A trend that's changing the face of the brokerage industry - fees as opposed to commissions - may help wirehouses, institutional banks and broker/dealers attract more money into separately managed accounts (SMAs).
A movement to fee-based services from commission-based ones is being aggressively pushed by some wirehouses as a means to grind down peaks and fill in valleys in their sawtooth income picture. The practice, which directly links a broker's income to an account's performance, may also be eyed as a way to rebuild investor confidence in the industry, as faith has been greatly shaken by bear market losses, corporate scandals and reports of financial misconduct.
Matt Schott, a senior analyst with TowerGroup, a research and advisory firm that focuses on global financial services based in Needham, Mass., compared the trend to an ocean swell that is overtaking the entire investment management industry. "It starts in the middle of the ocean and gathers steam as it gets closer to shore," he said. "The industry is in [the middle of] that rolling long-term change, shifting from a product-centric, transaction- and commission-oriented approach to [one] more of [building] relationships, developing long-term-solutions and charging fees for assets under management."
He reasoned that because the Internet has revolutionized the brokerage landscape, providing investors with free, easy access to information and low-cost trading, brokers are scrambling for ways to differentiate themselves. "The differentiation is going to be more on developing solutions, providing advice and managing risk," he said. "All those things go fairly nicely with what goes on in a managed account."
The New Gospel
In a managed account, he explained, an adviser sits down with a client and comes up with long-term goals. Then the adviser develops an asset allocation strategy based on those goals and the client's risk tolerance. Finally, those assets are parceled out to money managers to maximize the return on those assets. All the while, the adviser oversees the allocation and manages the client's risk. "Since most managed account business is fee-based business," he said, "it is very definitely consistent with the industry trend toward fee-based business."
For the nation's nearly 11,500 independent advisers, the trend toward fee-based business began around 10 years ago and has been pretty much adopted across the board. However, commissions still are king for the largest segment of the financial intermediary industry - the some 260,000 middlemen at broker/dealers, banks and insurance companies.
Although wirehouses have been pressuring their brokers to embrace the fee-based gospel, revenues from fee-based accounts remain low at around only 20% to 30%, according to a recent study by Cerulli Associates, a financial research and consulting firm headquartered in Boston.
However, the report noted that assets in fee-based products at wirehouses have increased three times over since 1994, from 5% to 15% today.
Wirehouses' interest in fee-based systems is stability, said Cerulli Senior Analyst Matt McGinness. Commissions are a very volatile form of revenue, as the past few years have proven, with many brokers having to lay off large percentages of their staff. "In a bear market, commission revenues drop because trading falls off. Revenues from principle transactions drop as IPOs [initial public offerings] slow down, and you may or may not see a decline in margin lending revenues," he said. "Asset-based revenues tend to be much more stable."
Ironically, some investment pundits predict that independent advisers, who have preached about the benefits of fee-based services for years, may lose a key selling tool as the practice proliferates throughout the rest of the industry.
But McGinness isn't one of those pundits. "It may take away one angle that some independent advisers exploited, but independent advisers have a different value proposition," he said. "They are getting a lot of mileage out of investment banking scandals and perceptions of biased practices within the wirehouse system."
But the mileage independent advisers can wring from those scandals may diminish as adoption of fee-based services grows. That's because the practice puts brokers and their clients on the same side of the payoff equation. "If the business grows, both the adviser and investor benefit," observed Michael Evans, a vice president with Financial Research Corp. (FRC), a Boston-based financial services research and consulting firm.
Applying a fee-based squeegee to the soiled window through which investors view the investment industry should help its efforts to exploit the heightened investor interest in SMAs, the assets of which are expected to explode during the decade.
Assets in SMAs will grow at a compound annual rate of 18.5% over the next five years, reaching $1.1 trillion by 2007, according to the TowerGroup. And by the beginning of the new decade, FRC estimates assets will break the $2 trillion barrier.
Wirehouse Goals
Not only is that growth attractive, but, because the SMA business is fee-based, it meshes nicely with wirehouses' overall strategic aims. "The distributors love the fact that this is a fee-based product," FRC's Evans observed. "This is a steady revenue stream that they can count on going forward without depending on transaction commissions."
That's not to say there isn't an appeal for investors, as well. They're getting a customized product, not the "one size fits most" approach of other investments. In addition, SMAs offer tax benefits. "There are no embedded gains associated with a separate account, as there may be with mutual funds" Evans explained.
Until recent times, SMAs were associated only with high-net-worth investors, which may explain why, Evans said, wirehouses and investment banks own 70% of the market.
But what's firing the market now is the rapidly shrinking entry point for investors. That entry point, through the use of technology, has dropped substantially to minimum investments of $100,000. One company, Curian Capital, of Denver, has dropped the minimum to an incredible $25,000, although skeptics question the wisdom of such a low point. "Does an investor really need direct security on $25,000?" asked Evans. "The answer is, probably not. But that remains to be seen."
Nevertheless, at that level, many financial planners, broker/dealers and registered investment advisers outside the wirehouses may be drawn to the SMA market. But those advisers, too, must cut the cord to commissions before they're in a position to get their piece of the trillion-dollar pie waiting for them down the road.
That's why Curian, an indirect subsidiary of UK-based Prudential, launched in March its Fee Advance Program along with its Web-based separate accounts product. With the Fee Advance Program, financial professionals receive several years' worth of fees up front when they open a new client's account or when an existing account is moved to the Curian platform. "The program allows us to front money to the reps to help them deal with the expense of converting a book of business from commission-based to fee-based," explained Curian Executive Vice President for Strategic Development James Vitale.
If advisers wish to forgo the up-front payments, they can take advantage of another feature Curian recently added, a level fee option, which allows them to receive a steady annual fee, billed quarterly and paid monthly for the life of an account.
The program is also a good deal for investors, Vitale said. Until Curian's offering, he explained, the minimum ante for an SMA was $100,000. For that, you would get one or two managers for your investment. "You really couldn't get a diversified portfolio for that kind of money," he said.
"We've been able to democratize the separate account business," he continued. "For $25,000, an individual gets a fully diversified portfolio, with anywhere from five managers to as many as 18, and from 500 to 900 securities, depending on the number of styles represented in the portfolio."
Moreover, the Curian platform is scalable. "That $25,000 portfolio is just as appropriate for someone with $3 million, $5 million or $10 million," Vitale said, "because they're getting institutional money managers, direct security ownership and customization - all the benefits of a separate account."
Will the glow around fee-based products like SMAs ebb once the bears return to hibernation? FRC's Evans doesn't think so. "People have gotten hurt so badly with this bear market that they'll stick to the process in managed accounts whether the markets are up or down," he said.
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