There has always been an arms race in the direct investing and asset management industry. As much as companies in the space want to compete on product selection, reputation, or even distribution - the one thing they all seem to be competing on is price. In this article, we want to go in more detail about the industry's price war and its implications for long-term investors.
The Price Wars
First, let's take a look at pricing for E-Trade Financial Corporation (ETFC). Stock trading costs $6.95 per trade unless you're a more active trader in which case it costs $4.95 per trade. It sounds like a good enough deal - especially if you're an active trader.
(Source: ETFC website)
But you go over to Fidelity Investments' website and you won't be so enticed by ETFC's pricing plans anymore. Stock trading costs $4.95 per trade without any minimum trading requirements. Trading options is also cheaper for Fidelity Investments at $0.65 per contract compared to $0.75 per contract for ETFC.
(Source: Fidelity Investments website)
But $4.95 per trade isn't the floor price yet for stock trading. JPMorgan Chase & Co (JPM) just launched their self-directed trading platform called You Invest which only charges $2.95 per trade. This is almost 40% cheaper than the next cheapest alternative from SCHW and Fidelity Investments.
(Source: JPM website)
Still - the bottom is actually $0 per trade. Robinhood offers stock trading at zero commissions. We believe that since companies are unlikely to pay people to trade on their platforms (although we also didn't expect negative yields to be commonplace) then $0 per trade is probably the lowest fee that can be charged in a direct investing platform.
(Source: Robinhood website)
But self-directed brokerage is only one part of the business. Companies operating in this space make up returns through a cash sweep program as we described in a prior article or through the sale of order flows to high-frequency trades (as described in this article). Plus the self-directed brokerage is relatively light-touch and has high incremental operating margins (i.e., the on-boarding cost of a new customer is practically nil) which means that having low commissions (or waiving them altogether) isn't as unprofitable as one imagines.
On the other hand, managing client portfolios have always been thought of as a high-touch and personalized affair much like life insurance. Goals have to be identified, strategies have to be developed, and clients' hands have to be held throughout market volatility. However, we were surprised to find out that the managed portfolio business is headed in the same direction as the self-directed brokerage one. In the table below we summarize the pricing plans for the different robo advisor offerings for the companies we've discussed so far.
|Company||Service||Description||Min. account size (USD)||Fees|
|Fidelity Investments||Fidelity Go||Affordable robo advisor||10||0.35% p.a.|
|Fidelity Investments||Fidelity Personalized Planning & Advice||Affordable hybrid robo advisor with coaching||25,000||0.50% p.a.|
|TD Ameritrade||Essential Portfolios||Automated investing to goal-oriented portfolios||5,000||0.30% p.a.|
|JPMorgan Chase & Co||You Invest Portfolio||Smart portfolio||2,500||0.35% p.a.|
|Charles Schwab||Schwab Intelligent Portfolios||Automated investing||5,000||0.00% p.a.|
|Charles Schwab||Schwab Intelligent Portfolios Premium||Automated investing with professional financial guidance||25,000||$30 / month|
(Source: Company websites. The Charles Schwab Intelligent Portfolios Premium charges a one-time fee of $300.)
As seen in the table above the pricing for a pure robo-advisor has dropped to 0.35% for Fidelity investments for a minimal $10 account, 0.30% for TD Ameritrade Holding Corporation (AMTD) for a $5,000 account, 0.35% for JPM for a $2,500 account, and a 0% for SCHW for a $5,000 account. There is no doubt that SCHW is aggressively leading the way to zero for the pure robo advisor offering.
Similarly, we find their hybrid offering to be a price leader at the higher levels of assets managed. The shift from a percentage of assets pricing to a more stable fee per month pricing is a massive change in industry dynamics and cements SCHW's role as a price leader. It allows investors to grow their assets without growing their expenses - building some scale in favor of investors (rather than simply for the investment management company).
Schwab's strategy and early success
As the price leader in the space, SCHW is able to dictate the tempo of the industry, forcing the other players to react to its initiatives rather than focus on simply their own. We believe that this is an invaluable advantage in a fast-changing environment such as the one these asset managers are in.
Furthermore, we find that this price strategy is exactly in line with the needs of the future customers of the industry. Note that the low minimum assets required are achievable for the relatively younger generations (e.g., millennials) who are just starting to build an investment base (as most of the income goes to payments on student debt, the rising cost of living, and family-building). Once these customers (who would not have had access to financial management alternatives or could not afford them) are taken into the SCHW platform, they could be kept in the platform through sustained performance, cross-selling (supported by SCHW bank), and financial services inertia (e.g., it can be a nuisance to move accounts from one financial institution to another despite perceived quality and pricing differences). As these customers mature and gain more assets to invest, SCHW can migrate them to higher-earning offerings (which includes personal financial advisors or financial planning teams). This self-perpetuating virtuous cycle can be hard to break and we think that's great of SCHW shareholders (even those just coming in now).
As we expected. SCHW has been executing well on this strategy and has released a press statement last 11 July 2019. Some highlights:
Since introducing new subscription-based pricing at the end of March, Schwab Intelligent Portfolios Premium has added $1 billion in new assets under management, reinforcing the significance of Schwab's move to a more modern way to deliver financial planning. In addition to strong asset growth, the service has seen a 25 percent increase in account opens, a 40 percent increase in average household assets enrolled, and a 37 percent rise in new-to-Schwab household enrollments.
Note how SCHWB vice president of digital advice and innovation Cynthia Loh describes the value to investors:
We've seen many new clients sign up who knew they needed help with financial planning but hadn't found an advisory model that fit them - either because they prefer a more digital approach, are cost-conscious, or find traditional planning services overly complex. These investors were managing their investments on their own but not necessarily by choice, so we're excited to give them a new way to get the help they need.
We're excited to see the progress of the strategy so far and look forward to its continued success in the next twelve to eighteen months. However, there are some risks to this strategy that we'd like to highlight.
Risks in Schwab's pursuit of zero
SCHW is the reigning leader price leader of the managed portfolio offering. It is practically challenging the rest of the industry to bring the price of managed portfolios to zero.
However, this means that the benefits of market share gains and market expansion which SCHW now enjoys may be short-lived. If the rest of the industry converges to SCHW's pricing in the next six to twelve months then the competitive dynamics of the industry may revert to status quo but with everyone (including SCHW) potentially earning a lot less.
Furthermore, SCHW's approach (especially if the rest of the industry follows in its lead) may condition customers (specifically the younger generations) to expect free asset management services as a starting point (rather than a perk). We can see this trend happening in the technology space in which customers mostly expect apps to deliver great functionality yet still be free. Such expectations from the customers of the future may significantly hamper SCHW's ability to offer products and services that charge much higher fees (even if commensurate with value provided). In sum, SCHW risks perpetually upsetting the pricing dynamics of the industry.
Recall that SCHW serves as a custodian for over 7,500 Registered Investment Advisers (RIAs). These RIAs act cooperatively but independently of SCHW in serving clients looking for portfolio management services (among other financial-related services). In launching a zero fee offering, SCHW is deliberately carving out the lower assets under management (AUM) clients for themselves and creating price pressure for their own RIA clients.
Alternatively, SCHW could have developed a solution or technology offering to help its RIAs serve the clients in a similar manner (e.g., robo advisor offered through the RIAs rather than through SCHW). Instead, it chose to reap the benefits of the price leadership for itself.
We see this as a potential escalation of conflict between SCHW and its RIA clients. While said conflict has always existed for example through the proprietary products that SCHW sells through its RIAs; this may discourage RIAs from transitioning their practice towards SCHW.
The third risk we are concerned with is the reputation risk associated with investing client assets in SCHW manufactured investment products. There is an inherent conflict in direct wealth management assets to internally-manufactured products especially if the products do not perform well. Clients may feel that meeting their financial goals only comes second to SCHW generating volume for their own asset management business. This risk has always existed but will now increase as SCHW makes market share gains in the robo advisory game.
We actually prefer a more independent approach towards the financial management business such as the one that LPL Financial Holdings (LPLA) engages in. However, we recognize that most of the other players in the industry are not taking this approach and have gone on to have their financial advisers sell investment products that they themselves create.
Sidestepping the competition
In spite of the aggressiveness coming from SCHW - some players are deciding to sidestep them altogether. During Raymond James Financial's (RJF) most recent employee-advisor conference (as covered by ThinkAdvisor) Chief Executive Officer Paul Reilly discussed that the client base for robo advisors do not necessarily overlap with their existing client base and that clients will always need a human on the other end of the relationship. Here is an excerpt:
We have not done this direct to the client. You have to go through the advisor. While there's lots of room for automation and big data, these advances are not replacing human advice.
Our own due diligence on the matter suggests that Mr. Reilly's sentiments are on the right track. After speaking with several financial advisors in several states (e.g., California, Texas, Louisiana, and New York) we heard that robo advisors become far less attractive to investors with over $100,000 in investment assets. The issues that these investors face are complex: foreign assets, multiple tax jurisdictions, illiquid holdings (e.g., farms), and other interrelated topics that are perceived to be too challenging for robo advisors to adequately address.
There is also a risk that these robo advisors or their underlying portfolios perform poorly (or relatively worse than their human counterparts) during a market downturn. Clients could then be hesitant to trust robo advisors for even more basic financial planning needs.
Another approach is the one taken by LPLA that seeks to automate and empower advisors rather than replace them with robots. LPLA offers services in portfolio management (through centrally managed platforms) and operations (through virtual assistant, virtual chief marketing officer, virtual chief financial officer, and chief technology officer) that will allow financial advisors to become a full-fledged relationship manager rather than part-time operator, part-time portfolio manager, and part-time relationship manager. LPLA hopes that as advisors leverage these capabilities - more clients can be served at a much higher service level while expanding margins for both the advisor and LPLA. In effect, LPLA is betting that humans will outperform robots in the battle for financial assets.
(Source: LPLA investor day presentation)
This approach actually raises the risk that advisers will migrate from wirehouses and other custodians to LPLA especially in the context of robo advisors. As we mentioned earlier in the article, advisors will not be excited to compete with their custodian even for a segment of the market that may be too small for them to profitably serve.
There is a massive price war in the asset management business and the major players must take a serious look at charging zero fees for both direct trading and managed portfolio services.
We believe that SCHW has positioned itself as the price leader in the low AUM managed portfolio space and that it stands to benefit from being the price leader. The generational benefits of maintaining this leadership and the synergies it creates with the asset management and banking businesses are massive. However, this strategy also poses some risks in terms of a persistent loss-generating industry, alienating RIAs, and reputation risks associated with product manufacturing.
Consequently, we think that competition will attempt to match SCHW's rates in time. JPM, AMTD, and Fidelity investments have the resources for a prolonged price war and they seem to be willing to utilize their balance sheet in pursuit of victory.
Alternatively, we find that RJF's approach of sidestepping the price war by focusing on their segment of the market to be a viable one - especially in terms of preserving profitability metrics. We also find LPLA's unique approach of empowering advisors to outperform robo advisors to be an effective means of adapting to this competitive environment.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.