelity have their own funds and Pershing’s parent company BNY Mellon has their own funds. For Charles Schwab and Fidelity, fund fees make up ~25%-30% of their revenues.
Custodial and Platform Fees
Custodians (like Schwab, Fidelity, Altruist, Pershing, etc.) may not charge you directly, but that doesn’t mean they aren’t extracting value. While some charge platform or account maintenance fees outright, many others earn revenue indirectly, through:
- Revenue-sharing agreements with fund companies.
- 12b-1 fees, often hidden inside fund expense ratios.
- Markups on trading costs, including bond spreads and mutual fund transaction fees.
Even “free trading” platforms typically earn money through less visible means, often more than if they just charged a transparent fee upfront.
Cash: The Hidden Profit Engine
One of the most overlooked revenue sources for custodians that we see is low interest yielding idle cash. While not intuitive at first, almost every major custodian and fund company now decreases their customers returns and increases their revenue through the use of idle cash in their customers accounts. While excessive amounts of cash in a portfolio or fund is not technically a fee, the result is the same, it increases revenue for the company and decreases client returns. It is also important to point out that not all custodians keep an “excessive amount of cash” but rather a proper amount for basic account functions.
How It Works:
Many custodians require investors to keep a portion of their portfolio in a default cash sweep account, often earning a very low interest rate. At the same time, the custodian invests that cash in instruments like short-term Treasuries or money market funds, earning 4–5% in today’s interest rate environment.
The spread between what they earn and what you receive is pure profit for them.
It’s not uncommon to see:
- Clients earning 0.30%–1.50% on cash
- While the custodian earns 4.5%+ on that same money.
This is called cash spread revenue, and it’s become a major source of profit for custodians and fund platforms. In fact, some have totally redesigned their business models around it.
Minimum Cash Allocations
Some custodians require mandatory cash allocations in model portfolios (I’ve seen as high as 10%!). That means even if your advisor recommends 100% equity exposure, you might only be 90–99% invested, with the rest sitting in low-yielding cash by default.
The result? Lower long-term returns for you, higher profits for the platform.
Cash Drag in High-Yield or Tax-Inefficient Funds
While not as egregious as the first two, cash drag and tax inefficiency are real issues, especially in non-qualified (taxable) accounts.
High-Yielding Funds
Funds that generate significant dividends or interest must periodically hold cash to meet redemption needs or distribute income. If a fund turns over holdings frequently, it may build in excess cash buffers that dilute returns.
Turnover and Tax Costs
Active funds with high turnover can trigger short-term capital gains, which are taxed at higher rates than long-term gains. Even if a fund performs well before taxes, your after-tax return may lag significantly.
Target-date funds, income funds, or dividend strategies may be especially prone to these issues when held in taxable accounts.
Other Hidden Drags to Watch For
Payment for Order Flow (PFOF)
Some custodians and robo-advisors route your trades to market makers who pay for that order flow. While this doesn’t always hurt execution quality, it introduces potential conflicts and, in some cases, you may not get the best price.
Share Class Arbitrage
Advisors or platforms may recommend mutual fund share classes with higher embedded fees (like A or C shares) even when lower-cost institutional shares are available—because the higher-fee share pays a commission or platform kickback.
Fund Revenue Sharing
Fund companies sometimes pay custodians to be included on “preferred” lists, models, or platforms. These pay-to-play arrangements can influence fund selection—and often favor the fund company, not the investor.
A far too common example:
Here is an example that we see in similar forms very often:
An individual opens a brokerage account through a financial company and desires an aggressive model portfolio; the company then places the client in that company’s own aggressive model portfolio. This person thinks to themselves “what a sweet deal, every time I contribute, I can purchase more of the fund for free and then it grows and is managed for me for a very low fee”. When we dive in deeper what we find is:
- The company, while not charging trading fees, takes payment for order flow so instead of purchasing more shares at the $10 dollar market price, this individual is really buying new shares at $10.03. Seems like a $0.03 fee to me, which doesn’t pop off the page but when buying hundreds or thousands of shares of a security at a time can start to add up. “I thought up-front fees like those charged by A share mutual funds were slowly going away” I think to myself. I guess not.
- Unfortunately for this individual, this company has a minimum cash requirement of 2% so 2% of their account balance is kept in cash earning a very low rate of interest. Over the long term this will reduce returns.
- What is even more difficult for an investor to see in this scenario is when the model portfolio is a product of the same company that the account is held, each fund embedded in the portfolio also has idle cash between 2% to 4%. Now this account has an even higher cumulative cash holding.
- It is no surprise that this company has only put their own funds in their model portfolio, they get to charge a small fee of 0.10% for giving access to their model and they collect the spread on the cash held in the funds. But wait, each of the individual ETFs held in this model charge their own expense ratio of 0.03%–0.10% (this is very similar to what can happen with target date funds as well. If you are invested in a target date fund, take a look at the holdings. Chances are, it’s made up of other funds from that same company, all charging their own fees and all with their own cash holdings.)
So, the investor thought they were paying 0.10% to use a model portfolio at a custodian/broker dealer that they thought was very low fees is actually paying “fees” in about 5 different ways. Talk about death by a thousand cuts.
Conclusion
Do I bring these things up to say, “the evil corporations are taking advantage of you”? no. At the end of the day these custodians/broker dealers provide great value and the options for investing have gotten substantially better over the last few decades. That being said, it is important to be aware of how the companies make money and what you can do to improve your own returns. At Sierra Hotel Financial we employ strategies where we simply try to match what the market returns in any given year, while losing as little as possible to these fees among other non-fee-based drags. While we have yet to do an official study on how much can reasonably be recouped, we anecdotally find that it’s usually between 0.30%–1.50% per year depending on how egregious the current prior allocation was.