Schwab challenging Merrill’s supremacy

In the battle of brokerage house titans, the company from the other side of the tracks is giving the rich boy a run for his money.

Over the past 15 years, Charles Schwab Corp. has grown from an obscure discount firm where client accounts averaged a puny $15,000 to a full-service powerhouse that’s challenging the supremacy of the nation’s top brokerage — Merrill Lynch & Co. Inc.

During that time, Schwab’s assets have risen from 8% to 43% of Merrill’s. More significantly, those assets are growing at more than double Merrill’s annual pace. If it wasn’t for Merrill’s overseas expansion, the disparity would be even greater, according to a yet-to-be-released report by Boston consulting firm Cerulli Associates, a copy of which was obtained by InvestmentNews.

“Indeed, Schwab’s asset-gathering momentum is presenting a formidable challenge to Merrill Lynch,” the report states.

The struggle is titanic in more ways than one. It is a microcosm of all the changes that are sweeping the brokerage industry and redefining the way stocks are bought and sold.

The revolution is being driven largely by the rise of discount and online trading coupled with an explosion in the number of wealthier and increasingly more sophisticated retail investors.

Brokerages that once moved in tandem with armies of brokers, feasting on pricey commissions, are being forced to adopt online strategies that could spell the eventual end of traditional brokers, the report states.

Merrill Lynch, for example, as part of its overall online initiative, is using the Internet to build brand awareness directly with the clients, and not necessarily through the brokerage rep.

The report estimates that 20% of the 50,000 full-service reps may be dropped in the brave new world of online investing.

“The fee-based model will purge the industry of those brokers that have been relying on commissions from high turnover,” says John Payne, co-author of the 328-page Cerulli report.

Offering customers fee-based advice and guidance online is no longer an option. “The only question now, is how many firms will introduce their own versions of discount trading,” he adds.

Mr. Payne says the 1% annual fee charged by the Merrill Lynch Unlimited Advantage program forces the rest of the brokerage industry to meet or beat that fee structure.

Merrill’s Unlimited Advantage “effectively sets the price for advice in the brokerage industry at 1% of assets,” he says. “All other online brokerage programs will have to incorporate flexibility which allows brokers to discount to 1%.”

“[T]ransactions are becoming a commodity and information is readily available,” he adds. “This is all forcing the broker to move into the advice and planning stage, as opposed to just making money off commissions. And in adviser mode, the name of the game is asset gathering.”

For independent financial advisers, the trend toward online advice is a double-edged sword.

Advisers are well-positioned with solid books of business built on fees, which match up well against online fee-based programs being developed at the brokerages.

According to the report, advisers are particularly vulnerable on the technology front, where they are grossly overmatched by the information technology resources of a full-service brokerage firm.

That’s why advisers have been the slowest of the full-service industry participants to incorporate the Internet into their business models.

“Because investors can now access financial planning tools and specific investment advice on the Internet, reps have to offer an improved advice product,” the report states.

Cathy Baker, co-manager of the $350 million RS Internet Age Fund, points out that low-cost online trading coupled with an extended bull market has “turned the power over to the investor.”

“The price discrepancy is so big between the traditional broker and online trading that people are willing to move their business,” she says.

“Right now you can almost throw darts at the wall and make money,” Ms. Baker says. “Maybe we need a bear market to make people really appreciate advice.”

Raphael Soifer, chairman of Soifer Consulting in Ridgewood, N.J., says full-service firms are following the fundamental premise that the customer is always right.

“If the customer wants it, they will get it,” Mr. Soifer says. “But these firms are…not going to start competing with day trading firms by offering $8 trades.”

In some respects, online discount brokerages are just the latest assault on the full-service brokers.

In the 1980s, they buckled to pressure to offer more non-proprietary funds; in the 1990s, the pressure came from registered investment advisers offering fee-based advice.

fee-based menus in response

Brokerages responded by rolling out full menus of fee-based offerings, including mutual fund and consultant wrap programs, and fee-based brokerage platforms.

Now full-service brokerages are faced with the challenge of fending off online brokerages like Schwab and E*Trade Group Inc.

Since 1988, Schwab’s assets have grown by 39% a year, compared to 17.5% for Merrill. Without overseas help, Merrill’s growth falls to 15.5%, the report states.

While Schwab’s customer account average once fell well below Merrill’s radar, in 1999’s fourth quarter Schwab’s average online account balance was $114,000 and the offline account balance was $106,000.

Both “now fall squarely on the border that historically marked the boundary between the self-directed and full-service worlds,” the report states.

Schwab also edged out Merrill in the growth of assets under management, which rose at 33% a year compared to 20% for Merrill. “Most notable is that Charles Schwab grew its online asset base 97% per year during the last 3.5 years through June 1999…indicating that the online distribution channel holds an important key to growth,” the report adds.