Discount firms risk losing successful clients

By Steven Lamb | July 20, 2005 | Last updated on July 20, 2005
3 min read

(July 20, 2005) Discount brokerages may enjoy lower cost structures than their full-service competitors, but they risk losing customers who find success in managing their own accounts, according to the IDA’s latest Wealth Watch report.

The brokerage industry association studied a sample of nine discount brokerages and nine full-service brokerages, comparing the performance of their businesses between 2002 and 2004. The study found that discount brokerage accounts were — perhaps not surprisingly — smaller than the accounts at full service firms. The gap between the two has grown over the past three years, as full-service accounts have outpaced the discount investors in terms of returns.

“A possible explanation, and concern, for discount brokers may be that some of their clients may migrate out to the full-service platform once their accounts reach a certain threshold,” the report speculates. “After a certain level of wealth is amassed, discount investors may feel more inclined to seek the advice of a professional to preserve or further grow this wealth.”

Most discount brokerage clients appear to be “stuck” in the discount world until their accounts grow to a size deemed acceptable by full-service firms.

“These investors perhaps either feel confident in their own investing ability or do not believe their accounts would attract a sufficient level of interest or service from a full-service advisor,” the report says.

The study also found a noticeable difference in the holdings of discount investors compared to full-service clients. Full-service accounts held an average allocation of 27.7% bonds, with 43.5% in equities. Discount investors hold only 9.9% in bonds and 58.6% in equities.

The report postulates that discount clients are far more comfortable with the concepts of trading stocks, while perceived complexities in the fixed income market scare them off. Most discount brokerages offer bond trading capacity, but few users seem comfortable with the asset class.

“Not fully understanding bond fundamentals such as accrued interest, yield, and call features for example may be a deterrent to bond investing for do-it-yourself investors,” the report said.

Full-service clients, on the other hand, benefit from professional advice and management, demonstrating trust in their advisor’s use of fixed income instruments.

Another difference between the two groups’ portfolios was the level of cash held. With discount investors focused on stock transactions, these clients tended to keep their powder dry, holding more than 10% in cash to allow them to take advantage of buying opportunities.

Full-service clients tend to be more fully invested, with only about 6.6% of their holdings in cash. Not only does this benefit the client, with more of their money working for them, but also their advisor, who will earn higher compensation from non-cash holdings.

The commissions earned by discount brokerages are far more heavily-weighted toward equity transaction charges, whereas full-service brokers have a more even split between stock trade commissions and mutual fund compensation. But the level of fund compensation has dropped, from 53% of revenues in 2002, to 45% in 2004.

Discounters derive only 14% of their commissions from mutual funds, even though funds make up about 20% of the account holdings. Discount clients tend to prefer no-load funds, which accounts for the discrepancy. Full-service brokers tend to steer their clients toward load funds, as they need to be compensated.

Discount brokers have benefited from relatively stable costs, with operating expenses climbing from $188 million to $190 million between 2002 and 2004. Full-service brokers have not had as much luck in keeping a lid on costs, which have risen by more than $100 million in the same time period to over $400 million.

Much of this difference comes from the use of automation and reduced staff among the discounters, which employed just 655 staff in 19 offices. The nine full-service firms in the study employed about 5,700 staff in 900 offices.

“The higher costs involved in running a full-service dealer have a significant impact on overall profitability of the two groupings,” the report says. “Profits (before bonuses and income tax provisions) were considerably higher at our sampled discounters than at the sampled full-service firms. Overall profitability has however improved in both sectors.”

Both channels have benefited from improved investors confidence as the markets rebounded from the tech-fuelled collapse.

“Strengthening investor confidence is vital to all retail brokerages, but more so for the discount firms,” the report concludes. “Unlike full-service firms, discount brokerages can’t rely on the established relationships between client and advisor to keep the clients coming back to the services of the firm. Self-directed discount investors, without the handholding of a professional advisor, must feel confident in their own investment decision making.”

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Steven Lamb