The Scuttlebutt Investor recently discussed the mental models that have been very successful to him as an investor. The first mental model discussed is “The Power of Secular Shifts”.
I don’t know if this is a mental model that Munger would officially endorse, but secular shifts are an important phenomenon that are sometimes under-appreciated and other times over-appreciated by market participants. Secular shifts are a change in volume, demand or relevance driven by secular or permanent forces. This is as compared to a cyclical shift or change that is driven by temporary forces like supply and demand. Secular shifts have the power to put entire companies out of business if they are no longer relevant (think Kodak with the advent of digital photography).
We think the financial services industry is undergoing a secular shift. The shift will be to Charles Schwab’s benefit.
Financial Services Secular Shift
The business of financial advice has been shifting from transactional to fee-based. From brokers selling financial products to advisors charging for advice and long-term planning.
Since the 2008 financial crisis, the independent RIA channel is the only one in the financial services sector to grow market share according to Aite Group. Independent RIAs have taken 13.7% market share which equates to about $17 trillion in assets.
Cerulli Associates of Boston estimate independent RIAs and dually registered firms have a 23% market share and will reach 28% by 2018.
Wirehouses are still the dominant firms in the financial services industry. The market share for wirehouses is 36%. However, their market share used to be 41.6% in 2007.
LPL Financial (LPLA) is a combination of fee-based advisors, brokers, and hybrids. LPL Financial’s largest business is its brokerage business. The secular shift in financial services is squeezing and changing the focus of its business model.
LPL Financial saw its total assets under advisory decline from $485 billion in Q1 2015 to $479 billion in Q1 2016. LPL Financial’s brokerage assets declined from $301 billion in Q1 2015 to $289 billion in Q1 2016. Whereas LPL Financial’s Fee-Based advisory assets grew 3% year-over-year.
During Q1 2016 LPL Financial announced that it is transitioning all remaining commissioned based business to fee-based.
The secular shift from transactional based business to fee-based received a boost with the Department of Labors new ruling on the fiduciary standard. Before the DOL’s new rules fee-base advisors operated under the fiduciary rule; everything done has to be in the best interest of the client. Brokers operated under the suitability rule; an investment had to be suitable to a client’s situation.
The DOL’s new rules will have the fiduciary standard applied to brokers too. Brokers can still do transactional business with their clients but the broker has to get in writing that the client understands the fees and agrees to continue to do business in this manner even if it’s not in the client’s best interest.
If the new rules stand, the increased regulation will spark more brokers to become fee-based advisors. If the brokers current wirehouse doesn’t embrace the shift then more brokers will break away from the wirehouses to set-up their own RIA or join other independent RIAs.
Charles Schwab is the largest custodian for independent RIAs. About $1.2 trillion of Charles Schwab custodial assets are under the management of an advisor. This includes about $193 billion managed by Charles Schwab advisors.
According to Charles Schwab, there are $23 trillion in affluent client assets that currently exist outside the RIA channel. Given Charles Schwab’s market position and committment to service, it is extremely well positioned to benefit in the secular shift from transactional based business to the fee-based advice business.