April 1, 2000

Scoping the Competition

At the annual TD Waterhouse conference, the buzz w

Illustration by Scott Laumann

In his opening speech at the TD Waterhouse Institutional Conference in San Diego, executive vice president Peter Mangan introduced the theme of the conference with an allusion to the story of David and Goliath. The analogy worked on two levels: small planning firms vs. institutions and Waterhouse vs. other firms. In the context of TD Waterhouse, everybody immediately recognized that Goliath was headquartered up the coast in San Francisco: The Schwab organization currently has roughly $200 billion of advisor assets and 5,500 advisor relationships, compared to roughly $13 billion and 2,500 advisors at Waterhouse Institutional.

The competitive equation between the two firms was the topic du jour in hallway conversations and during meals; every time you sat down, somebody at the table (and often three or four people) would confess that they were currently trading through Schwab, but, well, could somebody tell them how Waterhouse handles this or that kind of trade? How was the service overall? What did we all think now that Schwab had acquired U.S. Trust Company?

Meanwhile, instead of the usual 80 people, TD Waterhouse's preconference session on its current technology ballooned to more than 300 advisors, forcing the hotel to open up one of those sliding panels and put in more chairs. The session was hosted by technology honcho Dan Skiles, who was far better prepared for this kind of attention than he was the previous year, when Waterhouse was converting its entire trading system from Pershing to self-clearing. This time, he was able to introduce a very slick-looking client management system called VEO, a Web-based back-office tracking service that interfaces with client management software programs like Advent Axys, dbCAMS, Centerpiece, and Portfolio 2000. Like Goliath's system, it sends daily reconciliation and pricing files, and keeps track of which days or files you've already downloaded. For the first time, Waterhouse allows advisors to send in block equity trades over the Internet, buy or sell either in dollars or number of (fractional) shares, receive real-time quotes, and access a small but growing list of research providers. (Morningstar is next on the list.)

In fact, the interface looked like a client management software program, except that it's more intuitive in places. Click on any account on the list and it brings up the entire portfolio and all its holdings. Click on one holding in any account and it automatically brings up all the accounts that own that security. Advisors with slow modems or ISPs could opt for a text-only view of these pages, which should speed up everything if we can stand to look at a black-and-white screen. VEO even offers the ability to custom-code accounts using a blank set-aside field, so that all conservative portfolios can be so labeled, or all IRA accounts, or all accounts within a certain family. Some advisors are evidently starting to use VEO in lieu of a portfolio tracking program; several asked for a comment field that would allow them to list the lot number that was bought or sold, which could then be tracked by the advisor for tax management and reporting.

The only really controversial moment of the session came when Skiles introduced a new service, called AdvisorClient.com, which would allow clients to check their portfolios and view positions on the Web. The site was customized to each advisor; the advisor would have to fax in the names of clients and how they wanted their company name, e-mail address, and contact information to read when the client entered the site. The controversy came when Skiles told the audience that the client site would have trading capabilities. Such is the level of suspicion in the planning community that the advisors in the room instantly suspected that this was a sneaky way for Waterhouse to convert their clients into day traders. After some angry questions, the attendees learned that they have the choice of whether or not to offer trading capabilities to clients through AdvisorClient.com. Still, this could become an issue down the road, if some clients find out that the site offers trading, but that the advisor declined to give them that option.

The other potentially problematic issue was security pricing. At one point, Skiles asked how many people in the room were using the VEO system currently (roughly 40% were) and how many of those had clients invested in a security that TD Waterhouse is currently not pricing. (Roughly one sixth.) Other small glitches seem to be on the mend. Advisors who started with the Jack White organization, which was purchased by Waterhouse in 1998, are able to get Janus funds through the company's old no-transaction-fee platform, but those who started with Waterhouse currently cannot. There were a number of questions about why Waterhouse was charging $25 trades to advisors and advertising $12 online trades to consumers; Skiles said that we should look forward to a major announcement on the subject the following day. The next morning Mangan announced that, as of March 1, the new online trading price for advisors was $12 a trade for market orders, and $15 for limit orders. For broker-assisted orders, the price, as of April 1, would be two cents a share, with a $35 minimum. I found myself wondering why all the platforms don't simply price their trades at, say, 85% of whatever the comparable retail commission would be, but since nobody does it that way, there must be an excellent reason why not.

The second version of the "David vs. Goliath" theme at the TD Waterhouse meeting referred to the growing competition between small advisor shops and very large, increasingly financial planning-oriented wirehouse firms. Mangan touched on this trend in his opening remarks, strongly hinting that the advisors in the room were going to need more and better support from their service providers (including, of course, TD Waterhouse) to remain competitive with the Goliaths who were stalking the "fee-based" business.

In this debate, Mark Hurley of Undiscovered Managers is the man of the hour. He wrote a widely circulated white paper that suggests that the financial planning Firm of the Future will be a Goliath itself, with more than $100 billion under management. For Hurley, it was a fortunate bit of timing that his prototype firm of the future is not unlike U.S. Trust Company. Hurley himself offered a presentation, and was also included on a panel discussion moderated by Investment Advisor Editor-in-Chief Bob Clark, with fellow panelists Patty Houlihan, a practitioner and current chairperson of the CFP Board, and Roy Diliberto, who practices in Philadelphia and is chairperson of the Financial Planning Association.

Diliberto and Houlihan repeatedly noted that they are not concerned about survival, and that, in fact, they believe that survival will go to the companies that provide the best service, rather than those with the largest corporate headquarters. At one point, Diliberto confessed that he had little personal interest in building a megafirm even if (and he felt this was questionable) it could provide the level of service his company was now providing. Houlihan stated at the outset that she wasn't defending or attempting to resurrect the so-called "CFP Lite" proposals, but did note several times that the Hurley report tended to support the CFP Board's concerns about the changing landscape of the profession, and the logic behind its proposals. But she, too, seemed disinclined to pursue brute economies of scale.

Hurley defended his report from some of its more pointed critics (including this writer, in "Nuclear Autumn," November 1999), and seemed to describe it more as a wake-up call than an actual prediction of the future. "Nowhere did we say that the independent financial advisor will not survive," he said, adding that advisors would need to develop specialized services and client niches in order to prosper in the years ahead. Rather than dwell on the megafirms, he preferred to talk about the more recent encroachment by Merrill Lynch (which he once worked for) and its ability to change the dynamics of the market. "Merrill Lynch doesn't have to earn any money at all from its retail operations," he told the group. Because it's able to cover all of its overhead from asset management fees, Merrill will be able to, in Hurley's delicate phrase, "screw up the pricing structures of the planning market, offering a broader menu of services for less than the boutique shop is able to charge."

This conversational give-and-take was not as interesting in itself as the discussions it sparked in the hallway afterwards, the gist of which is that, in the age of the Internet, larger firms may not have any significant systems or pricing advantages, so any competition will come down to the quality of the people who are actually serving the individual client. People who run their own firms will tend to be more motivated to offer better service and will be able to take their compensation directly, rather than have it support a bloated management structure and a headquarters' worth of overhead.

The panel discussion was not the best-attended keynote session; that honor went to Richard Thaler, the University of Chicago professor who is helping to pioneer the study of behavioral finance, and who has argued convincingly that the investment markets are neither rational nor efficient. Thaler believes that the efficient market zealot is a vanishing breed even in academia, replaced by people who hold a more moderate view: that stock market prices are highly correlated with an undefinable quantity known as "intrinsic value," but that there are nonsystematic divergences that depend on market or investor psychology. As evidence of these divergences, he talked about Shell Oil and Royal Dutch Shell, which are parts of the same company that trade on the London and Dutch stock exchanges respectively. Since 60% of the company is represented by the Dutch shares, and 40% by the British shares, the price of the two stocks should trade in a ratio of 6:4 or 3:2. "This is a special case where we can actually observe intrinsic value," he told the audience. "We really can't know exactly what the whole company is worth, but we can be pretty sure that the ratio of one to the other should be 6:4."

In fact, the values of the two stocks have diverged pretty much for their entire existence, sometimes in favor of the British part of the company (it has apparently traded at a market value higher than the Dutch portion); sometimes in the other direction, for no reason that anybody - least of all the efficient market academics - can explain. "If Royal Dutch Shell can differ from intrinsic value by 20% or more, stock prices can differ from intrinsic value by at least that much," Thaler told the group. "What is the intrinsic value of Amazon.com? Can anybody here say with confidence that it is not zero?" he asked, to audience laughter, adding that "a lot of companies that lose $500 million a year are worth zero."

Thaler appears to believe that markets are subject to the as-yet-unwritten rules of mass psychology. He noted early in his presentation that in 1990, the Japanese investing public thought their markets were appropriately priced, while U.S. investors thought they were wildly overvalued. Today, the reverse is true. Who's right? Unfortunately, investors and academics have no clear way of knowing until after the fact. Thaler noted that it is really impossible for anybody to say with any certainty what, exactly, a stock's intrinsic value might be - and that this has made it impossible for anybody to prove or disprove the efficient market hypothesis. He expects markets will become less efficient as time goes on, because of the growth of indexing (fewer people bothering to set prices in the marketplace), the decline of hedge funds (fewer large investors capable of swooping in and correcting inefficiencies that they've identified), and the growth of day trading and Internet investing based on information procured in chat rooms.

The other keynoter, Alice Rivlin, former vice-chair of the Federal Reserve Board and one of the top budget policy makers in the Carter Administration, had some interesting things to say about the current economic cycle. Not only is it now the longest in U.S. history, she said, its pattern is also very different from the norm. "Under normal circumstances, you get high growth to the point of overheating early in the cycle, and then kind of a petering out at the end," she told the group. "This market cycle has seen a long growth period that accelerated years after its start."

Her explanation for this weird cycle is a spurt of labor force productivity, which was growing at an average rate of 1.5% from the late 1970s through around 1996, and since then has been growing at an average rate of about 2.8% - as high or higher than the boom years from 1947 through 1973. Rivlin offered several possible explanations - that companies are finally figuring out how to use computers to raise output per worker hour; that tight labor markets have forced companies to spend more on technology per worker; that companies are reorganizing their structures in inherently more productive ways - and then cheerfully admitted that nobody knew the real answer. The theme of her talk was a dark warning that the virtuous cycle could end as mysteriously as it began, kicking the legs out from under the economic expansion.

The rise in productivity, she said, is like a shock absorber that keeps the economy from stumbling because of other causes. Like what? Slow growth in Europe and a recession in Asia and some of the Latin countries have reduced demand globally, which means that imports are cheaper, reducing inflation pressure. At the same time, the revolution in health care has kept prices in that sector from rising at uncontrolled rates. Open trade has pushed down labor costs and promoted more sales abroad. All of these, Rivlin suggested, represent positive forces reinforcing a virtuous circle, and none of them are permanent. It is not hard to imagine increasing worldwide demand for goods and services, stabilization, a return of higher health care costs, and the possibility of a new round of protectionism in Congress.

Rivlin spent a large part of her talk on the budget process, drawing amused smiles when she told the audience that she was one of the deficit hawks who thought it might be possible to balance the federal budget by 2003 or 2004 if the President moved aggressively enough. "We never dreamed we could get it to balance in just a couple of years," she said.

Her concern today is that policymakers and the American public apparently think that the surplus is larger than it actually is. "Of the $4.3 trillion, the published figure for the surplus," she said, "$2.3 trillion is in the Social Security trust fund, and that's not enough to fund the promises we've made to the baby boom generation at retirement. Another $2 trillion is predicated on assumptions that we'll keep those very strict budget caps that were imposed in 1997," she added, "but those have already been breached." If you project that the federal budget will rise as it has in the last two years, then the $2 trillion figure drops to $800 billion. Of that, only about $150 billion is projected in the next five years; the rest may be too far in the future to forecast accurately. "But there is bipartisan support in the Congress for more defense spending, prescription drug coverage, and a tax cut that could easily spend more than we really have in the surplus," she argued. Her point: The safest thing to do is to pay down the national debt on an as-you-go basis, and spend any surplus as it comes in.

As I walked through the sessions and hallway conversations, it was impossible not to compare David with the Goliath organization up the coast. For the most part, the comparisons favored David. The Schwab organization has claimed that its annual meeting - with fees upwards of $750 for 1,500 attendees, plus exhibitor fees to participate in an exhibit hall so wide you can see the curvature of the earth from one side to the other, plus gold, platinum, silver, and bronze sponsorship fees that start at $100,000 - is a purely break-even affair. Waterhouse runs what looks more plausibly like a break-even meeting; the company doesn't charge people to attend the conference and uses the exhibitor fees to pay one night of the attendees' hotel room costs. The company turns away would-be exhibitors, which is discouraging to some of the smaller fund companies, but the result is a manageable exhibit hall with more traffic per booth.

The roughly 700 planner attendees were able to mingle with Waterhouse executives, who purposely put themselves on display between sessions, and there was a constant buzz of activity around a technology display area where advisors could try out VEO on one of the computer screens. But it was refreshing to find that the host didn't have the biggest area in the exhibit hall or constantly hype the importance of its brand name to advisors' businesses. When a Waterhouse executive made a speech, it wasn't on a grand stage with lighting that would have done a rock concert proud and stirring music over the loudspeakers as the speaker approached the lectern. The speeches tended to ramble a little, but this lack of polish actually helped rather than hurt, by making the audience feel more connected to the speakers.

And identifying Waterhouse with David - at a time when the planning profession views itself as a David in another ongoing struggle - may be a bit of marketing genius, similar to the way Avis compared itself to Hertz before the two companies finally reached comparable size. That, clearly, is what Waterhouse intends. The sling has been released and the stone is in the air. It may be years before we know whether it reaches its target.

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