In a Slump, Charles Schwab and Merrill Lynch Seek Middle GroundPublished: July 18, 2001 in Knowledge@Wharton
Consider it a tale of two companies, each wrestling with a difficult market and, to some extent, trying to move to the middle to escape the worst of the extremes. Merrill Lynch, the country’s biggest brokerage, and its chief rival, Charles Schwab, won’t become mirror images of one another, but both are struggling to deal with one of the industry’s biggest problems: how to assure steady revenue even when investors are too fearful to trade.
"The broad-based movement in the brokerage industry, I think, is going to be toward asset-based compensation and away from transaction-based compensation," says Wharton finance professor Jeremy Siegel. In other words, commissions for executing customers’ buy and sell orders will be less important in the future as brokerages instead emphasize fees based on the value of assets held in a customer’s account, Siegel says.
Merrill, a traditional full-service brokerage and investment bank, and Schwab, the discounter that emphasized low commissions for do-it-yourself investors, each flourished during the stock boom of the late 1990s. Merrill shares soared from around $10 at the start of 1995 to $80 last Jan. 23. Schwab stock skyrocketed from around $4 at the end of 1995 to more than $43 on March 24, 2000.
But the market slump of the past year has hurt both companies. From the high last January, Merrill shares have fallen 34% to around $53, while Schwab is down 64% from its peak, to about $15.50.
On July 17 both companies reported results for the quarter ended June 30. Merrill said net income had fallen to $541 million, or 56 cents a share, from $921 million, or $1.01 a share a year earlier. Merrill attributed the drop to declines in all three of its major businesses – brokerage, asset management and investment banking. Revenue for the quarter was 19% below the year-earlier figure.
Merrill executives said they would continue to pursue cost cuts; the company had 68,200 full-time employees at the end of June, down 3,800 since the start of the year. Still, the company has predicted that the current quarter could be worse than the last.
Schwab reported that second-quarter earnings fell to $97 million, or 7 cents a share, from $199 million, or 14 cents a share, a year earlier. Revenue fell to $1.1 billion from $1.4 billion. The main culprit: Commissions, long the company’s most important revenue source, fell 37%. Schwab is not involved in investment banking; all its operations revolve around brokerage services.
Traditionally, Schwab has been a discount broker with a big online presence. It charges a basic commission of about $30 a trade, though it charges less for very active traders. Unlike Merrill, Schwab does not have brokers to advise investors. A full-service firm like Merrill might charge five or 10 times as much as Schwab, depending on the size of the trade.
Schwab has about 51% of the discount brokerage market, with about 7.6 million online accounts containing $806 billion as of March. These gushed cash when stocks were soaring in the late-‘90s and early 2000, as millions came to believe they could trade successfully for themselves with low commissions.
But when stocks began to slump last year, many small investors froze, and trading commissions shrank – not just at Schwab and the other low-commission discounters, but at Merrill and the other traditional, full-service brokerages as well.
Merrill’s investment banking operation, which earns fees helping client companies issue new blocks of stock, is also cyclical; initial public offerings and secondary offerings shrink when stock prices fall. In addition, Merrill and similar firms can lose money trading for their own accounts. Merrill had trimmed its bond operations after a bad year in 1998 and missed out on some potential profits this year and last when falling interest rates drove bond prices up.
In its search for new revenue sources, Merrill has in the past couple of years expanded its online operations, offering lower commissions in hopes of landing some Schwab-type customers. But that, of course, does not help reduce the company’s revenue volatility.
Because market gyrations can affect revenues in so many ways, many securities firms are seeking new approaches to the business, says Wharton finance professor Andrew Metrick. "All of Wall Street is looking at customers not as a way to get commissions but as a way to get fees," he said.
Two summers ago, Merrill introduced its Unlimited Advantage account, which is designed to bring in steady revenue in bad times as well as good. Customers continue to receive the kind of investment advice and other services they expect from full-service brokers. But instead of paying commissions, customers pay an annual fee that starts at $1,500 and goes up depending on the amount of assets in the account. Generally, the charge is 1% on stocks in their accounts, 0.3% on bonds and cash.
One appeal to the asset-based approach, says Siegel, is that it eliminates the broker’s financial incentive to recommend trades just to generate commissions. "The interests of the customer are more in line with the interests of the broker," he said. If the best investment strategy is to stand pat, the broker can recommend that without suffering a loss in income. Yet the broker, receiving an income based on the size of the customer’s account, would earn more by helping the account grow.
Industry insiders report that the stock slump of the past year has made investors more interested in getting professional advice. This has not been a traditional service among discounters like Schwab, but many are trying to change that, either by offering advice from humans or by providing ever more elaborate data and research services.
Last year Schwab purchased U.S. Trust, through which Schwab will offer fee-based trust management, estate planning and private banking services, mainly to affluent customers. Some analysts expect non-trading revenues, which accounted for 45% of Schwab’s revenues in 1999 and 49 percent in 2000, to break 50% by the end of this year.
Through its branch offices, Schwab now also offers one-on-one "investment consultations," which include reviews of investors’ portfolios and strategies. In addition, the company has instituted "investor workshops" – group meetings on investment topics. And it has a referral system for customers seeking financial advisors. All of this is intended to make Schwab a place for customers to keep all of their money and investments, rather than merely a place to keep a small account for active trading.
The recent earnings reports show that Schwab and Merrill continue to be dangerously exposed to market gyrations, supporting the case for expanding asset-based revenue streams.
But it’s not entirely clear that asset-based accounts are good for investors. For an active trader who wants professional help, such an account may be better than paying full-service commissions that can come to hundreds of dollars each. But the active trader who does not want a full-service broker’s advice may do better with a discount broker charging $8 a trade.
Meanwhile, the passive investor with an asset-based account can end up paying a steep annual fee even if his buy-and-hold strategy does not involve trading or require much advice.
While investors may seek the soothing arms of investment advisors when the market slumps, they might scorn such help when the market rebounds. Asset-based compensation could be the new hot thing in the brokerage industry, but it’s not yet clear it will always be a hot thing with investors.