There is one overriding question for broker/dealers today: Who needs one, and why? After all, RIAs are prospering quite nicely without having to use the services of a broker/dealer. Moreover, the number one revenue source for broker/dealers in 2007 was actually advisory fees–a business that by definition does not involve a broker/dealer. On top of that, when we consider the sources of profitability for independent broker/dealers, we will find that the sources are essentially anything but the broker/dealer business. Broker/dealers are profitable from the fee business, markups on trade tickets, charges to reps, and revenue sharing from investment managers rather than the net revenue retained after making payouts to advisors. Considering all of that, then who wants to be a broker/dealer in the first place, and why?
Today, close to 80% of the independent professionals (120,000 ) affiliate with a broker/dealer, while some 35,000 professionals practice inside an RIA. (Source: Moss Adams, “Uncharted Waters 2008,” published by Pershing LLC.) Tomorrow there may be many fewer broker/dealer-affiliated advisors. In fact, I would venture a forecast that in 10 years there will be over 100,000 professionals inside RIAs while the number of B/D-affiliated advisors will stay flat. In other words, there will be a roughly equal number of B/D- and RIA-affiliated advisors.
Don’t get me wrong–I am not suggesting that the current independent B/D firms will disappear or that advisors will roam the financial services landscape unaffiliated. I do believe that in the next five years, we will see a transformation of the traditional broker/dealer into a business entity that will be focused primarily, if not exclusively, on the fee business. The value proposition of that fee-only broker/dealer will also change dramatically and focus entirely on the ability of the broker/dealer to help the advisor build a practice; either through branding and business development or through business and practice management resources.
Why Change Is Necessary
Today’s broker/dealer is an organization of dedicated people who work incredibly hard for their advisors and are compensated significantly less than any other part of the value chain. They are tired and frustrated, and have been painted into a corner by a combination of regulation and competitive forces. The industry has to change. It either has to disassociate itself from its distribution past and accept a fiduciary role next to the advisor; or find itself pigeonholed in selling variable annuity, variable life, and other products through an ever-shrinking population of specialized advisors and a dwindling group of clients whose investable assets would place them below the minimums set for fee-based accounts.
To begin with, the term broker/dealer does not describe a business model but rather a regulatory entity that is required by FINRA as a supervisor of any transaction that involves commissions. The largest source of revenue for broker/dealers today, however, has nothing to do with commissions. It is the fee-based business governed by SEC regulation that has absolutely no requirement for the involvement of a broker/dealer. In 2007, the average independent broker/dealer derived 17% of its business from fees with the remaining 83% coming from variable annuities (20.7%), mutual funds (18.2%), trail commissions (15.5%), and variable life insurance (11.8%), according to 2007 FSI Financial Performances Survey, produced by Moss Adams LLP. Note the significance of the life insurance and variable annuity businesses. In fact, if we exclude the insurance broker/dealers from the sample, the typical independent broker/dealer today gets 22.8% of its revenues in fees (these are numbers for 2007) and is rapidly growing. In 2004, using the same sample of firms, the average broker/dealer reported that only 13.9% of its revenues came from fees.
What is important to realize here is not merely the growth of fees in the revenue mix of broker/dealers but rather the growth in fees in the revenue mix of advisors. It is not a secret that advisors are transitioning their business to fees and in most cases have done so already. The largest investment-oriented advisory practices today derive more than 80% of their revenues from fees, with commissions representing a shrinking legacy rather than an area of growth. As they complete that transition, each and every B/D-affiliated advisor will eventually ask the question: Why do I need my broker/dealer?
Already Looking in the Mirror
This process is nothing new to broker/dealers themselves and many are not surprised to hear the (spoken or unspoken) question coming from their reps of “Why do we need you?” In fact, many broker/dealers themselves may already be asking themselves, “Why are we doing this?” Consider the profitability of the typical independent broker/dealer in fiscal 2006, a fairly successful year: it was only 0.9%. If margins are 0.9% in the best of times, what are they going to be when markets are worse? The answer–negative 4.2%, as it was in 2002, according to Moss Adams data. The financial issues behind this profitability picture are well-known. For example, the typical independent firm pays out 83% of the total revenue generated by advisors, pays 3.4% of its revenue to the clearing firm, and then has operating expenses of 17.1%. At this point you may accuse me of fishy math–after all, these expenses sum up to 103.5%. How can they turn a profit?
Here’s where it’s necessary to relate the story of Milo Minderbinder–a character in Joseph Heller’s novel Catch-22 who buys eggs in Malta at seven cents an egg, only to sell them for five cents an egg and somehow still make a profit. To make a profit (in the case of broker/dealers, not Milo), a portion of the revenue is not paid out to the advisors and in fact accounts for most of the profit. Items such as fees to reps, markups on tickets and charges, and interest on margin account for nearly 7% of total revenue (those items also account for an additional 1.2% in expenses), according to Moss Adams. This means that the typical broker/dealer makes money on everything but the brokerage business.
This problem does not only apply to independent firms. Full-service firms are subject to the same issues. While I don’t have many statistics in this part of the industry, my experience is that wirehouse firms pay out 40% to 50% of their revenue in the form of cash or other compensation, run the local offices at about 30% overhead, and have a home-office expense of about 20% of the revenue payable to advisors. Profitability is again found in product margins and product-like margins–trading, interest, account charges, etc. (Source: 2007 FSI Financial Performance Survey)
Back to B School
The broker/dealer problem is almost a classic MBA value chain exercise. Consider how many investment intermediaries generate revenue when an advisor invests the client’s money in a mutual fund held inside a brokerage account. The mutual fund manager and advisor, the clearing firm, the broker/dealer, and the advisor are all involved. Considering the number of parties at the table, it is no surprise that some of them will experience at least some pressure on their margins. The question is, who will feel the burn the most? Generally, that tends to be the link in the chain that is most uniform in characteristics and quality and therefore becomes commoditized the fastest. The bargaining power, the scale necessary to compete, and the ease of entry will play a role, as Harvard Business School Professor Michael Porter’s classic writings on competition teaches us. Independent broker/dealers that provide a regulatory function and borrow most of their technology and capabilities from their clearing firm not surprisingly end up with the short stick. Clearing firms have scale and bargaining power on their side, mutual funds have their managers’ styles and performance as differentiators. Broker/dealers have payout, which is a rather unfortunate choice.
Compare this situation with the same mutual fund bought by an advisor on behalf of the client in a fee account. The mutual fund advisor and manager still get paid, the custodian charges a ticket charge (or not if the fund is part of its lineup), and the advisor receives an advisory fee. No broker/dealer is involved and one of the links has been eliminated.
The Kernel of the B/D Problem
This simple counting exercise between the broker/dealer and advisory channel lays out the key problem ahead of the entire broker/dealer industry. The broker/dealer (or any other entity participating in the value chain) has to either add value to the chain or advisors will perform simple regulatory “arbitrage” and go to the channel with the fewest participants. As the overall investment business has already substantially shifted to fee-based pricing, the broker/dealer industry has to quickly define that value-added role. While the actual number of business models for that role is unlimited, the general directions are not that difficult to foresee. The choices are branding and business development, business management and advice, operations and management, or training.
Today, most broker/dealers approach the fee-based future rather mechanically. They seek to play the same role they play in the commission business, only this time applying it to the fee business. By now, most independent broker/dealers have established their own RIA entity and allow advisors to affiliate with that entity in order to transact their fee-based business. So if we have XYZ Capital broker/dealer, they most likely have XYZ Advisors LLC which is registered as an RIA. The typical XYZ Advisors entity today has $1.7 billion in assets under management (AUM) and has been growing by 35% in the last couple of years.