Fidelity Investments, the privately held mutual-fund giant, has quietly built one of the biggest brokerages on the planet. Operating almost entirely online, it has added more than 1 million retail accounts in the past two years, giving it 9.9 million customers at the end of 2004. That's 40% more than Charles Schwab Corp. (SCH) and 10% more than even Merrill Lynch & Co. (MER). Fidelity ended the year with $1.13 trillion of assets in its customers' brokerage accounts, muscling aside Schwab for the first time and closing in on Merrill's $1.36 trillion. "Fidelity was always big, but they were viewed as a sleeping giant," says Richard H. Repetto, an analyst at securities firm Sandler O'Neill & Partners. "Now they're seen as in the game."
Fidelity's renewed assault on the industry's leaders began in October, 2002, when it tapped a 12-year company veteran, Ellyn A. McColgan, to run the brokerage unit. She trimmed costs, spent millions to upgrade the Web site for retail customers, and launched a series of ruthless price cuts. Fidelity now charges customers who make 120 trades a year just $8 a pop, vs. $14 for customers making 240 trades when she took over. "They spent a lot of money to upgrade their technology and improve customer service without drawing attention," says Matt Snowling, an analyst at Friedman, Billings, Ramsey Group Inc. (FBR). "Not until all that was in place did they come with the price cuts, the media campaign, the conference calls."
The onslaught has other online brokers scrambling. In just two years, Schwab has lost almost 10% of its brokerage accounts, and E*trade Financial Corp. (ET) 20% of its accounts. That has forced both to cut staff and close offices. The price cuts have been so harsh -- Schwab's average commission per trade fell 43% from 2002 to 2004 and continues to fall this year -- that some analysts say online brokerages are rapidly becoming unprofitable. Only firms that can use trading to attract customers for other services will survive, says Tom Watson of Forrester Research Inc. (FORR).
Schwab says it more than made up for the lower commissions with higher revenue from managing funds and providing banking and advisory services. Its fourth-quarter operating profit margin reached 15.5% -- the highest in almost five years. "We have our own punch list of what we think are great ideas, [rather] than responding to what the competition does," says Michelle M. Swenson, senior vice-president in the advisory broker unit. Meanwhile, Merrill spokesman Erik Hendrickson says the firm is not a discount broker and it hasn't cut its commissions. Unlike the online firms, Merrill has 14,000 brokers who provide advice and other services.
For all of McColgan's success, she has been unable to break Schwab's grip on the lucrative business of catering to independent financial advisers. In the past two years, Schwab has actually widened its lead among advisers, who place hundreds of millions in client assets with brokerages. But McColgan senses an opening as Schwab tries to steer more customers to its in-house advisers without alienating the thousands of outside advisers it also serves.
Schwab also has competed fiercely for retail customers, especially since founder Charles R. "Chuck" Schwab returned as chief executive last summer. After Schwab cut its trading commissions last year both it and Fidelity took market share from smaller online competitors. "Just because Schwab has a chance to grow doesn't mean it has to come out of [Fidelity Chairman] Ned Johnson's hide," says fund manager Ron Baron, who bought more than 1 million shares of Schwab in the fourth quarter and owned almost 15 million at yearend.
Fidelity won't disclose its brokerage unit's results, but it is probably more profitable than Schwab's, analysts say. That's because almost half of Fidelity's brokerage assets are invested in Fidelity funds, as opposed to the one-eighth that are managed in-house at Schwab. Fidelity makes about 0.7% to 0.8% on each dollar of brokerage assets, compared with only 0.2% to 0.3% at Schwab, says Chip Roame, managing principal at Tiburon Strategic Advisors, a consulting firm in California. "Fidelity is ragingly more profitable." With so much money at Fidelity sitting in Fidelity funds, he adds, the firm "is already ringing the registers."
As a private firm that doesn't need to hit quarterly earnings numbers expected by Wall Street, Fidelity can afford to keep up the pressure on Schwab and others with little concern for the up-front costs. Last year it spent $700 million on technology alone at the brokerage unit. "It's somewhat scary for everyone else," says analyst Snowling. "[Fidelity] doesn't have to play by the same rules."
Before joining Boston-based Fidelity in 1990, the 51-year-old McColgan earned her stripes on Wall Street. After getting an MBA at Harvard Business School in 1983, she worked as an assistant to Jeffrey B. Lane, then chief operating officer at Shearson American Express and now vice-chairman of Lehman Brothers Inc. (LEH). "She handled a big bureaucracy exceedingly well, and that's always a sign of someone going places," Lane recalls. McColgan made her name at Fidelity when she turned around a money-losing unit that ran retirement plans for nonprofits, almost quadrupling its assets, to $75 billion, from 1996 to 2000. When she took over the brokerage operation in 2002 she had never worked with retail customers. At the time, the bear market was in its third year, and the unit was in a slump. "Fidelity's pricing was uncompetitive, their [online] platform had gotten outdated, and they were losing market share," says Snowling. "Their trading volumes were in the gutter."
Most of McColgan's turnaround strategy came right from the playbook of Edward C. "Ned" Johnson III, who has run Fidelity since 1972: Spend and spend to improve technology and customer service, and emphasize market share first and profits later. To attract frequent traders, McColgan purchased Wealth-Lab, a software program used to develop trading strategies, and added a dozen outside research sources to its Web site. The site not only offers reports from firms such as Lehman and Prudential Equity Group but also rates how accurate their past stock picks have been. McColgan also began adding branches around the country, opening 10 last year, including six within a half-mile of a Schwab office.
She also did something uncharacteristic of Fidelity: She spent more than $500 million on an acquisition spree. That beefed up its brokerage services for institutions and helped the firm gain ground on Bank of New York's (BK) Pershing, the market leader in terms of clients. Fidelity has vaulted over Goldman Sachs (GS) and Bear Stearns (BSC) by adding clients such as Northern Trust (NTRS), Washington Mutual (WM), and Bank of America (BAC).
"A BURST OF ENERGY"
Now McColgan is focusing on Fidelity's failure to make much headway with financial advisers. In January she decided to replace the longtime head of the advisory business, Jay Lanigan, a 25-year Fidelity veteran. Over the previous two years his operation had doubled the amount of assets it handled, to $137 billion. But Schwab had collected much more and now boasts $348 billion. Lanigan declined to comment. McColgan says she's looking to hire someone who will "bring a burst of energy" and close the "big fat lead" Schwab has built up. To catch Schwab, Fidelity will spend "a lot more" to boost its service for advisers, she adds. "We shoot for No. 1." Just last week, Fidelity introduced Web software for advisers that combines customer portfolio and contact information with trading and planning tools.
The battle to win over financial advisers and attract the assets of their clients is crucial to staying on top in the brokerage business. That's because each adviser brings in hundreds of accounts, and offering advice is the fastest-growing part of the investment industry. The long bear market and the host of scandals embroiling brokers and fund firms are driving the trend. "Wherever [New York Attorney General] Eliot Spitzer shines his flashlight, he's driving more and more assets to independent advisers," says Tiburon's Roame. And most advisers use a brokerage firm to maintain their customers' accounts and execute trades.
As Schwab has bulked up its own staff of advisers, Fidelity has been able to sign up some newer and smaller advisory firms that are worried about competing against Schwab for clients. But Fidelity is finding it much harder to get more established advisers to switch firms. To do so, the adviser must seek approval from each client, and many don't want to move. Frank Armstrong, who runs a $300 million advisory company in Coconut Grove, Fla., has long used Schwab, but he's nervous about its growing in-house business. He's having Fidelity handle some of his clients' accounts, but many other clients resist switching. "Twice a year we tell them that there are better, more economical choices, but they want to stay," he says. Schwab says its success at attracting more business from advisers belies the notion that it is seen as a competitor. "At some level, the numbers speak for themselves," says Schwab's Swenson.
Armstrong says Schwab has even tried to poach some of his customers when they visited a branch. Schwab says staffers are trained to steer customers to the most appropriate adviser, including one of the 329 independents who are part of Schwab's outside network. Schwab referred more than $6 billion of business last year to these independent advisers. But fewer than 7% of the roughly 5,000 advisers who keep client assets at Schwab got referrals. Schwab says more want to join than it can accommodate.
This fight over financial advisers might determine which firm wins online brokerage supremacy. For now, Fidelity's vast resources and freedom from the tyranny of hitting quarterly earnings numbers are giving the mutual-fund giant an important edge.
Corrections and Clarifications
In "The busiest broker on earth" (Finance, Apr. 18), E*trade Financial Corp. had a 3% increase in new brokerage accounts during the past two years following a redefinition of active accounts, not the 20% fall shown in its 10K for 2004.
By Aaron Pressman in Boston