Fido Bites the Street
By paying for research and trading separately, the financial giant threatens brokers' business models.
By Shawn Tully

(FORTUNE Magazine) – Fidelity Investments is putting the squeeze on Wall Street's most prized money machine: commissions. On Oct. 3, Fidelity began a revolutionary brokerage arrangement with Lehman Brothers that allows Fidelity to do the unheard-of----pay separately for trading and research. Until now big money managers paid one fat commission rate, usually around 5 cents a share. For that price they got the basic service of buying and selling stocks--together with a grab bag of goodies we'll get to in a minute. For the first time, Fidelity is moving from prix fixe to à la carte. It's handing Lehman between 2 and 2½ cents a share strictly for trading and paying an estimated $7 million a year for Lehman's research. If the big Wall Street brokers aren't trembling over this news, they should be--"unbundling" is bad for their profits. Here's why.

Until recently the old commission structure was a great deal for mutual fund (and hedge fund) managers and Wall Street alike. It was also a ripoff for investors. Money managers liked the arrangement because by in effect overpaying for trades they got a lot of extras, including big allocations of underpriced IPOs, meetings with CEOs and CFOs of companies they might be interested in, and exclusive tips on what the brokerage house's analysts were thinking. "The analysts would always inform their best clients first when they were about to change their ratings on a stock," says Steve Jackson, director of research with Further Lane Securities. The brokerage firms also provided money managers with everything from Reuters terminals to newspaper subscriptions to help distributing their funds.

By paying for overhead via commissions, the fund managers pile expenses they'd normally have to pay out of their own fees onto their investors. That lowers returns on their mutual funds but boosts their own profits. "The excess commissions are a way of paying operating costs with other people's money," says Doug Atkin, former CEO of Instinet and chief of Majestic Research, an independent research firm.

But the value of those extras is fading. IPOs aren't the bonanza they were during the tech bubble, and the Securities and Exchange Commission's fair disclosure regulation bans companies from feeding exclusive information to favored analysts. The SEC has proposed tightening rules on using commissions to pay for overhead. So what's left, besides plain-vanilla trading, is mainly research. The insights of Wall Street analysts aren't terribly valuable to big outfits like Fidelity, which have their own research staffs. And given the choice, smaller fund companies may decide to to buy their research from the growing number of independent boutiques like Majestic.

It's hard to predict how many funds will follow Fidelity's lead. At first, unbundling may cut profits for Fidelity, because it will be paying for research and overhead expenses from its own pocket. But Fidelity's funds will get an instant performance boost, since their trading costs will go down. That should help them attract a flock of new investors, and more investors means more profit in the long run. When Wall Street trembles, investors should rejoice.