Don’t Get Swept Away

July 21, 2006

The good news about the Fed bringing interest rates back up is that investors no longer have to make due with pitifully low yields on the cash they have lying around.

Trouble is, many poor souls with accounts at the nation’s premier brokers are STILL earning rock bottom rates of around 1% (and lower) a year. In today’s 5% world, this just shouldn't be. The culprit is the innocuous sounding “sweep” account. At the big four “discount” brokers – E*TRADE, TD Ameritrade, Schwab, and Fidelity – investors parking cash often get carjacked.

How are the brokers sticking it to customers, and what can customers do about it?

When you are not in stocks, bonds, or mutual funds, your cash is swept into the broker’s “interest bearing” account.

Many investors keep a good chunk of their account in cash at any given time – not just between trades but often for years at a time. Recently E*TRADE customers had total cash deposits of $10 billion in sweep deposit accounts – the largest single place customers park cash, more than money market, savings accounts, and CDs combined. E*TRADE paid out an average rate of 0.74% on this $10 billion last quarter.

Today, buying an ordinary Vanguard money market fund yields near 5%. For E*TRADE and other discount brokers, borrowing money from customers at less than 1% is very profitable, especially when they can loan the money back to other customers in the form of margin loans at near 10%.

E*TRADE now makes more from net interest income than they do from stock trading commissions. According to E*TRADE, customer cash “…[is] a low cost source of funding.” Other big brokers also make big dollars from lending their customers money.

But shrewd investors know that these brokers often have higher-yielding options for sweep balances – they just go out of their way to hide them from you.

When setting up a new account online, E*TRADE offers new customers a couple of sweep account options. The default choice is the E*TRADE Extended Insurance Sweep Deposit Account. Here, an investor with $4,000 lying around earns a whopping 0.25% APY, or $10 per year. Larger investors do slightly bit better. Bring your cash balance up to $45,000 and they will reward you with 0.50%. A $90,000 balance earns a paltry 1% - a fraction of what somebody with $3,000 can earn at Vanguard in a plain vanilla money market fund.

What E*TRADE doesn't want new customers to do is choose a money market fund as their sweep balance, but if you select “view tax-free alternates” when asked to choose a sweep option, other higher-yield options appear.

The tax-free money market funds pay far more than the normal sweep options – and the interest is tax-free federally, and could be tax-free in states with the appropriate fund.

Already have an E*TRADE account and want to switch? You can’t do it online, but if you send an email to service@etrade.com with the subject line, “Change My Sweep Option selection” (include your account number and desired fund choice – like JPMorgan Municipal Money Market Fund, E*TRADE Class Shares – in the email itself), within days you’ll be earning about 2.3% tax-free.

TD Ameritrade offers a similar raw deal on sweeps. A $4,000 balance gets you 0.25%, $20,000 earns 0.50%. $40,000 offers a slightly less-ridiculous 1.45%. TD talks a good game about better options, but it’s unclear how you get them. On a new online account application at TD, you are not given a choice for money market funds. On the website you can find a page that shows the tantalizing 4% + yield, but you have to call to buy the fund.

When I called TD Ameritrade a representative told me there are no higher-yield options available to me unless I had $100,000 in cash in the account. Such a standard, which the vast majority of TD Ameritrade accounts never reach, earns you a money market fund sweep option with a yield of roughly 4% or so.

I was informed I could gain access to this privileged club by simply trading more frequently – though how much they could not say. According to the representative, TD didn’t make any commissions off my account, which is in mutual funds.

Schwab offers a slightly better deal than E*TRADE and TD Ameritrade do for ordinary customers who do not hunt for a better sweep account option. While Schwab reserves the high-yielding money market funds as a sweep option for those with $500,000 in total Schwab account value (does not have to be in cash, and includes linked accounts), those with over $100,000 in total Schwab assets earn between 2% and 3% on idle cash (the rate goes up with total Schwab account size). Those with under $100,000 earn about 1%. Schwab has much higher average account sizes than either E*TRADE or TD Ameritrade, so many are getting better yields.

As a Schwab spokesperson is quick to point out, they offer a variety of options including CDs to buy with idle cash – though such options require trades, as apposed to an automatic sweep.

Good choices for Schwab investors include Schwab YieldPlus (SWYPX), a $2,500 minimum ultra short-term bond fund yielding over 4%. The fund is available for no transaction fee for Schwab customers and can be sold with no onerous short-term redemption fees like Schwab charges for sales in non-Schwab mutual funds. Those who can meet the $50,000 minimum will do slightly (like 0.15%) better in the lower-fee Schwab YieldPlus Select (SWYSX) class.

Fidelity offers the squarest deal of the big four on sweep balances in their brokerage accounts. The default sweep option yields almost 3% – even on cash balances under $10,000. The rate goes up slightly on larger balances. Like E*TRADE, Fidelity customers can choose a municipal money market fund as a sweep option and earn tax-free income. Like Schwab, clients can buy and sell Fidelity Cash Reserves (FDRXX), a money market fund with a $2,500 minimum and low fees, currently yielding about 4.6%. Better yet, Cash Reserves is available as an automatic sweep option for retirement accounts.

Fidelity is in line with the better deals generally available at smaller discount brokers. Scottrade offers 1.5% on even a $50 sweep balance. On $5,000 you’ll earn 2%, and 2.75% on over $10,000. Firstrade offers 2% on less than $10,000 in cash, with rates going up with larger balances. Keep in mind that the big four are far more expensive places than Scottrade or Firstrade to buy and sell most mutual funds.

If your broker doesn’t have better options, there are a number of mutual funds that are essentially higher-yield money market funds (though technically they have slightly more risk). SSgA Yield Plus (SSYPX), Payden Limited Maturity (PYLMX) and PIMCO Low Duration Class D (PLDDX) are three funds most any brokerage client can buy for no transaction fee (NTF) and earn a normal yield (currently around 4.5%).

Unfortunately, if you have to sell these funds in a few months time, the brokers will likely charge you a short-term redemption fee for the privilege (often defeating the purpose of the purchase in the first place). Your best bet is the broker's own house brand ultra short-term bond funds or money market funds, if any, as these funds can be traded with no penalties. Those with lousy sweep options but low trading commissions could consider iShares Lehman 1-3 Year Treasury Bond (SHY), an exchange-traded fund that owns short-term government bonds – not quite a money market fund but a very low-risk choice. Just don’t let the commissions eat up the extra yield.

1 COMMENTS: POST A COMMENT
This article was extremely
Anonymous (not verified) — POSTED December 20th, 2008 5:57PM

This article was extremely helpful!

I was setting up an IRA on E TRADE to transfer my old 401k after getting laid off. I called customer service to ask what a sweep account was. I don't know much about investing, I thought any profits just get put back into the account and re-invested, which now I know is a DRIP that you have to sign up for.

I wasn't sure what sweep account to pick and started googling. So glad I came upon your article! After reading it then fiddling and finagling my way around on E TRADE I did find that the JP Morgan sweep was .09% while the automatic selection, Sweep Max is .05%.

Thanks Jonas.