The no-load predicament.

By many measures, banks have managed a successful entry into the retail investment services business. In the decade and a half since the first banks began offering annuities, mutual funds, and discount brokerage services, banks have expanded their presence so that last year banks accounted

According to the Kehrer-Alliance Capital Bank Investment Program Benchmarking Study, the typical bank investment program has a profit margin of 31%, which is high by traditional securities industry standards [Chart A, p.44]. Banks have achieved these margins by focusing on the most profitable part of the retail securities business -- selling load mutual funds and especially annuities to customers with substantial savings that can be converted to other investments.

While so far bank retail investment programs contribute only about 4% to the overall banking enterprise's net income, the investment services unit appears to have accomplished its other main objectives of helping stem the loss of customers to securities and insurance firms.

Too late to the party?

On the other hand, a skeptic might argue that banks have embraced the traditional retail securities business just as it was dying. While banks have been building up sales forces to sell load mutual funds, investors have been increasingly turning to no-load mutual funds and fee based planners.

While mutual fund sales have been booming overall, no-load mutual fund sales have been growing much faster than load mutual fund sales. Since 1986 (around the time many banks were starting to sell load funds), assets in no-load funds have grown by 23% a year, compared to an average annual growth rate of 16% for load funds. By 1996 no-load funds accounted for 53% of all mutual fund sales.

While full-commission brokerage firms such as Merrill Lynch and Smith Barney still control about 38% of all investable assets, the picture is changing. In 1995 (the latest year such information is available), mutual fund assets grew 31%, compared to growth of only 12% for full service brokers. The assets in discount brokers, driven by the no-load mutual fund supermarkets at Charles Schwab, Fidelity Investments, and Jack White, grew even more -- 35% [Chart B].

Here come the planners

At the same time, more and more investors are turning to fee-based planners or independent investment advisors for financial advice, and investment purchases. These planners and advisors have actually experienced a larger growth -- 41% -- in their share of investable consumer assets than the other financial services competitors.

Indeed, a recent Dalbar survey found that over two-thirds of the investing public perceive financial planners as providing reliable advice, almost twice as many of those who deem investment advice from bankers to be reliable. Stockbrokers are perceived to be somewhat more reliable than bankers, but not as reliable as planners and independent investment advisors [Chart C].

Are banks being outflanked in the battle for consumer investable assets? If we look beneath the surface of these trends, we see opportunities for banks with stockbroker sales forces.

According to Alliance Capital's Richard Davies, the statistics on the growing market share of no-load mutual funds are misleading, as a large percentage of no-loads are sold institutionally through 401(k) plans and increasingly through fee-based financial advisors. Only one-third of retail mutual fund sales come from direct marketing; two-thirds are still "advisor assisted."

Davies and others see the real growth in investment services in investment accounts in which the advisor or planner is paid a fee to manage the account, rather than the more traditional form of advice -- suggesting an investment in an individual stock, bond, or mutual fund for which the investor pays a commission. The advisor/planner might pick a portfolio of stocks and bonds for the investor. But increasingly they are choosing no-load mutual funds.

Research by Charles Schwab & Company indicates that no-load mutual funds are the investment vehicles of choice for retail investment managers and fee-based planners. More than eight out of ten owners of retail investment advisory accounts have some or all of their assets invested in no-load mutual funds, while only 63% have some individual stocks in their portfolio. Even fewer (51%) hold some of their wrap account assets in individual bonds. According to Cerulli Associates, so-called mutual fund wrap accounts have grown at an annual rate of 71% since 1993.

There are two kinds of these mutual fund wrap accounts: those where an investment model makes the mutual fund selections and those where the advisor/planner or investor makes the selection.

The growth of these accounts -- which "wrap" investment advice around a bundle of no-load mutual funds -- appears to be driven by consumers' need for choice on the one hand and the difficulty of making an informed decision in a world of thousands of mutual fund choices. The choice is made through the advice of a planner/investment advisor, usually with the help of an asset allocation model that creates a portfolio designed to achieve the investor's target rate of return within the investor's risk tolerance.

Opportunity and challenge for banks

Nonbank financial services firms have already staked out a strong position in the fee-based product market. It is widely reported that about 35% to 40% of all no-load mutual fund sales are captured by Charles Schwab & Company's One Source mutual fund supermarket. But according to Schwab's Chuck Roame, about half of these no-load funds are purchased through independent advisors and planners, not directly by the public.

The retail securities firms that banks have emulated are moving briskly to capture the market for fee-based products. Merrill Lynch's 14,000 brokers are now emphasizing Merrill's Financial Foundation financial planning methodology. Merrill already has $830 billion in assets, but in a short time has gathered $30 billion in wrap account assets. At Smith Barney, a pioneer in discretionary fee-based asset management accounts, 60% of its 10,500 brokers have sold at least one fee-based wrap account. And LPL Financial, the largest wholesale broker/dealer serving the independent financial planner/advisor market, has a large and growing share of its business in a proprietary wrap product.

Banks are belatedly organizing themselves to serve this market, too. First Union and KeyCorp are offering access to Schwab's One Source Mutual Fund Supermarket, and Nations-Bank is launching its own version of this gateway to no-load mutual fund investing. And both NationsSecurities (the retail broker/dealer of NationsBank) and Key Investments (KeyCorp's broker/dealer) have committed to the use of financial planning in the delivery of investment services. Fee-based wrap accounts will be the cornerstone of this new strategy.

How to get there from here?

The problem that banks face in introducing fee-based services is that they might cannibalize some of the load mutual fund sales they have struggled to build. Bank broker/dealers, like their parent banks or holding companies, face strong pressures to build earnings every quarter. Fee-based wrap accounts, which typically pay a fee of 1% to 1.5% of assets under management, earn only 25% to 40% of the fees earned when customer dollars are invested in a load mutual fund with a gross dealer concession typically in the 3.5% to 4% range). On a pro forma basis, both the bank retail investment program and its stockbrokers would have much higher earnings five years from now by switching substantial amount of business to fee-based products. But can the sales person, let alone the bank, weather the earnings hit in the short run?

Fee-based products like mutual fund wrap accounts provide the opportunity for banks to leverage their stockbroker sales forces to meet the emerging needs of investors in the coming decade. But banks face thorny problems of product design and the financing of the transition to fee-based product delivery.

For banks with proprietary mutual funds, fee-based mutual fund wrap accounts provide a way to increase assets under management in the proprietary mutual fund complex. The asset management fees provide the basis to subsidize the sales force or at least offset the commission revenue foregone from selling fewer load mutual funds.

Banks without proprietary mutual funds need to find a way to make the fee-based business additive, rather than cannibalizing their potential load mutual fund sales. One approach to this problem is to target trust customers or securities brokerage customers who invested in mutual funds through the bank's broker/dealer some time ago, and have not been active investors. They might be ideal candidates for fee-based wrap accounts. Ideally fee-based wrap accounts can be used to consolidate a customer's investments from a variety of providers, thus bringing assets to the bank's broker/dealer now held in outside accounts.

Banks that sell investments through licensed branch bankers rather than full-time brokers are in a better position to compete for the fee-based wrap account business, because the low cost of those sales forces -- typically 25 to 50 basis points of sales -- enables the bank broker/dealer to compensate the sales force and still potentially make a profit on distribution of wrap accounts in the first year, rather than waiting three to five years for asset fees to catch up to foregone earnings.