PRU Prudential Financial Inc

By Jason Zweig 

Morgan Stanley's takeover of E*Trade Financial Corp. for $13 billion shows how drastically the brokerage industry's business model has changed.

Firms no longer want to offer investment products from all sources. Instead, they want to milk their customers' cash and manage all the assets themselves. Investors need to understand the rules of the new game.

For decades, big banks and brokers aspired to become " financial supermarkets" where consumers could open bank accounts and buy stocks and bonds, mutual funds, insurance and the like.

In the 1980s, Prudential Financial Inc. sold securities alongside insurance. American Express Co. pushed brokerage services and financial advice to credit-card customers. In the 1990s, Citigroup Inc. flogged stocks and mutual funds in its bank branches. Even the retailer then known as Sears, Roebuck & Co. sold securities in its department stores, earning the nickname "Socks 'n' Stocks."

Some outfits -- especially Charles Schwab Corp. and Fidelity Investments -- made one-stop-shopping work, managing money themselves while offering funds from other firms as well.

But most flailed. Prudential paid more than $1.5 billion in regulatory fines over sales of risky partnerships. American Express, Citigroup and Sears sold their brokerage and fund units.

Nowadays, the name of the game isn't to offer all things from all sources to all investors. It's to offer only what keeps the fees in-house.

Much as the Plains Indians used every part of the buffalo, from flesh to skin to horn to sinew and hooves, Wall Street excels at creating strategies with fees that can be harvested from every component. In practice, that means investment firms want to grab as much of your money as they can and farm out as little of it as possible.

Wall Street can't make oodles of money off your trades anymore; technology has driven commissions to near zero. And it can't make the windfall it once did off managing portfolios; there, too, market-tracking index funds and exchange-traded funds have become cheap as dirt.

Where are the remaining profits for brokerage firms?

They can take your cash and, instead of investing it for your benefit in the highest-yielding money fund or deposit account, they can put it in their own bank and pay you peanuts. Then they lend it out and keep the profit for themselves.

Morgan Stanley, E*Trade and Schwab all own banks to which they route much of their customers' cash. E*Trade pays its customers 0.01% to 0.25% on their uninvested cash; Morgan Stanley, 0.03% to 0.2%; Schwab, 0.06% to 0.3%.

Brokerages have been pocketing 2% and up on that money (and you can do almost as well, if you pull the cash from your brokerage account and park it in a certificate of deposit or savings account at the right online bank).

Schwab, which has hoovered up $220 billion in bank deposits, earned 61% of its total net revenues in 2019 from the interest it captured on those balances.

Financial firms can also invest your money in funds they run themselves. That way, they capture fees you would otherwise pay to somebody else.

By my estimate, 57% of the $16.5 billion in total assets of the FlexShares ETFs, managed by an affiliate of Northern Trust Corp., are held by Northern Trust clients. The firm "adheres to an open-architecture investment platform, applying the same objective and rigorous selection process to third-party and proprietary investment products," says a spokesman.

Even Vanguard Group, the investment giant owned by its fund shareholders, is freezing out other firms. In its $161 billion Personal Advisor Services program, which manages money for individual clients, Vanguard won't recommend mutual funds or ETFs from any other companies. Clients aren't compelled to sell their non-Vanguard investments, says a company spokesman.

The house brand isn't always bad, of course. A firm's own funds can be cheaper or better than the alternatives. But investors need to be on their guard: Under federal rules, a firm can recommend its store-brand investments whether they are ideal or not, so long as they are a "reasonable" choice.

Finally, complexity pays -- for investment firms, if not their clients. Take " structured notes." The return on these short-term debt instruments is pegged -- often in complex ways -- to the performance of other assets, often stocks or market indexes.

You can lose money, but issuance is booming; in less than one hour on Thursday, banks and brokers filed nine prospectuses with the Securities and Exchange Commission. Here again, firms often hawk them to their own clients.

Structured notes are a fee bonanza. Firms rake in upfront charges of 1% to 4.5%. They earn more fees for calculating the value of the notes. They also can make money by trading against the assets the structured products are linked to. There's generally no market, so if you need to sell before maturity, the firm will buy your note at a price it sets -- including a "spread," or trading cost to you.

The best questions to ask on the new Wall Street, then, are these. What are my financial advisers doing in-house that someone elsewhere could do cheaper or more safely? Where do my brokers put their own cash? Do my advisers buy structured products for themselves? Above all, should I diversify not just my portfolio -- but my financial advice?

Write to Jason Zweig at intelligentinvestor@wsj.com

(END) Dow Jones Newswires

February 21, 2020 11:14 ET (16:14 GMT)

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