Schwab and Fidelity have ample leverage with mutual funds to raise their toll, analysts say

April 14, 2010 — 6:13 AM UTC by Brooke Southall

3 Comments

Brooke’s note: Generally when I think about distributors — at least in any traditional sense — I think of middlemen. In today’s information economy, middlemen have a nasty habit of getting squeezed out by the manufacturer on one side and the consumer on the other. What makes this article about no-transaction-fee platforms interesting is that just the opposite seems to be happening. The distributor is making the manufacturer pay more, which makes it possible that some of that cost will be passed to the consumer/investor. This would be the second time in two weeks that I’ve written about the might of distributors. See: 10 reasons the Envestnet IPO is for real

TD Ameritrade’s move to increase the fees it charges mutual funds to be on its platform may spur a reverse price war among the parent companies of the three major asset custodians, say analysts.

The mutual fund supermarkets run by the TD, Charles Schwab & Co. and Fidelity Investments have been growing in power, especially in the wake of the financial crisis, which eliminated some competing platforms.

Because so many investors buy their funds directly or indirectly from the no-transaction-fee platforms, most mutual fund companies have little choice but to pay whatever the companies demand to use the platforms.

“We’re kind of locked in,” says Nicholas Gerber, who owns Ameristock Inc. of Moraga, Calif. and makes heavy use of OneSource, Schwab’s NTF platform. “People want to pay nothing when they buy us.”

About 80% of the $200 million of assets in his funds came though NTF platforms, he adds.

Command a premium

Historically, Schwab and Fidelity were able to command a premium — .4% — from mutual funds because, as larger companies, they give mutual fund companies access to more investors with more assets. As bigger companies, they may also have slicker technology and ancillary services.

But last week, Omaha-based TD Ameritrade announced that after making improvements to its web site and adding more research to accompany the funds on its platform, it is raising the fees it charges mutual funds from .35% to .4%. The fees are calculated based on the assets held by investors that were distributed through the mutual fund supermarket.

InvestmentNews first reported the TD fee increase last week.

Most eyes now are on Schwab, whose famous NTF platform, OneSource, has long been a force to be reckoned with in the industry. Launched in 1992, it has more than 11,000 funds with no loads [including affiliate funds].

Wouldn’t be surprising

“Schwab has been at .4% for a number of years,” says Matthew McGinness, principal of Best Practice Research in San Diego, Calif. “It wouldn’t be surprising to see the toll go up.”

A Schwab spokesman said, “We review our pricing constantly, but there is nothing new to report at this time.”

Fidelity’s platform, which is the industry’s second largest NTF platform, will also keep its fees the same for now.

“We have no plans to change the fee,” says Stephen Austin, spokesman for Fidelity.

TD now can justify charging the same fees as its top rivals, says Kristin Petrick, spokeswoman for the company.

Deserves to be paid

“Fund companies don’t want to pay more than they currently do, but they are aware that TD Ameritrade is one of the top three mutual fund supermarkets now, and deserves to be paid appropriately for the web tools, research, education and access to RIAs that we provide,” she says.

Robert Ellis, a New York-based analyst and principal of Fast Track Advisors LLC, believes that Schwab’s next pricing review could lead the big San Francisco broker to conclude that market demand from mutual funds justifies a fee hike.

“There is no reason to believe that they will not raise them again — and keep raising them,” he says. “Funds that want to play will have to increase their payments.”

Burton Greenwald, a Philadelphia-based mutual fund analyst agrees that Schwab and Fidelity likely have the leverage to charge higher fees.

Lifeblood

“The OneSource-type platform is the lifeblood of many fund groups – especially no-load,” he says.

No-load funds are ones that investors can buy and sell without paying a commission. Some may charge investors higher internal expenses if it means the funds can be bought and sold with relative impunity [though NTF mutual fund platforms have trading limits].

Schwab and its rivals have gotten a stranglehold on the distribution of mutual funds because they are in the best position to provide the convenience of one-stop shopping and one-statement viewing that no individual mutual fund company ever could.

“It is true that investors can go direct to many of the larger fund families, but they give up a consolidated view of their accounts when they do that,” Ellis says. “We know that clients value that single report that shows all their holdings.”

Increasing leverage?

Greenwald adds that the leverage that Schwab, Fidelity and TD enjoy as fund distributors may actually be on the rise in the wake of some of last year’s financial events. Big mergers like those of the Bank ofAmerica and Merrill Lynch, Morgan Stanley and Smith Barney, and A.G. Edwards, Wachovia and Wells Fargo eliminated several mutual fund platforms, he says.

“Distribution opportunities are lessening rather than growing,” he says.

Another reason that the fees are likely to go up is that many mutual fund companies can afford to pay the freight, according to the analysts.

“Fortunately, the mutual fund business, like most asset management, is highly profitable – about a 50% [profit] margin — and the bigger fund families can absorb this,” Ellis says. “This change, in the end, is simply recognition of the changing balance of power between manufacturers and distributors; same as we saw with the managed account business.”

Redressing an imbalance

McGinness agrees and says that increases in distribution fees are part of a long-term trend of redressing an imbalance in the financial industry.

“It may be correcting for weaknesses in the pricing model,” he says. “Most distributors operate on lower margins than asset managers. The distributor is doing the hard work of finding the customer.”

Despite the apparent pricing power enjoyed by owners of mutual fund supermarkets, analysts say that there could be ramifications if prices go too much higher.

“They started at 25 basis points. At some point you kill the golden goose,” Greenwald says. “You have an effective 55 basis-point fee. Can [a mutual fund manager] afford to give up 45 basis points to a third party?”

Pondering NTF alternatives

Gerber says he is already pondering alternatives if Schwab jacks up the NTF fee again. One possibility is to convert his fund to an ETF. In that instance, his fund would be available for purchase anywhere stocks are sold and cost-conscious investors can find cheap commissions in todays’s market

“How do you like that for competition?” he asks.

Another possibility for small funds is to band together, Ellis says.

“As fees increase and the platforms capture more of the value stream, I would not be surprised to see smaller mutual fund families, faced with extinction, combining into a sort of 'open architecture fund warehouse,’ and pull their diminished fund sales from the platforms,” he says. “A fund co-op could undercut Fidelity, Schwab and TD Ameritrade while still providing a single report.”

RIAs will react

Another factor that asset custodians need to consider is how RIAs will react to the pressure they put on the fees they pay. “RIAs watch it closely,” McGuiness says. “You get different opinions based on how frequently they trade.”

RIAs tend to have a very strong emotional reaction when NTF fees climb higher because they feel left out of an important decision, says Philip Palaveev, principal with Fusion Advisor Network.

“Advisors feel like a small boat on a large ocean,” he says. “They feel like they have no control.”


Mentioned in this article:

TD Ameritrade
Asset Custodian
Top Executive: Tom Nally



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Stephen Winks said:

April 14, 2010 — 1:46 PM UTC

Because of breakthroughs in technology and portfolio construction, composite portfolio performance reporting incorporating all a clients holdings is now available to all. From the perspective of the consumer, the advisor and that of a fiduciary, managing accountability, cost, transparency and performance can be achieved far less expensively than a very narrowily focused mutual fund platform which affords little or no holdings transparency. A new generation of investment vehicles and portfolio construction and management technology is about to (1) cut out redundant account administration cost at the manager, client and trustee level that add no value, (2) make it possible to electronically manage and extraordiniary degree of investment and administrative values for an unlimited number of unique custom client portfolios at (3) a fraction of the cost of a mutual fund, while (4) providing the advisor 50% more in compensation.

Trying to win market share by cloning the old mutual fund supermarkets simply makes you competitive using decades old technology. By embracing innovations in portfolio construction technology and investment vehicles (real time buy/sell manager research and overlay management) custodians like TD Amertirade can (1)make continuous comprehensive counsel required for fiduciary standing possible, (2)make advice a process the advisor manages (asset/liability study, investment policy, portfolio construction and management with an audit path to statutory documentation to assure fiduciary standing)rather than a product which brokers sell, (3) greatly elevates the role and counsel of the advisor (4) definitively serves the best interests of the consumer and (5) increases advisor productivity by 50%.

Given we are at the tipping point where advice is not longer incidental to trade execution but trade execution is incidental to advice, the industry is in need of leadership, not just the cloning of outdated platforms based on a different time—where fiduciary standing was not possible. Leadership is advancing transformative innovation rather just keeping up. That is what made Schwab a market leader and is what will again reorder the industry.

SCW

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Skip Schweiss said:

April 16, 2010 — 4:54 PM UTC

To say that many no-load “funds have steep 12b-1 fees that load funds do not carry…” is incorrect, Mr. Southall. Virtually all load funds carry a 12b-1 fee, usually 25-35bp. To be considered a “no load fund”, the fund cannot have a 12b-1 fee greater than 25bp.

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Brooke Southall said:

April 16, 2010 — 5:15 PM UTC

Hi Skip,

Thank you for clarifying that point. Sorry bout that and I’ll make the change in the article.

Brooke


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