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Commoditization and Fee Compression

Risk, Performance, and Reporting

By Steven P. Greiner Ph.D.  |  April 4, 2019

When the only difference is the price, commoditization has arrived. Commodities lack qualitative differentiation across an often global market. When there’s a loss of differentiation of goods or service across suppliers, cost becomes the only variable impacting client purchases. Uber is cheaper than your typical taxi ride, because it’s commoditizing the ride-service industry right? The price of subscription service for cable TV and cell phone services continues to fall, due to commoditization. Amazon disintermediated book sellers and retail still further. Hence, commoditization is often seen as boding ill for profits and accompanied by slowing growth. The resultant falling price is usually a benefit to consumers but that hardly helps a firm.   

But does commoditization have to be bad for every company? While many fail to navigate this commoditization process effectively, others are able exploit it and flourish. Take Wal-Mart, which faced rapid commoditization in the retail industry. By adopting a low-cost approach through scale and efficiency, the retailer continued to achieve success for over a decade even as many other big-box retailers were being forced into bankruptcy.      

Recently, products based on intellectual capital and/or intellectual property are becoming commoditized. Pharmaceuticals, silicon chip memory, and even financial services are obvious examples as the global spreading of knowledge assisted by technology facilitates the ease of mass production for products and services. The innovation, experimentation, and customer insight needed to win as a premium player are very different from the optimization, efficiency, and scale capabilities that drive success for cost-sensitive producers.  

The next piece to fall may be the commoditization of scale itself however. Even Amazon is reaching “peak scale” these days, where size and efficiency alone aren’t enough to continue promoting growth, which is why branching into cloud computing and groceries are new strategies for Bezo and company. Consider a small firm that can outsource to specialty companies its HR, payroll, compliance, logistics, distribution, 24 hour call-centers and accounts receivable needs. It can compete with a company that has had historically, scale and size as its advantage. Scale itself, with the aid of technology may soon cease to be a competitive advantage.

So what’s a firm to do? 

Changing Approaches 

First, accept that everything becomes commoditized over time. Develop a strategy that doesn’t simply rely on having scale. Develop a difficult to replicate strategy that assumes everyone will have the advantages of being the biggest. Get to know your clients and customers more deeply than your competitors know theirs, and develop a vision of your future by practicing anticipation, what is likely to happen and what will you do then? Build things and offer services that people want. Realize that everyone will have access to scale and intellectual property. The late Kate Spade said, “the biggest challenge facing companies this century will be to differentiate themselves from everyone else – to create a passionate following among customers who have too many choices."  

It’s an obvious cliché to include making differentiation your goal, so you must stand out by adding value in creative ways or make a strong case why you are a better choice. It’s required though because the cost of competing on price alone will always drive a race to the bottom. Profits must be maintained in order to continue to grow and innovate so to do so, make your customers win by evolving to meet their needs in an on-going fashion. We need to remind ourselves what Benjamin Franklin said, “The bitterness of poor quality remains long after the sweetness of low price is forgotten." 

However, we must be cognizant that all that sparkles is not platinum. Elisabeth Kashner, director of ETF research at FactSet, says that of ETF’s launched between 2007 and 2016, over 45% of funds that failed to achieve $50 million in AUM by the end of their first year ended up closing and ~30% are still below $50 million in AUM. False differentiation is smelled out by clients. Consider that stemware is crucial to the success of many top-end restaurants, that oversized spherical ice is more alluring in a jigger of whisky with cocktail garnishes, and the invention of the “mini-slider” all have something to say about differentiation, but there does come a point when an attractive novelty becomes an offense. Differentiation must be accompanied by real value to a customer and just picking an ETF strategy without deep regard to how it can help clients may just be a waste of time. 

Make commoditization just as much an opportunity as it is a risk for your business. Think about how you can release potential value by adapting your operating model and strategy. We all know change can be hard because it requires modifying well-established formulas of success, unfortunately, success in the past usually becomes enshrined in the present by the over-estimation of the influence one’s policies, procedures and attitudes have had which accompanied historical success. It’s easy to come up with new ideas but the hard part is letting go of what worked two or three years ago, but will soon be out-of-date. It is not the strongest of the species that survive, nor even the most intelligent, but the one most responsive to change. You know who said that? Charles Darwin. Hence, change is always pushing against the status-quo which is far easier to maintain for an organization but in the end, knowing what your value proposition can be, not what it is, is the most important knowledge for a firm.  For “keeping a little ahead of conditions is one of the secrets of business, the trailer seldom goes far," Charles Schwab said.

Now up to this point, I’ve talked just about philosophy, which is far easier than creating a new business strategy and executing on it.  Let’s focus attention for our readers here on investment management. That “fee compression” is happening, is the consequence of, and an observation of the commoditization of our industry. There are a variety of contributions to its commoditization, cost transparency, trading technology, information and business information throughputs, ETF creations, robo-advising. The list goes on, but as a fact, investment management and trading fees continue to fall. Trading commissions will become free everywhere as they already are in many places and instances. Assets under active management continue to flow toward passive strategies with seemingly no end in sight which offer significantly lower costs to customers. How might the enterprising manager, advisor, or broker/dealer evolve their business model to differentiate themselves?

Well for starters the answers to three questions shed some light. What are people buying and why? What are the trends? Where will the business be in three to five years? They’re buying inexpensive Exchange Traded Funds. One might even think “performance chasing” has died and “low fee chasing” is the new normal. We’d probably expect over the near future, more of this trend. In three to five years, trading will be free, ETF’s will be close to having the majority of assets under management and only the very best active managers will survive, though at lower cost. Independent RIA’s will continue to grow as the main advisory conduit. These are unmistakable observations though and invite one last question. What is the minimum viable cost? If it is reached for all producers, then where are margin opportunities?

Is it possible to reach a point where there are significantly diminishing returns for increased customer service?  When do you reach a maximum in customer service?  When “free” products or service is achieved, what is left to keep clients from departing for other’s free service?  What is anticipated that clients will need that they don’t know yet?  What products and services are required just to stay competitive? Imagine a bank these days without an app that can take photos of a customer’s check and deposit them. It adds little (if any) to revenue and earnings, but without it they won’t keep customers.

Ask yourself, what is your minimum viable product? What is the maximum level of customer service you will offer and how do you know when you reached it? Most importantly, ask what are my customer’s needs that they don’t know they have yet? This will lead you to discover your future value proposition.

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Steven P. Greiner Ph. D.

Senior Vice President, Schwab Equity Rating

Steven Greiner is Senior Vice President, Schwab Equity Ratings for the Schwab Center for Financial Research (SCFR). In this role, he is responsible for managing the team’s activities in model upgrades, maintenance, production, operations and new product development.