DIY Investment Trend To Benefit Discount Brokers

By Eugene Bukoveczky | July 29, 2009 AAA

A July 24 Reuters article reported that a lot of deeply disillusioned investors were opting to bail on the traditional full-service brokerages in favor of the DIY model on offer by online brokerage outfits like Charles Schwab (Nasdaq:SCHW) and TD Ameritrade (Nasdaq:AMTD). Both firms are reported to have collectively picked up in excess of $32 billion in new assets since the crisis began. Even hard-pressed E*Trade (Nasdaq:ETFC), which recently reported its eighth successive quarterly loss as it continues to struggle with sizable losses associated with an ill-timed investment in the mortgage markets, managed to pick-up $3.5 billion in new assets in the final quarter of last year.

For the purveyors of full-service stock brokerages like Citigroup's (NYSE:C) Smith Barney and Bank of America's (NYSE:BAC) Merrill Lynch, the flow of funds has been decidedly in the opposite direction. In fact, investors have transfered more than $100 billion from such firms.

So, has the once-in-a-generation drubbing experienced by many investors over the past year prompted a major shift in how investors manage their wealth?

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Discount Brokers Have Reaped a Windfall of New Money
While some of this money no doubt came from investors who threw in the towel with their brokers, a lot of it also came from break-away brokers that elected to set-up their own shops following the collapse of firms such as Lehman Brothers. These small independents then arranged custodial services from discounters like Schwab, which disclosed that it had managed to attract 74 new independent advisors during the first half of the year. However, this windfall may just have been a one-time event, as Morgan Stanley (NYSE:MS) and Citigroup recently asserted that their new brokerage joint venture has so far managed to hang on to most of its advisors.

Nevertheless, demographics appear to favor the growth prospects for the discounters, which could see annual asset growth rates in the 8-10% range, according to Schwab's top execs. Some of this growth could stem from its decision to launch its own stable of exchange-traded funds (ETFs).

Trading Activity Has Also Picked Up
Getting all these new advisors helped boost trading revenues for both Schwab and Ameritrade over the last quarter, as advisors appeared to have been quicker off the mark than individual investors in participating in the market rally. Following strong trading volume growth in April and May, volumes in June dropped off by about 15% and have slumped by about 20% so far in July, according to numbers released by Schwab. While some of this is no doubt seasonal, much of it could also be attributed to continued fence-sitting on the part of individual investors hoping for a market pullback. If the market trades sideways from this point on, this fence-sitting could continue, dampening trading volumes further.

Fees Slump Prompts Low Interest Rates
The continuation of historically low interest rates has also promised to further dent discounters' bottom lines. With rates of return on money market investments now at historical lows, Schwab and Ameritrade have been forced to cut fees on such investments in order to give clients some sort of return on cash. Schwab plans to waive up to $200 million in fee income this year, roughly equal to one-quarter's net income. A similar slump in fee-based income has also been reported by smaller players like TradeStation (Nasdaq:TRAD). Any turnaround here depends on a decision by the Federal Reserve to begin the process of pushing rates higher, but that remains unlikely until unemployment shows signs of easing. That might not happen until well into 2010.

Regulatory Hassles
Further dampening the profit outlook is the increased level of risk arising from the regulatory imposed requirement to buy back auction rate securities (ARS) from investors. Reacting to a fraud probe by New York Attorney General Andrew Cuomo, about a dozen firms have agreed to buy back $61 billion of these interest-bearing investments from clients following the collapse of the market for these securities last February. While Ameritrade has agreed to buy back $456 million of these securities, Schwab has so far refused to comply with the attorney general's probe, claiming that other Wall Street players are responsible for the collapse of the ARS market. The firms that have so far agreed to buy back these securities are now making a fairly hefty bet that they'll realize full value on their investments. Another credit market disruption could test that notion. (For background reading, see Auction Rate Securities: Bidding On The Long Run.)

The Bottom Line
While near-term drags associated with the onset of the summer trading doldrums and the loss of fee income are likely to hold discount brokers' shares in check over the next couple of quarters, these stocks could be the major beneficiaries of the seismic shift in investor attitudes. That trend will likely gain momentum in the years ahead. (To learn more, check out Full Service Brokerage Or DIY?)

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