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October 3, 2019

MRP Adds Short U.S. Brokers & Asset Managers to its List of Themes

US brokerage firms and asset managers have been riding a rising tide of wealth for years. But now the party is ending. Technological innovation has made it so every broker must charge zero commission fees if they want to maintain market share. Come October 7, the era of zero-commissions officially begins for the big brokers. As for asset managers, investors are paying them the lowest fees ever.

Tough Times Ahead for Brokerage Firms

When online brokers like Schwab, E*Trade, Interactive Brokers, and TD Ameritrade arrived on the scene years ago, they were the disrupters that took market share away from traditional brokerage firms by offering low-commission trading. Now, those same discount brokers are being disrupted by new Silicon Valley startups that have ushered in the era of free trading.

Brokerage firms have been pressured to go to zero fees ever since digital startups like Robinhood began offering commission-free trading to customers. Then it became only a matter of time before the more established brokers felt pressured to do the same. Apparently, that time has come.

Last week, Charles Schwab announced that it is ending commission fees for online trading effective Monday. Others quickly joined the “race to zero” including Interactive Brokers, TD Ameritrade and E-Trade. Analysts expect most of the industry to follow suite. The firms are adopting very similar cost structures. TD Ameritrade for example will eliminate all commission fees for online trading of equities, ETFs and options listed on US and Canadian exchanges.

The move to zero-commission will cost Schwab as much as $100 million in quarterly revenues, which is equivalent to about 4% of its total net revenue. TD Ameritrade’s CFO said the zero-fee structure will have a 15% to 16% impact on quarterly net revenue, compared with the 3% or 4% that Schwab’s CFO, Peter Crawford, estimates. E*Trade estimates a loss of approximately $300 million per year in revenue from the drop in commissions.

After Schwab’s news hit the tape on Tuesday, the Big Four broker stocks fell between 9% and 26% as investors surmised (correctly) that all the other brokers would follow Schwab’s lead. TD Ameritrade took the biggest hit, tumbling 26%, the most since 1999. E*Trade dropped 16%, the most in more than a decade. Shares of Interactive Brokers and Schwab slid about 9% and 13%, respectively.

Anticipating trouble, Barclays has downgraded the entire online brokerage sector to underweight. Bank of America has double-downgraded TD Ameritrade to underperform from buy, because the latter derives more than a third of its revenue from commissions in fees.

Some analysts believe the shift to commission-free trading could push Ameritrade and E*Trade to consider a merger. As a combined entity, they would be in a stronger position to compete with Schwab.

San Francisco-based Schwab, with about $3.7 trillion of client assets, gets a majority of its revenue from net interest income and just 7% from trading commissions. But Schwab’s decision to eliminate trading commissions comes at a time when interest rates are low, which is not great for a company that relies so much on net interest income.

Headwinds for Asset Managers

US asset managers are also getting increasingly aggressive on price to defend their turf against traditional rivals and new startups. The mounting pressures on asset managers are coming from various points.

First, the internet has made more information & data accessible to everyone, chipping away at some of the information advantage that portfolio managers used to have. The edge increasingly belongs to managers that are able to integrate artificial intelligence and machine learning into their investment processes. Second, there are now tens of thousands of productions that investors can choose from, which means asset managers have to hustle harder to keep their customers from wandering over to a competitor.

And just like we’re seeing this month in the brokerage space, asset managers have had their own fee wars. Since the middle of last year, the biggest firms including Fidelity Investments, Vanguard Group and JPMorgan Chase & Co. have eliminated fees and commissions on a range of offerings.

Fidelity, for example, cut fees to zero across a long list of traditional revenue sources, including account service fees, transfer fees, low-balance fees and IRA closeout fees. The $7 trillion asset manager also consolidated nearly two-dozen separate stock and bond index funds into its lowest-cost share class. As a result, the asset-weighted annual expense across those index funds fell by 35%, with some fund expense ratios settling around 0.015% or below.

Morningstar’s Annual Fee Study found that investors are paying the lowest fees for funds ever. Across US funds, the asset-weighted expense ratio dropped to 0.48% in 2018, compared to 0.51% in 2017. Accordingly, investors saved an estimated $5.5 billion in fund fees in 2018. This 6% percent year-over-year decline is the second largest recorded since Morningstar began tracking asset-weighted fees in 2000.

The proliferation of ETFs continues to add downward pressure on asset management fees, and things are not about to let up anytime soon. The Securities and Exchange Commission (SEC) has just adopted a new rule that’s meant to modernize the way ETFs are regulated and issued in the United States.

The rule change will make it cheaper and quicker to bring a new ETF to market. In the past, securing the requisite clearance from the SEC to launch an ETF could cost an issuer upward of $1 million. Now that the SEC is lowering the bar for issuance, we can expect to see more ETF products hitting the market and being offered for a lower fee.

As it is, the ETF environment has been heating up this year, what with BlackRock and Vanguard cutting fees, new entrants like SoFi touting zero-fee funds, and Salt Financial introducing a new ETF that will temporarily pay people to invest. As thousands more options become available, investors will expect even lower costs, and asset managers could experience further margin compression.


New MRP Theme: Short U.S. Brokers & Asset Managers

MRP foresees a difficult stretch ahead for brokers and asset managers. Many players that had thrived during this extended bull market find themselves in less friendly territory as we move further into the era of zero-commissions / zero-fees, low interest rates, declining trading volumes, and fears of a recession.

Brokers will find it harder than ever to squeeze money out of their clients who are now accustomed to trading and investing for free. Asset managers face increasing competition from low-cost products and automated passive strategies that will eat into their profit margins. Many will have to restructure their businesses, align themselves with new partners, and/or build up new sources of revenues in order to thrive again.

These headwinds compel us to add Short U.S. Brokers and Asset Managers to MRP’s list of active themes today. We will track the theme via two ETFs. The iShares U.S. Broker-Dealers & Securities Exchanges ETF (IAI) and the SPDR S&P Capital Markets ETF (KCE).

IAI holds25 companies with roughly two-thirds being broker-dealers and investment banks, and the other third being securities exchanges like CME and Intercontinental Exchange. KCE is a more diversified capital markets ETF. Asset managers account for 44% of KCE; investment banks and discount brokers comprise another 44%; market data firms make up the remainder of the portfolio.

Brokers & Asset Managers vs Private Equity vs S&P 500