The retail brokerage model in the U.S. is flawed. Why? Because advisors get too much of the revenue pie.

That's the conclusion of a report published recently by Morgan Stanley, titled U.S. Retail Brokerage: Flawed but Improving. The report argues that operating leverage in the U.S. retail model is being squashed by the amount of money going to FAs, resulting in mediocre returns for firms. It's the age-old push-and-pull between manufacturing and distribution, says one commentator. Put another way, the argument continues over who owns the client: the firm or the advisor?

“Most of the value in this business — the revenue — ends up in the pockets of the distributor,” says André Cappon, principal and co-founder of the CBM Group, a New York-based consulting firm. “Why? Because if it doesn't, he can pick up and take 80 percent of his assets to LPL or another independent.”

The exception, says Cappon, is Merrill Lynch, where departing advisors manage to take, on average, only 40 percent to 50 percent of their books with them. That's because Merrill has created a brand that retail clients value and trust — even, apparently, over their relationships with their advisors. As a result, the firm enjoys operating margins of between 18 percent and 20 percent, says the report. By comparison, the average operating margins for full-service brokerage firms in 2004 was a paltry 15 percent, though Smith Barney also enjoyed Merrill-like numbers. The average for regional brokers A.G. Edwards and Raymond James was only 12.6 percent, according to the 2005 FPA Compensation and Staffing Study.

Morgan analysts say consolidation is the answer. For example, slapping two 10,000-plus advisor firms together could improve operating margins by as much as 5 percent, they reckon.

Or perhaps more firms will rid themselves of their advisor forces — like American Express and Legg Mason did this year. “With more full-service brokerages looking at open architecture, I think you're likely to see more separations between manufacturing and distribution,” says Philip Palaveev, a senior analyst at Moss Adams. “And reports like these will force the issue.”