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Fee Trend Benefits Managed Accounts

A trend that's changing the face of the brokerage industry - fees as opposed to commissions - may help wirehouses, institutional banks and broker/dealers attract more money into separately managed accounts (SMAs).

A movement to fee-based services from commission-based ones is being aggressively pushed by some wirehouses as a means to grind down peaks and fill in valleys in their sawtooth income picture. The practice, which directly links a broker's income to an account's performance, may also be eyed as a way to rebuild investor confidence in the industry, as faith has been greatly shaken by bear market losses, corporate scandals and reports of financial misconduct.

Matt Schott, a senior analyst with TowerGroup, a research and advisory firm that focuses on global financial services based in Needham, Mass., compared the trend to an ocean swell that is overtaking the entire investment management industry. "It starts in the middle of the ocean and gathers steam as it gets closer to shore," he said. "The industry is in [the middle of] that rolling long-term change, shifting from a product-centric, transaction- and commission-oriented approach to [one] more of [building] relationships, developing long-term-solutions and charging fees for assets under management."

He reasoned that because the Internet has revolutionized the brokerage landscape, providing investors with free, easy access to information and low-cost trading, brokers are scrambling for ways to differentiate themselves. "The differentiation is going to be more on developing solutions, providing advice and managing risk," he said. "All those things go fairly nicely with what goes on in a managed account."

The New Gospel

In a managed account, he explained, an adviser sits down with a client and comes up with long-term goals. Then the adviser develops an asset allocation strategy based on those goals and the client's risk tolerance. Finally, those assets are parceled out to money managers to maximize the return on those assets. All the while, the adviser oversees the allocation and manages the client's risk. "Since most managed account business is fee-based business," he said, "it is very definitely consistent with the industry trend toward fee-based business."

For the nation's nearly 11,500 independent advisers, the trend toward fee-based business began around 10 years ago and has been pretty much adopted across the board. However, commissions still are king for the largest segment of the financial intermediary industry - the some 260,000 middlemen at broker/dealers, banks and insurance companies.

Although wirehouses have been pressuring their brokers to embrace the fee-based gospel, revenues from fee-based accounts remain low at around only 20% to 30%, according to a recent study by Cerulli Associates, a financial research and consulting firm headquartered in Boston.

However, the report noted that assets in fee-based products at wirehouses have increased three times over since 1994, from 5% to 15% today.

Wirehouses' interest in fee-based systems is stability, said Cerulli Senior Analyst Matt McGinness. Commissions are a very volatile form of revenue, as the past few years have proven, with many brokers having to lay off large percentages of their staff. "In a bear market, commission revenues drop because trading falls off. Revenues from principle transactions drop as IPOs [initial public offerings] slow down, and you may or may not see a decline in margin lending revenues," he said. "Asset-based revenues tend to be much more stable."

Ironically, some investment pundits predict that independent advisers, who have preached about the benefits of fee-based services for years, may lose a key selling tool as the practice proliferates throughout the rest of the industry.

But McGinness isn't one of those pundits. "It may take away one angle that some independent advisers exploited, but independent advisers have a different value proposition," he said. "They are getting a lot of mileage out of investment banking scandals and perceptions of biased practices within the wirehouse system."

But the mileage independent advisers can wring from those scandals may diminish as adoption of fee-based services grows. That's because the practice puts brokers and their clients on the same side of the payoff equation. "If the business grows, both the adviser and investor benefit," observed Michael Evans, a vice president with Financial Research Corp. (FRC), a Boston-based financial services research and consulting firm.

Applying a fee-based squeegee to the soiled window through which investors view the investment industry should help its efforts to exploit the heightened investor interest in SMAs, the assets of which are expected to explode during the decade.

Assets in SMAs will grow at a compound annual rate of 18.5% over the next five years, reaching $1.1 trillion by 2007, according to the TowerGroup. And by the beginning of the new decade, FRC estimates assets will break the $2 trillion barrier.

Wirehouse Goals