Trading Places

Remember the Minotaur of Greek mythology? The competition for retail investors is spawning a similar hybrid on Wall Street, as Merrill Lynch, the retail giant, and Charles Schwab, the onetime discount pioneer, move onto each other's turf. In recent years, Schwab has moved squarely into the full-service business while Merrill has created online trading systems and call centers to attract the kind of small investors that flocked to Schwab.

The two giants share a single goal: to provide a seamless system of tools, products and services that will give them the best chance to sign up and hold the most investors. How well their strategies work will say a lot about how retail brokerage — and the business of registered reps — plays out in coming years.

Schwab, once the proud “discount broker,” now offers managed accounts, high-end trust services, and fee-based advice. Merrill, the Wall Street powerhouse that vowed never to bow to the popularity of the Internet, offers cheap online trades and has rolled out Schwab-style call centers. Which one is the Internet-age maverick, and which the old-school stalwart? Save for Merrill's investment banking and asset management units, which Schwab does not have, the two go head-to-head.

Spending Cuts

In a weird coincidence, both simultaneously are scaling back retail operations in Asia and Australia, as well as instituting draconian cost-cutting programs in response to the bear market. Significantly, both firms are adding financial advisors — don't say brokers — even as they cut jobs in nearly every other department.

The goal for both, analysts say, is to create seamless, segmented retail networks designed to capture maximum wallet share of a broad range of clients, with emphasis on the high-net-worth set. “The truth is that both are trying to do essentially the same thing,” says Jaime Punishill, an analyst at Forrester Research in Boston. “They're telling potential clients, ‘no matter who you are, no matter what you look like, we can help. We have everything — advice, planning, cheap trades, access to private-capital deals.’”

If history is any guide, the changes these behemoths are making will have a significant ripple effect on the industry as a whole. “Merrill's the only full-service firm that can move the market,” Punishill says. “Pru [Prudential Securities] started online trading in May 1999. It came and went. No one blinked. Merrill started in July, and the industry was scared to death.”

As for Schwab, “It's obviously the biggest mover of the so-called discount-brokers. And its RIA network is the biggest and best of its kind, so Schwab definitely impacts the industry,” Punishill adds.

Kelly O'Donnell, a senior consultant for Boston-based Cerulli Associates, uses the phrase “scalable advice” to describe the model the two firms are trying to create. “Scalable advice means offering a range of advice and services for a broad cross section of clients based on their need for advice and their level of wealth,” O'Donnell says. “Merrill has been the pioneer in scalable advice among national full-service firms, and Schwab has been the pioneer among discount brokerages.”

To do that, Merrill invested in technology to distribute automated advice and online trading to small clients, while at the same time encouraging (some would say cajoling) its 18,000-strong brokerage force to focus on higher-net-worth clients with fee-based accounts. Last year, Merrill rolled out a Schwab-style call center for retail clients with less than $100,000, freeing brokers to attend to more lucrative business.

According to Guy Moszkowski, securities-industry analyst for Salomon Smith Barney, the effort succeeded in both pleasing clients and boosting revenue. “The firm believes it is already resulting in revenue improvement because the customers are far better taken care of, as their original brokers tended to ignore them,” he says, adding that revenue capture on the assets of this clientele has gone from 30 basis points annually, to 60 basis points, which is “far closer” to the company average.

Perhaps emboldened by that success, the firm is driving its brokers to move even higher on the food chain. A Merrill broker told Registered Rep., on the condition of anonymity, that the firm is pressuring brokers to only consider new clients with at least $250,000. “Merrill just doesn't want brokers spending time on accounts under $250,000. The days of going out and opening a $100,000 account are over because it'll take too much time. They can be the nicest people in world, but it won't happen,” the broker says.

Of course, such clients are free to open an account through ML Direct, Merrill's Schwab-like online platform, as well as avail themselves of Merrill's new call centers. And for clients who make the asset cut, Merrill already has an array of offerings in place, from proprietary mutual funds and separate accounts to estate planning and IPO access.

And unlike Schwab, which distributes Goldman Sachs' stock reports to its clients, Merrill offers in-house proprietary research. Of course, the tech bust of 2000-2001 brought bad publicity to Wall Street firms whose analysts seemingly slapped a “buy” rating on everything that moved, including certain bone-headed Internet plays. Schwab steered clear of that fallout; Merrill did not. But Punishill thinks Merrill's research team remains an asset in the battle with Schwab. “The public forgets fast,” he says. “When the stock market starts heating up again in a sustained way, no one will remember Henry Blodget,” Merrill's humbled former Internet-stock analyst.

In essence, then, “Merrill basically has all the pieces in place” for delivering the full gamut of financial planning and advice, O'Donnell of Cerulli says, adding that “now, the test will be in execution.” She says the biggest challenge will be moving clients up the scale as they accrue wealth without causing excessive internal friction. “The system is just now being implemented. We won't know how it works in practice for a few years.”

For Schwab, however, the road to full-scale advice is bumpier, O'Donnell says. If full-blown financial planning consulting is a continuum, Schwab has a huge gap in the middle. Clients with less than $500,000 are efficiently served by the firm's excellent trading platform and services, such as the $400 portfolio review. Clients with more than $2 million can be ushered smoothly into the U.S. Trust division, with its impeccable wealth-services reputation. For clients in between, however, Schwab's offerings are muddled, O'Donnell contends.

“A client with $500,000 to a $1 million to invest would fit right into Merrill. But at Schwab, they'd have trouble getting much advice beyond basic mutual fund recommendations,” she says. Of course, Schwab refers clients in that range who want more extensive advice to its network of independent RIAs, who in turn agree to use Schwab's back-office services. “The RIA-services division is important, and it typically contributes about 15 percent of Schwab's bottom line,” O'Donnell says. “But the truth is, you capture more money with a captive sales force.”

Also, Schwab's RIA system impedes one of the key features of advice, O'Donnell says: the ability to nudge clients up the food chain as they gain wealth. For example, an ML Direct client whose account fattens to a sufficient level can be ushered seamlessly into the hands of a fee-based broker, and thus a more lucrative relationship for Merrill. But once a Schwab client is referred to an RIA, there's no guarantee of getting him into the fold when his assets grow to a point that might interest, say, U.S. Trust. “The U.S. Trust acquisition was great for Schwab, and it really boosted their high-end advice abilities,” O'Donnell says. “But right now, there's no feeder in place to push existing clients into it once they get wealthy enough.” In fact, some independent advisors regard Schwab and its U.S. Trust division as competitors.

Of course, Schwab could acquire a mid-sized firm with a broker team — or build one from scratch. But that would risk alienating its RIA force, and thus destabilizing a key source of revenue, O'Donnell says. “In our view, Merrill has a huge advantage because it's easier to add technology and build out ML Direct than it is to add human resources.”

Moszkowski of Smith Barney has a different take on Schwab's RIA program. “It's been exceptionally profitable and resilient, and in many ways has been the backbone of Schwab's continued profitability in a very difficult market,” he says. And Schwab management has signaled that it plans to maintain closer relationships than in the past with clients it refers to RIAs, although it hasn't outlined how exactly, Moszkowski adds. One way could be cross-selling U.S. Trust services through the RIA channel. Moszkowski points to a recently rolled-out program that allows Schwab-network RIAs to offer trust services designed by U.S. Trust to their own clients.

Moszkowski also points out that Schwab has already unleashed a program designed to keep upscale clients in-house. Last spring, it opened Schwab Private Client, aimed at investors with at least $1 million. It has six regional offices located in New York, Houston and Los Angeles. Private Client is aimed at wealthy investors who want personalized advice, but prefer to retain ultimate decision-making control.

Another effort designed to keep the assets of the wealthy in-house is managed accounts. Although Schwab only rolled out its managed account offering last year, it already boasts $8 billion under management, tenth highest in the industry. To be sure, Schwab's program is dwarfed by Merrill's managed-account business — with $48 billion in AUM, the industry's third highest — but it's off to a good start.

Nevertheless, Moszkowski acknowledges that Schwab faces huge challenges. First and foremost is developing a reputation as a valuable source of advice, after spending years positioning itself as an objective executor of trades for self-directed clients skeptical of Wall Street hucksterism. “One of our concerns is management of the brand message, given that the firm is attempting to send so many messages to so many different segments simultaneously. There is potential for confusion,” he says. “Their strategy looks breathtakingly complex to execute, on paper at least, but then Schwab has a history of strong execution.”

O'Donnell of Cerulli concurs. She points out that as late as 1997, Schwab was still calling itself a discount broker. “They quietly took ‘discount’ out of their name, and before you knew it, they were putting Wall Street on the defensive,” she says. “If any firm can succeed in this market without a captive sales force, it's Schwab.”

As these two hybrid creatures face off, imitating one another as they put in place similar business models, O'Donnell is placing her bets on the old-line firm. “Merrill has always had the advice model, and it has a huge and experienced sales force in place. Schwab is having to play catch-up,” she says.

But the battle is far from over. “Call up anyone at Merrill and they'll tell you they still take Schwab very seriously,” Forrester's Punishill says. “Essentially, Schwab offers 80 percent of the Merrill experience at 50 percent of the cost. That's powerful competition.”

And the scalable-advice model that both firms are trying to implement will likely serve as the blueprint for the industry as a whole in the years ahead, he adds.