Financial Services: Fiduciary Standard Rule Could Have Drastic Impact
by Stephen Ellis | 12-29-15
We assess that the U.S. Department of Labor's proposed conflict-of-interest, or fiduciary standard, rule could drastically alter the profits and business models of investment product manufacturers like BlackRock and wealth management firms like Morgan Stanley that serve retirement accounts. Based on our proprietary estimates, we believe that the rule will affect around $3 trillion of client assets and $19 billion of revenue at full-service wealth management firms.
Additionally, we think that investors and business analysts looking only at the more studied implementation costs of the rule are vastly underestimating the rule's potential impact on the financial sector. Current government and financial industry reports have a high-end annual cost estimate of $1.1 billion, but even our low-end prohibited transaction revenue estimate, arrived at using Morningstar Direct data, is more than double that at $2.4 billion. The rule's financial repercussions also extend far beyond wealth management firms.
Full-service wealth managers may convert commission-based IRAs to fee-based IRAs to avoid the additional compliance costs of the Department of Labor rule. As fee-based accounts can have a revenue yield upwards of 60% higher than commission-based, this could translate to as much as an additional $13 billion of revenue for the industry.
Robo-advisors stand to benefit from the Department of Labor rule, as they pick up a portion of our estimated $250 billion to $600 billion of low-account-balance IRA assets from clients let go by the full-service wealth management firms. Capturing a fraction of these loose assets will bring stand-alone robo-advisors much closer to the $16 billion to $40 billion of client assets that we believe they need to become profitable.
We believe that over $1 trillion of assets could flow into passive investment products from the Department of Labor rule. The increase would be from higher adoption of robo-advisors, increased usage of passive investment products from financial advisors that formerly may have been swayed by distribution payments, the proposed "high-quality, low-cost" exemption, and the effect of advisors trying to balance out higher explicit financial planning charges.
We believe beneficiaries will be discount brokerages, like Charles Schwab SCHW; companies tied to passive investment management, like State Street STT; and robo-advisors. Conversely, some life insurance companies, like Prudential Financial PRU, will probably be challenged. Companies with economic moats will be the winners of the disruption to the investment product distribution landscape.
We expect REIT prices generally to move inversely with changes in long-term government bond yields. Higher interest rates would take some time to show up in REIT financial metrics, but eventually, higher rates could cause higher debt financing costs, put pressure on traditional after-interest expense measures of REIT cash flow (such as funds from operations, adjusted funds from operations, and funds available for distribution), and lead to higher cap rates, which could pressure investment spreads.
Also, to the extent that low interest rates have diverted investor funds to REITs searching for higher yield, funds could flow out of REITs if interest rates rise, pressuring commercial real estate and REIT valuations. Although rising interest rates might signal a strengthening economy, which could benefit real estate fundamentals, we do not expect the macro environment to improve enough to offset what could be another 200-basis-point rise in U.S. government bond yields to levels nearer historical norms.
Although the potential negative impact of rising interest rates remains a key concern for REIT investors, U.S. REIT management teams seem less concerned. The majority of U.S. REITs have improved their balance sheets since the last downturn and appear as a group to remain more conservatively leveraged than the last boom in the mid-2000s. Moreover, upcoming maturities for many U.S. REITs over the next few years still carry interest rates that far exceed current borrowing costs, so even a 100-basis-point rise in rates from here would have a negligible impact on cash flow, at least over the medium term.
Nonetheless, recent trading activity suggests that investor expectations about actual or expected future interest rates can have an immediate impact on U.S. REIT stock prices. Although we still view the potential for higher interest rates as a valuation risk for U.S. REITs, we would expect higher interest rates to have a negligible impact on our estimates of value. We already embed a mid-4s yield on the 10-year Treasury into our weighted average costs of capital, relative to the low-2s level recently observed in the Treasury market.
TD Ameritrade AMTD
We believe that there are three concerns on investors' minds that are overblown. The first is a market correction. While this will have a direct impact on the company's assets under management revenue streams, stock market volatility will increase trading volumes, and the benefit from rising interest rates is more important.
The second is that an increase in interest rates will lead to a trading commission pricing war. Commission pricing wars are a negative-sum game, so we don't think any rational player will start one. While historically there may be some correlation between rising interest rates and lower commission pricing, the last 15 years can be characterized as having more players and room for material differences in trade pricing. Now, client assets are concentrated in the hands of fewer, larger players, and commission pricing is low in absolute terms with changes in pricing less likely to cause client switching.
The last major concern is over how much TD Ameritrade may share the benefit of rising interest rates with clients. It's important to note that the "trading cash" awaiting investment by TD Ameritrade's customers is largely rate insensitive. They are traders hoping to put the cash to use, instead of people shopping around for the highest certificate of deposit rate. While the company may have to slightly revise its guidance for how much it will benefit from rising rates, the market has more than already priced this in.
Toronto-Dominion Bank TD
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Stephen Ellis does not own shares in any of the stocks mentioned above.
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