The Future Of Wealth Management And Morgan Stanley’s $28 Billion Opportunity by Sam McBride, New Constructs

Big banks are facing competitive pressures from two forces in recent years: regulators and new (fintech) competitors. Regulators have cracked down on many of the traditional activities that fueled growth in the financial sector during the pre-crisis boom. To compensate, many big banks have migrated towards more retail-like activities such as wealth management that face less regulation.

As they attempt this pivot, the banks have also found that new technology-driven entrants are putting pressure on their traditional advisory model. “Robo Advisor” startups such as SigFig, Betterment, and Wealthfront offer cheap, automated investing services that threaten to disrupt the wealth management business.

The big banks still have significant advantages though. Their brand names, financial capital, advisor networks, and large client bases give them the opportunity to leverage the innovations of these startups and become the biggest winners in this new wealth management model.

“Digital advice will become a multi-trillion dollar market over the next decade,” says NextCapital CEO John Patterson. “Trusted brands with large installed client bases that rapidly adapt to digital advice will win this opportunity.”

Morgan Stanley (MS) has that large installed client base. In 2009, it became one of the biggest wealth managers in the world with the acquisition of Smith Barney. As Figure 1 shows, its wealth management business has always been more profitable than its investment banking activities.

Figure 1: Segment ROIC: Wealth Management Is the Leader

Morgan Stanley, Wealth Management

Sources:   New Constructs, LLC and company filings.

What’s more, the company has already taken the first steps towards adapting digital advice. At its current valuation of ~$29/share, Morgan Stanley has the potential to create almost $28 billion in value for shareholders if it successfully completes this digital transformation.

Regulatory Squeeze On Margins

What used to be a profitable and growing business is now plagued by ever tightening margins as banks spend more and more money on compliance. The six biggest U.S. banks—J.P. Morgan (JPM), Bank of America (BAC), Citigroup (C), Wells Fargo (WFC), Goldman Sachs (GS), and Morgan Stanley—spent over $70 billion on regulatory compliance in 2013, more than double what they spent in 2007.

Those numbers come from a recent article in the Wall Street Journal. That same article described a town-hall meeting at Barclays (BCS) where bankers described compliance officers as “nuns with guns,” indicating the extent to which regulation has become a constant squeeze on investment banking activities.

Return on invested capital (ROIC) has dramatically declined since the financial crisis for the big banks. In 2006, they earned an average ROIC of almost 15%. Last year, their profitability had been cut in half, at ~7.5%.

Wealth Management Is The Way Forward For Margin Expansion

Before the financial crisis, Morgan Stanley’s small Wealth Management division was highly profitable, while the much larger Institutional Securities division was not as profitable due, in no small part, to massive bonuses for its many investment bankers.

After the financial crisis—and the Smith Barney acquisition—the Wealth Management division’s ROIC fell, but it remained in the double digits. Institutional Securities, on the other hand, has failed to achieve an ROIC above the company’s WACC every year since 2006.

Increased capital requirements and compliance costs make Institutional Securities a dead end for profitable growth. If Morgan Stanley wants to grow profits and create value for investors, it needs to invest heavily in wealth management.

Changing Culture Is Difficult And Takes Time

As Morgan Stanley reorients itself towards a greater focus on wealth management, it will need to bridge the gap between the value that advisors believe they deliver and what clients say their priorities really are. As a recent report from EY shows, advisors put a much higher priority on regular interaction and personalized understanding, whereas clients are more concerned with performance, transparency, and fees.

Another interesting finding from the report is that clients see the most beneficial use of social media as a forum to connect with other clients to ask questions and share experiences.

These findings suggest that Morgan Stanley, which currently has the largest advisory force of any firm, will need to undergo a major cultural shift to meet the needs of more digitally active clients. A failure to do so could lead to a mass exodus of clients as wealth transfers to the younger generations. However, it also opens up the possibility for major gains in margins and efficiency.

A truly comprehensive digital transformation would be one that embraces automated portfolio management, full transparency in fees and holdings, and a robust online community the enables clients to find and share information easily. Such a transformation could lead to significantly larger margins by allowing Morgan Stanley to further reduce its advisor count (a process that can happen organically with 25% of advisors near retirement age), as well as maintaining fewer physical branches.

New Entrants Bring Change, Challenge & Opportunity

Robo Advisors own a very small fraction of the market right now, but their share is growing rapidly. Just as importantly, their emphasis on low fees is already forcing more traditional advisors to adapt.

We can see this focus on low fees play out in Morgan Stanley’s financial statements. Between 2008 and 2015, fee-based accounts—which tend to be less lucrative than accounts that pay commissions per trade—went from 25% to 40% of its assets under management. In just the past three years, the average fee rate on those accounts has fallen from 77 basis points to 74.

The old advisor model won’t work in this new world of falling fees, and it’s clear Morgan Stanley already knows that. The company has been steadily reducing its advisor headcount and number of retail locations since 2009. In that time, it has increased its revenue per representative by 6% compounded annually.

In January, Morgan Stanley hired Naureen Hassan, the executive that led Charles Schwab’s own Robo Advisor launch. Hassan will help spearhead a digital overhaul that will use automated investing services—along with a number of other digital tools—to complement its existing advisory force.

This digital overhaul comes at a particularly sensitive time in the wealth management business. At the moment, Morgan Stanley has about 10% of the wealth management market for high net-worth individuals. However, the wealth management industry could face a major upheaval in the coming years with an unprecedented intergenerational wealth transfer as baby boomers begin to pass down money to their children. 66% of children fire their parent’s advisor after receiving an inheritance, which means there’s an opportunity for Morgan Stanley to gain (or lose) market share.

In addition, technology promises to grow the wealth management pie by enabling banks to profitably serve lower net worth individuals. Robo Advisors are a perfect example of a disruptive innovation. By automating much of the portfolio management process, they’ve been able to meet the needs of lower-end customers that traditional wealth managers have typically ignored, and now they’re moving up the income ladder.

Failure to adapt to changing technologies could lead to Morgan Stanley getting squeezed out of its most profitable business. On the other hand, a well-executed digital overhaul could allow Morgan Stanley to gain market share from traditional competitors, expand its potential customer base, and cut

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