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What a Difference a Decade Makes

Back in 1998, with the Internet craze in full riot, Merrill Lynch legend John Steffens, then head of the firm's private client unit, delivered a keynote address at the PC Expo in New York. What was amazing about his speech was his explicit condemnation of online trading which, at that time, had come from nothing to represent around 15 percent of all U.S. stock trading in just a few years. The do-it-yourself

Back in 1998, with the Internet craze in full riot, Merrill Lynch legend John “Launny” Steffens, then head of the firm's private client unit, delivered a keynote address at the PC Expo in New York. What was amazing about his speech was his explicit condemnation of online trading — which, at that time, had come from nothing to represent around 15 percent of all U.S. stock trading in just a few years.

“The do-it-yourself model, centered around Internet trading, I think should be regarded as a serious threat to Americans' financial lives,” Steffens famously told a sizeable audience of true Internet believers. “This approach to financial decision making doesn't serve clients particularly well. As far as we're concerned, it's not likely to create long-lasting value.”

For days afterwards, market “visionaries” scoffed. Once again, critics said, the big Wall Street firms were out of touch with reality; Steffens' remarks were Exhibit A. About a year later, NPR's Marketplace radio show awarded Steffens a “hostage to fortune” of the year award — for “the kind of public statement that comes back to haunt its creator in light of new developments later.” The host, David Brancaccio, gleefully recounted the PC Expo speech and noted, “Today, Steffens' company Merrill Lynch announced that it, too, will enter the online stock-trading business, a testament to what a difference a year and the Internet make.”

Who is the hostage to fortune now? Surely not Steffens, who left Merrill in 2001, after 38 years of service, to run a hedge fund. Indeed, from where we sit today, Steffens is looking like the visionary his Merrill colleagues always said he was. (In that same speech, and what Marketplace ignored, Steffens did announce that Merrill would offer customers the ability to trade online starting sometime in the fourth quarter of that year.)

Price Wars and Other Business Plagues

Today, suffering a price war, reduced trading and overcapacity, online brokerages are consolidating, and flesh-and-blood financial advisors seem to have recovered (see compensation story on page 34). E*Trade Financial, the third-biggest online broker by trading volume, wants to merge with Ameritrade Holding, the No. 2 online brokerage. It turns out retail investors like to “do it themselves” — but mostly during bull markets, according to Forrester Research. Otherwise the impact on financial advisors has been muted, to say the least. In fact, you could say it has been reversed, with online firms having to act more like full-service firms.

One impact online trading had was to force Merrill and other traditional advice givers online. After Merrill offered its customers discounted trades online, of course, most other firms followed suit. But interestingly, most do-it-yourself online traders do so with “play money” in accounts with $50,000 and less, according to research by Friedman Billings Ramsey, leaving the bulk of their assets at other financial companies. The online investing that is done is often more speculative, the goal to earn a little extra loot to fund an extra vacation or a new car.

Also, the rise of online brokers “made me review and re-emphasize my value proposition,” says Phillip Cook, president of Cook and Associates, a financial advisory firm in Torrance, Calif. Though he finds “I have to strike down the online dragon fast” when talking to prospective clients, doing so “isn't a tough sell.”

But the pressure on commissions continues, as recent cuts by Charles Schwab, among others, demonstrate. “Commissions are becoming a commodity,” observes Chris Congema, a branch manager for Schwab in Garden City, N.Y., and Forest Hills, N.Y. “I wouldn't be surprised to see them go down to zero across the board.” What firms want today is “wallet share,” Congema says: the ability to sell more services to each client. “Online trading might be something that helps bring some people in, but other factors drive revenue now.”

Lauren Bender, an industry analyst with Celent Communications, a Boston-based independent research and consulting company, agrees. “There are two ways for the online brokerages to grow. Increase market share or expand outside of trading,” she says. Consolidation, through either acquisitions or mergers, is inevitable. Schwab and Fidelity have long been diversified beyond brokerage, and E*Trade has successfully moved into banking and other services. “Only Ameritrade and privately held Scottrade are pure play brokers among the larger online firms, though you could argue that TD Waterhouse is also pure play since it is owned by a bank,” Bender says.

Trading by retail investors is driven by the health of the market, which from 2001 through most of 2003 wasn't robust. The industry uses the measure of Daily Average Revenue Trades (DARTs) to track trading volume. Each DART represents a trade that generated a commission. (Certain trades, such as many mutual fund trades, do not produce a commission and are not included in the calculation.) Bender, who worked in Schwab's online division as the company was launching its online platform in the late 1990s, notes Schwab recorded 242,000 DARTs in 2000. By 2002 the number of DARTs had fallen to 134,100. The company's DARTs rebounded to 156,400 in 2004 as the market slowly recovered. Schwab's experience mirrors that of the industry as a whole, Bender says.

Which is why online brokerages are acting more like traditional financial companies — trying to eke out efficiency gains. E*Trade's push into banking and other financial services, combined with investments in more efficient technologies, enabled it to cut its breakeven point from 150,000 DARTs in 2003 to only 45,000 the following year. Schwab's revenue mix has also changed. In 1999, Schwab reported that 44 percent of its revenue came from commissions; by 2004, commissions were worth just 22 percent of Schwab's revenue. Commission cuts and lower trading volumes were part of the picture, but so too was Schwab's push towards advisory services and other wealth management products, Bender says, adding “Schwab's advisory business is booming. People are looking for validation.”

But online trading should remain hopelessly tied to stock market performance. In November 2004, Forrester Research's Tom Watson wrote (in a report entitled The Future of Online Trading) that fewer investors planned to trade online in 2004 than 2003, despite the S&P 500's upward momentum at the turn of the year. Watson attributed this to the more risk-averse mindset of investors, and an increasing desire for investment advice before a trade order was placed. Forrester calculated that six million households made 96 million trades in 2003.

And that's where it will stay, Watson says, unless the market improves. If the S&P 500 increased by 5 percent a year, Watson wrote in his 2004 report, the number of U.S. households making at least one trade online will rise to nine million by 2009, a 50-percent jump over 2004. If the S&P falls by 5 percent a year, online trading stays at about the 2003 level, with six million households trading at least once per year, Watson estimates.

“The tough thing about measuring online trading today versus five years ago or 10 years ago is that most people look at 1999 to 2000 as where it should be now,” Watson says. “But, really, that period was an anomaly. The ‘Net was popular and online trading itself was something of a fad. The market was remarkable and people kept getting online. Today, the question really is about finding the right equilibrium.” It's possible, Watson says, that equilibrium will be at a point below the historical peaks, at least for a time.

Seek Techie Clients

That said, tech-savvy clients are not a bad thing. Whatever the dynamic, Gene Guerrera, senior vice president, investments, at RBC Dain Rauscher in New Haven, Conn., thinks computer-literate, better-informed clients work more effectively with their financial advisor. Often, “clients are getting information faster than I am,” he says, and the result can be a more engaged relationship. Of course, John Gay of Frisco Financial Planning in Frisco, Texas, cautions, “The Web has made all of this more visible — and may have helped some people shoot themselves in the foot. They looked at their accounts more frequently and second-guessed themselves more than they should have.”

And those techie, do-it-yourself investors might come to realize that they need some help, especially as they grow richer (online traders tend to be wealthier). While big firms are directing smaller clients to call centers in place of personalized contact with financial advisors, Forrester notes that “millions” of prospective online trading customers are young, well-educated, want advice and don't have the asset levels to make personalized, human advice worth an advisor's while. But, “I see enormous opportunity in a big group of people without experience who will need the expertise of the financial advisor,” says Gay.

Michael Curcio, executive vice president of retail brokerage for E*Trade Securities, sees online brokers as offering “a solution” for new investors as they build up the value of their portfolios. Companies like E*Trade, he points out, offer basic investing tutorials and other educational information. “New and lower-end investors are a great opportunity for us,” he says. At the same time, E*Trade offers personalized asset allocation and other services at 13 locations across the U.S.

While much attention has been given to dropping commissions, reps say such stories ignore their real role: to guide the client. “The role of the broker is evolving,” says Congema. “There's more information available from more places, and people need help sorting it all out. Firms that can provide research and help clients apply it to their own situation will be the winners.”

Says Cook: “I believe people understand this is complicated stuff. They don't have the time or inclination to understand it all. So they need advice.”

Bender agrees. “I'm a prime example. I look at this stuff regularly as an analyst and I don't have time to manage my investments. I finally said to myself, ‘Lauren, give it to a professional who does it all day long.’”

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