How to Avoid Hidden Fee of ‘Side’ Exchanges

If you’re a small investor who likes to buy stock in big companies, there’s a good chance you’re getting nickel-and-dimed by your broker in a way you’ve never considered.

Sure, everyone knows that brokerage firms are charging more for their services. On top of commissions, you’re likely to get hit with higher annual charges for IRAs and money market accounts, as well as new fees for postage, charges on inactive accounts and even charges to get stock certificates.

There’s also a good chance that you’re getting hit with a cost that doesn’t show up on any customer account statement.

To understand exactly what this is and where it’s coming from, you have to understand a bit about how stocks are traded.

When you call a broker and say you want to buy 100 shares of a company listed on the New York Stock Exchange, your broker can usually send that order to any number of market makers. Market makers work on the floor of most of the nation’s stock exchanges, including such so-called side exchanges as regional and over-the-counter markets.

The broker should send your trade to the market maker who offers the best price. But many industry experts believe that that doesn’t always happen.

In the past several years, it has become common for market makers who work for side exchanges to pay brokers for sending trades their way. The payments are generally only for smaller orders--trades of 100 to 400 shares. And they’re small payments--typically one to two cents per share. In other words, on an order of 200 shares, the broker could conceivably make an additional $4. This payment-for-orders practice seems to be particularly prevalent in the over-the-counter, or NASDAQ market, experts say.

These payments seem to have had an impact. In 1980, 85% of the Consolidated Tape trades were executed on the New York Stock Exchange. But by 1990, only 66% were, according to a newly released study by the University of Michigan’s School of Business. Meanwhile, NASDAQ’s share of the market rose to 8.53% in 1990 from only 2% in 1987.

“Since the location is largely decided by the broker, this volume shift reflects a change in brokers’, not investors’, behavior,” said Charles M. C. Lee, the assistant professor who conducted the study. Some believe that the shift is primarily the result of the financial incentives given to brokers.

None of this is supposed to matter a bit to investors. In theory, these trading fees are not passed on to customers: They simply reduce the market maker’s profit. But Lee’s study maintains that theory and practice are again at odds.

Indeed, his study revealed that there can be noteworthy discrepancies between prices paid for a company’s shares, depending on which exchange handled the trade. Small investors tend to pay lower prices for buys and get higher prices for sells when the trade is handled on the New York Stock Exchange versus a side exchange, he said.

Those trading from 100 to 400 shares get hit the hardest. Trading costs them an average of 1.9 cents per share more when the order is sent to a side exchange, according to Lee. Those who trade upwards of 500 shares at a time, he said, will see much smaller differences, if any.

Even though this charge is small when taken a nick at a time, anyone who actively buys and sells stocks will find these little costs adding up.

The Securities and Exchange Commission is reviewing Lee’s findings. However, SEC insiders say any SEC action could be years away.

Meanwhile, investors who want to avoid paying these hidden fees do have some options, according to Lee. First, they should ask their broker the difference between the bid and the ask price. If it’s less than one-eighth of a point, they probably don’t have to worry which exchange the trade is sent to, Lee said; usually when differences are that small, there are fewer differences in trading prices, regardless of the exchange.

If the spread is larger--a quarter point or more--they can ask to have the trade executed on the NYSE. Their broker should honor the request.

If you don’t want to specify an exchange, you might put in a limit order requiring the trade to be executed at a particular price. But when you do this, you risk not completing the deal, because the trader must wait until prices hit the level you’ve specified.