The Internet has changed forever the behavior of investors and investment managers. Low cost, combined with free access to data and research, has made on-line trading a cheap thrill for millions of people and forced full-service brokerage and mutual-fund firms to rethink what they are and how they can compete.

That was round one of the revolution. With the stalwarts of the industry launching the counterattack, round two is now well under way. At this stage of the game, two main challenges face the protagonists. The first is gaining access to a larger proportion of the assets of investors who have already gone on-line than the 5 percent they have so far invested via the World Wide Web (Exhibit 1). Since trading is becoming a commodity, it will be more important to gain access to those other assets than to collect fees for trades.

The second challenge is reassuring investors by offering help. People who are just beginning to trade on-line are unlike those who have been doing so for a while: less stock- and tech-savvy and less sure of themselves. In short, they need on-line advisory services (one might say "e-dvice"). The brokers’ reward for investing in them will be a share of the $2 trillion in assets that, we estimate, will be moving on-line over the next two or three years.

On-line trading emerges

Until brokerage fees were deregulated in 1975, stock trading was largely the province of the wealthy. Even afterward, limited access to timely and accurate information about public companies discouraged broad market participation.

With the emergence of the Web, a number of "no-frills," deep-discount trading operations appeared, among them Datek Online and Ameritrade Holding, in 1996. Offering basic trading facilities and free information, they catered to a relatively small, sophisticated, and active set of investors who wanted low-cost trading and not much else. Over the next couple of years, a number of mid-discount operators, such as E*trade and DLJdirect, emerged. They charged higher fees but offered, besides information, more research and some investment analysis tools. Emulating the pattern of many other industries, both kinds of Internet first mover were pure plays, with no bricks-and-mortar presence.

Encouraged by the success of the Dateks and the E*trades, Charles Schwab, a major off-line discount broker and mutual-fund marketplace, ramped up a major Web presence in 1998. Fidelity Investments followed. Largely on the strength of powerful brand names, these companies were able to charge more than the mid-discount firms did. Finally, traditional full-service brokerages, such as Merrill Lynch and Morgan Stanley Dean Witter (MSDW), deployed basic on-line offerings at rates similar to those of Charles Schwab and Fidelity.

What have these firms been fighting over so far? As the first phase of the evolution of on-line trading came to a close, around the middle of 1999, a total of nine million on-line accounts held $400 billion in assets. Many observers thought that the great majority of these accounts belonged to young, price-sensitive, independent-minded, and active traders attracted by the low commissions and convenience of the on-line brokers. In fact, the picture is more complicated.

These account holders are indeed heavy traders—their on-line accounts represented less than 5 percent of investable assets and 15 percent of all brokerage accounts by mid-1999 but 37 percent of all trading volume. Many of the on-line pioneers are young, but more than 40 percent are upward of 50. Ten percent of these older on-line investors have $1 million or more to invest; 25 percent have between $250,000 and $1 million; and an additional 20 percent have $100,000 to $250,000. About 30 percent are small-business owners with extensive and varied financial needs.

Given such attractive demographics, there is plenty to fight for. But as the new contenders are already finding out, they won’t succeed by offering the same propositions put forward by those firms that first brought investors on-line. For starters, customer acquisition costs have risen by more than half in two years—a daunting figure for any new low-cost, no-frills service to bear. Second, the top six on-line brokers have begun to entrench themselves, increasing their market share by over 14 points (from 72 to upward of 86 percent) in the 18 months up to the end of the third quarter of 1999. Third, and most important, the characteristics of investors who have not yet gone on-line differ from those of investors who have.

The "middle"—middle-income, middle-aged investors who have a middling aversion to risk— will dominate the second wave

The first wave of on-line brokerage customers consisted, broadly, of people who were afraid neither of computers nor of investing: a mix of young, first-time investors and older, more experienced ones. Seventy percent were men. The second wave will be dominated by the "middle"—middle-aged, middle-income investors with a middling aversion to risk. Sixty-five percent will be between 30 and 49 years of age, compared with 48 percent of on-line investors today. They will trade less frequently, and they will have less to invest (Exhibit 2).

A full segmentation of the data suggests five core segments: lifetime savers, dependent family heads (householders, with families, who rely on others for guidance on economic decisions), demanding and affluent investors, young traders, and novices. While there are real differences among the segments, all but the young independents are looking for help in one form or other. The key implication of this segmentation scheme is that to gain and keep control of the assets of second-wave investors, companies will have to deliver comprehensive, customized, and low-cost advice that is easy to understand and use, and they will have to make it available through more than one channel.

Answers to a simple question in the survey that yielded our data bear out our analysis: of those not yet trading on-line, 67 percent said that access to advice was highly important to them, compared with 38 percent of those already on-line. Sixty-two percent of the former also said that access to individual brokers was highly important, compared with 30 percent of the latter. In both respects, established operators, with their armies of skilled advisers, seem to have the advantage, though in shifting some part of their operations on-line, they, unlike Internet pure-play attackers, must worry about cannibalization issues.

Winning

What might a winning value proposition look like in the brokerage industry? We believe that there are four prerequisites for successful advice-based on-line business models.

1. Aggregated client information

First of all, providers will have to aggregate information about their clients on the clients’ behalf, not their own. Financial institutions have long pursued the holy grail of becoming the sole source of the financial products that their customers buy, and to that end they have mined the data they collect on the behavior, assets, and needs of those customers. In general, however, these institutions have failed in this quest. Although the Internet might seem to offer an unprecedented opportunity for gaining access to, gathering, and synthesizing such data, the Web will weaken neither the desire of investors for the best possible product nor their belief that shopping around among a number of suppliers is the only way to get it.

So the goal cannot be simply to cross-sell on the basis of extensive analysis of the data. Instead, it should be to develop a fuller financial picture of the company’s clients to help them manage their expenses more efficiently and make more suitable risk-adjusted decisions about their investments. Consumers who find themselves making sounder, more rewarding decisions based on the advice they receive will of course become more and more willing to share their financial information with the adviser. The survey found, for example, that between a third and a half of respondents were "very" or "extremely" interested in receiving a consolidated net-worth statement. Financial information aggregators such as Onmoney, VerticalOne, Witan, and Yodlee, as well as financial-services companies, now offer this type of service.

2. On-line tools

Such firms have at their disposal easy-to-use on-line tools for the 33 percent of new on-line investors who don’t require human help with financial planning. To compete seriously for the other two-thirds, it will be necessary to develop tools that let providers and clients collaborate closely, without any need for extensive one-on-one interaction. These tools, we believe, should be modular and event driven, pre-filling, continuously updating, tiered, and linked to execution capabilities.

They should be modular and event driven because consumers often want advice on the issues concerning them at a given moment, rather than comprehensive financial-planning recommendations. Pre-filling tools use new consumer data-aggregation technologies to fill out forms, automatically, that make it possible to deliver tailored advice unprompted by the consumer.

Continuously updating tools stay on top of the consumers’ constantly changing financial situation, in contrast to "this-is-your-plan-now-stick-to-it" consultations. Tools that are tiered give general advice instantly but offer increasingly tailored advice as a reward for providing additional information. Through the linkage of tools and execution, consumers can act immediately on advice by clicking on a link at the site where it is received.

3. Integrated multichannel facilities

Providers must make it possible for customers to reach them through three channels: on-line, over the telephone, and in branch offices

Providers must offer contact through three channels—on-line, over the telephone, and in branches—and must continuously update each customer’s transaction and interaction history no matter which channel a customer uses for a particular transaction.

The proliferation of low-cost broadband Internet service will allow consumers to combine work they do on their own with work done under the guidance of company personnel. Customers might, for example, use an asset allocation tool to determine whether more stocks were needed in their portfolios, but they would want a live broker to tell them—by telephone, over the Web, or in a branch office—which kinds of stocks would be most suitable for them to purchase. They might then use an automated filter to narrow the selection, and the broker would reenter the picture to make specific recommendations. Customers would download research on these stocks and then wait for e-mail notification when they hit a target price.

4. New pricing models

Second-wave pricing models should be based on asset levels, types of investments, trading activity, and attitudes toward fees

Finally, providers will have to base their prices on a more granular understanding of customer economics. First-wave pricing models assumed that trading commissions and related margin spreads would be the source of revenues and that simple discounts would be given to volume traders. But these models are losing their relevance as the cost of transactions declines. Second-wave pricing models will have to be based on asset levels, trading activity, types of investments, and attitudes toward fees.

To make it truly worthwhile to serve people who trade infrequently and have few investable assets, for example, brokers will have to base their charges on assets rather than transactions. Brokers will also find it necessary to give customers incentives, such as declining percentage fees for higher levels of assets, to concentrate their assets in a single place. To secure more of the assets of the wealthier first-wave investors, brokers could commoditize transactions by bundling them. Merrill Lynch’s Unlimited Advantage and MSDW’s iChoice, for example, give trades away. The American Express on-line offering waives transaction charges for clients who keep sufficient levels of assets in their accounts.

Many people are no longer willing to pay the premium that is embedded in full-service commissions but are not yet ready to pay separately for investment advice. Pricing for these investors should be based on their levels of assets or on "implicit" revenues, deriving from charges that are typically invisible to the consumer. (Implicit revenues come from sources such as interest rate spreads, in which an institution lends at a higher rate than it pays on its deposits; mutual-fund trailers, the fees that funds pay to brokers, based on the assets the brokers place with them; sales of proprietary products; and referral fees.) Alternatively, investors could pay a monthly or annual fee for investment advice as well as a limited number of trades. Firms that succeeded in portraying their investment advice as a professional service could even charge their customers by the hour.

Some firms are already experimenting with new pricing models. Merrill Lynch’s Unlimited Advantage and MSDW’s iChoice provide the advice of a broker, proprietary research, free trading, and the rest of a full-service relationship for a single asset-based fee. American Express offers free trading to clients with assets above a certain level in an AmEx account. Charles Schwab varies pricing according to the delivery channel customers use and the volume they generate.

On balance, the attackers now seem to face the greater challenge in figuring out how to integrate, in an effective and low-cost way, advice and product bundles tailored to the needs of individual consumers. But that shouldn’t make incumbents complacent. After all, only two years ago the momentum appeared to be with the attackers. In another two years, the picture may look different again.