Discount Brokers Initiation

EQUITYRESEARCH RBC Capital Markets, LLC
Bulent Ozcan, CFA (Analyst)
(212) 863-4818
bulent.ozcan@rbccm.com
March 26, 2015
Initiating on Discount Brokers: From Robo-Advisors
to Breakaway Brokers
Favorable secular trends bode well for discount brokers
We initiate coverage on the discount brokers with a favorable outlook. This initiation includes coverage
of Schwab and E*Trade, both with Outperform ratings, as well as TD Ameritrade, rated Sector Perform.
Combined, these three companies represent 97% of the public discount brokers. We are forecasting
average earnings growth (CAGR) of 21.5% over the next three years for these three companies, given
secular trends driving assets to the Discount Brokers, as well as the forecast increase in short-term
interest rates that should benefit money market fund earnings.
Discount brokers are uniquely positioned to grow their client base as more investors are
taking their financial destiny into their own hands
• Large numbers of investors are leaving their financial advisors, questioning whether the advisors put
their clients' interest before their own.
• Do-it-yourself investing is becoming more popular and technology enables investors to take charge
of their own financial future like never before.
• Discount brokers, with their focus on the technology and low cost, are well positioned to target a
mostly untapped market, namely the Millennials.
We expect more advisors to leave wirehouses, opting to become independent. This, too,
could fuel asset growth at discount brokers
• As wirehouses focus on their wealthiest clients, more advisors depart to become independent.
Registered Investment Advisors are confronted with a difficult choice: Drop clients with investable
assets of $250,000 or less or accept lower payouts. The increase in independent Registered
Investment Advisors could benefit discount brokers as they provide custodian services to those RIAs:
Think cross-selling opportunities.
• The move to a fee-based model could bode well for discount brokers as RIAs manage more sticky
assets. This is a win-win-win situation for clients, RIAs and the custodians.
Increased popularity of ETFs could lead to AUM and revenue growth
• We expect ETFs to continue to take share from active managers. We believe that discount brokers
could capitalize on this opportunity: Think revenue-sharing.
We advise against investing in discount brokers that focus on trading volumes only
• We looked at potential reasons as why overall volumes are down. We could not prove that there
are structural changes, which is positive for discount brokers. However, there is also no conclusive
evidence as to whether volumes could increase from here on. Our conclusion is investors should look
at other value drivers and view higher volumes as a free option.
Our in-depth analysis reveals that discount brokers stand to benefit from rising rates
• We expect earnings to increase meaningfully with higher interest rates. Schwab is the most asset-
sensitive name, with EPS growing 33% with a 50 bps move in rates.
Within this context, these are the company-specific catalysts:
• SCHW: The firm is uniquely positioned to take advantage of (1) the RIA opportunity; (2) a trend
towards do-it-yourself-investing; (3) popularity of passive investing; (4) higher interest rates; (5) cost
benefits associated with economies of scale.
• ETFC: Shares could benefit from (1) realignment of legal entities and growth in excess capital; (2)
deferred tax assets that could add to excess capital; (3) higher interest rates.
• AMTD: We like (1) the regulation light model; (2) shareholder friendly management team; (3) and we
see the firm as a potential takeover target. However, we believe (1) TD Ameritrade is too dependent
on trading commissions; (2) has the lowest asset sensitivity among peers; (3) has limited shareholder
voting rights.
Priced as of prior trading day's market close, EST (unless otherwise noted).
All values in USD unless otherwise noted.
For Required Conflicts Disclosures, see Page 48.

Table of contents
Discount brokers are uniquely positioned to grow their client base as more investors are
taking their financial destiny into their own hands ..............................................................3
Currently, discount brokers seem to be the beneficiaries of dissatisfaction with advisors
post the financial crisis. Will the pendulum swing back? Unlikely, in our opinion. ...................3
Rise of the machines – will robo-advisors change the business? We believe so and this
could reduce dependency on human advisors even further .....................................................5
Could discount brokers win the hearts and money of Millennials and Generation X? Yes,
as long as Millennials and Generation X remain unprofitable for advisors to pursue ...............7
We expect more advisors to leave wirehouses, choosing independence and open
architecture instead. This could fuel asset growth at discount brokers ..............................10
Could growth of Independent Registered Investment Advisors (RIAs) continue?
Certainly, and this trend could even accelerate.......................................................................10
Will discount brokers benefit from a transition by RIAs from a commission based to a
fee based business model? We believe so: RIAs have an incentive to grow assets under
management ............................................................................................................................14
Increased popularity of Exchange-Traded Funds could lead to AUM and revenue growth at
discount brokers.................................................................................................................18
How will growth of passive investing impact discount brokers? We believe that ETFs
could add to AUM and revenue growth for discount brokers .................................................18
Investors should not take a position in discount brokers in hopes of higher trading volume..... 22
A) Will trading volumes improve from here on? Difficult to have a strong conviction that
they will....................................................................................................................................22
B) Would we need increased volatility to see an uptick in trading volume? It would help,
but only with a positive economic backdrop ...........................................................................24
C) Could increased demand for ETFs result in more frequent trades by active managers
in order to differentiate themselves from their respective benchmarks? We would have
expected it, but the opposite seems to be happening.............................................................26
D) If you can’t beat them, join them? Did “benchmark hugging” negatively impact
trading volumes? Again, the data is inconclusive ....................................................................28
E) So did the popularity of ETFs contribute to a decline in trading volume, which would
be a permanent issue in our view? We believe that ETFs might have actually helped
volumes....................................................................................................................................29
F) Could another product have contributed to a decline in trading volume? Potentially,
yes, but this would not have impacted volumes significantly..................................................30
Our conclusion: Trading volumes are unlikely to bounce back. We would not base our
investment thesis on increasing volumes ................................................................................31
We expect rising interest rates to lead to significant earnings growth ...............................36
Valuation framework .........................................................................................................38
The Charles Schwab Corporation.............................................................................................38
E*TRADE Financial Corporation ...............................................................................................41
TD Ameritrade Holding Corporation ........................................................................................45
Valuation Matrix.......................................................................................................................47
Initiating on Discount Brokers: From Robo-Advisors to Breakaway Brokers
March 26, 2015 2

Discount brokers are uniquely positioned to grow their client base as more
investors are taking their financial destiny into their own hands
There have been many changes over time that have transformed how companies conduct
their business. These changes are sometimes sociological and sometimes technological. We
believe that both forces are at work now in the discount brokerage business. Consumer
behavior is changing as technology enables individuals to do things that they could not have
done on their own just a decade ago. These days, a vast amount of information is accessible
online by the general public. We also believe that the recent financial crisis has had a deep
impact on the society and has accelerated the “do-it-yourself” movement. After the financial
crisis, investors have become dissatisfied with their financial advisors and are questioning the
value of the advice they receive.
Thus, we believe that we will continue to see more investors leaving their financial advisors
and choosing to self-direct their investments. In addition, the younger generation is less
dependent on face-to-face advice and technological advances can only expedite the DIY
move.
Currently, discount brokers seem to be the beneficiaries of
dissatisfaction with advisors post the financial crisis. Will the
pendulum swing back? Unlikely, in our opinion
We expect continued asset growth at discount brokers as mass affluent investors are
continuing to question whether financial advisors add value.
We believe that it is undeniable that the financial crisis has impacted the “mass affluent”
market in multiple ways. We categorize this market as households with investable assets of
$100,000 to $1 million. The recent financial crisis seems to have changed the behavior of
Americans, who saw a decline in real and perceived wealth. In a sense, individuals who might
have considered themselves “mass affluent” prior to the crisis started perceiving themselves
as middle-income households. These investors have become more cost-conscious.
With their portfolios having lost significant value, investors became more conscious of the
fees they were paying and the advice they were getting. To some, the value they were
deriving from the advice and the fees they were paying for it seemed out of balance. A study
undertaken by Deloitte in 2012 titled “The out-of-sync advisor” seems to support this view.
Based on this survey, the percentage of mass affluent individuals working with an advisor
declined from 42 percent prior to the crisis to 33 percent after the crisis. When asked why
these individuals no longer used a financial advisor, the answers indicated that they either
viewed the costs unjustified or that they had lost confidence in their advisor altogether.
Exhibit 1 below shows this.
Many investors are leaving
their advisors as they are
dissatisfied with the
service. This bodes well for
discount brokers, who have
been “building better
mouse traps”
March 26, 2015 3

Exhibit 1: Large numbers of mass affluent left their advisors as they ascribed little value to the guidance given by them
6%
7%
8%
10%
15%
19%
20%
23%
27%
27%
0% 5% 10% 15% 20% 25% 30%
I thought my financial advisor was not competent
I found another advisor who I thought was better for me
Transitioned to a more conservative portfolio and didn't need advice
anymore
My financial advisor did not offer me the right investment options
The quality ofadvice received was poor/below my expectations
Had more time to manage investments on my own
Realized I enjoy managing investments on my own
Felt doing it on my own would yield better outcomes
Felt the cost offinancial advice was no longer worth it
Didn't trust my advisor anymore, felt they were putting own interests
ahead ofmine
Source: Deloitte; RBC Capital Markets
We believe that the discount brokers were actually the beneficiaries of the financial crisis, as
they appealed to investors who saw little value in the traditional advisor-investor
relationship. Could the pendulum swing back with self-directed investors putting an advisor
behind the wheel? We do not think so for the following reasons. First, with equity markets
having appreciated significantly since the financial crisis, most self-directed investors will
think of themselves as great investor. Consider this: Had you put money to work buying the
broader market as represented by the S&P 500 on January 1, 2009, you would be up 135%
through the end of 2014. That is an annual return of close to 20% over a five-year period.
One could have achieved this return by simply buying an exchange-traded fund (ETF) tracking
the S&P 500. This type of gain is likely to boost investors’ confidence in their abilities.
Furthermore, we believe that investors have become more sophisticated since the financial
crisis. The financial crisis left a deep mark on many investors and drove them to seek to
better understand what had happened to the economy and their wealth. Respected names
such as Lehman Brothers, Bear Stearns, Merrill Lynch ceased to exist as independent entities.
Ponzi schemes such as the one run by Bernard Madoff only added to investor insecurity.
Investors started paying more attention to their portfolio holdings and educating
themselves. We also believe that the financial services companies pushed investor education
as a tool to increase investors’ market participation rate, i.e., to get them to put money to
work again. Discount brokers, who have been growing their client base, were part of this
effort.
Finally, we believe that the discount brokers have created “better mouse traps” to retain
their clients’ assets. There is a theory that advice becomes more important as the clients
build wealth. Discount brokers understand this too. They offer fee-based advisory services in-
house or provide their clients with referral services that match independent advisors with
the discount brokers’ clients. Consequently, wealth management has become an increasingly
important part of their business model, a major change from the commission-oriented
businesses they once were.
March 26, 2015 4

The evolution progresses, and discount brokers continue to introduce disruptive
technologies that have the potential to fundamentally change the wealth management
business. Understanding investors’ desire to be self-directed, but also their need for advice,
discount brokers are expanding their product offering to appeal to the next generation of
investor. We are referring to what some label as “robo-advisors”.
Rise of the machines – will robo-advisors change the business?
We believe so and this could reduce dependency on human
advisors even further
We expect robo-advisors to significantly change how advisors operate their businesses.
While some advisors see these portfolio management tools as a threat, others embrace
them as they believe that these tools can help attract a new client base. Whether advisors
adopt the technology or their clients choose to be self-directed given the powerful new
tools, we believe discount brokers stand to win.
We believe that a new breed of online portfolio management tools (robo-advisors) has the
potential to significantly change how investors manage their assets. The impact on the
financial advisory community could be similar to that which exchange-traded funds have had
on the mutual fund industry. In the recent past, investors had few options. They could either
be self-directed investors, relying on their own portfolio management skills, or they could
use financial advisors and pay them for their services.
Today, an increasing number of financial service providers are offering technology that could
help investors create portfolios at fees that are just a fraction of what financial investment
advisors charge. This would appeal to the cost sensitive investor, who is likely already using
discount brokers. These households might not have the necessary wealth to get the personal
attention of financial advisors, who charge up to 2% on assets under management for their
services. Certainly, advisors have to charge higher fees on smaller account sizes to remain
profitable. However, this is a drag on performance, leaving both the advisor and the client in
a lose-lose situation. Adding the cost of the funds underlying a portfolio, performance would
have to be north of 2% above the appropriate market benchmark for the investor to recoup
expenses and generate alpha.
Are these online portfolio management tools new? No, they have been around for some
time. The robo-advisors use a number of questions to determine an individual’s financial
situation and relying on modern-portfolio theory and employing algorithms they help an
investor create a portfolio with minimal human intervention. Financial advisors have had
these tools available to them since the late 1990s to create personalized asset allocation
plans for their clients. The big change, however, is the fact that this technology is now being
made available to the public. The biggest advantage of the robo-advisor is cost. Fees range
from none at all to 50 basis points.
Charles Schwab is introducing its own robo-advisor, “Schwab Intelligent Portfolios”, in the
first quarter of 2015 to its retail clients and to registered investment advisors shortly
thereafter. It will offer a number of exchange-traded funds to customers to construct their
portfolios. This will be a Registered Investment Advisor (RIA) offering (RIA advisory account
vs. brokerage account), meaning that it will be a fiduciary-based product. In fact,
management stated that only one of the ETFs it offers on Schwab ETF OneSource passes the
screen to be on this platform. The firm will not charge advisory fees, trading commissions or
account service fees. However, the firm will earn fund-management fees on Schwab’s
proprietary ETFs, platform revenues from third-party ETF providers and will be able to earn a
yield on cash balances held by clients. The ultimate goal is to attract new clients outside of its
Robo-advisors could impact
financial advisors targeting
the mass affluent market
the same way ETFs have
changed the mutual fund
industry. Strong
performance and superior
service will become even
more important than today
March 26, 2015 5

core baby boomer client base, with a focus on the next generation. Clients need to hold at
least $5,000 in assets. Investors with $50,000 in capital will also be able to construct
strategies with this tool that will aim to maximize the after tax return on their portfolio.
TD Ameritrade is taking a different approach with its Veo Open Access platform. It is
providing its clients access to a number of robo-advisors on its trading platform and
functions simply as a custodian. RIAs will have access to these service providers, with the
robo-advisor determining how much control the adviser will have in managing their clients’
assets. TD Ameritrade wants to appeal to advisors who prefer an open architecture. The firm
already has its own basic portfolio construction service called iRebal, but sees a benefit in
having multiple robo-advisors competing for client assets as technology changes quickly.
Their view is that advisors should get to choose which technology best fits their clients’
needs.
E*TRADE offers what it calls its Online Portfolio Advisor. This tool analyzes an investor’s
needs, generates a recommended asset allocation and allows the user to adjust this
allocation manually to that client’s specific needs. The firm introduced this basic product in
2009.
Fidelity, on the other hand, works with Betterment and charges a 25 basis point fee on assets
invested and receives fees for referrals from Betterment. Exhibit 2 below summarizes fees
charged by various robo-advisors.
Exhibit 2: Fees charged by robo-advisors range from none to 50 basis points
Advisor Fees
Betterment 0.15% – 0.35% /annually
FutureAdvisor 0.5% /annually
Jemstep Free for first $25k, $17.99 – $69.99/month depending upon
balance
LearnVest $89 – $399/setup and $19/month
MarketRiders $14.95/month + trading fees
Motif Investing $9.95/trade
Personal Capital 0.49% – 0.89% /annually depending the amount invested
Rebalance IRA 0.50%/annually, $250 setup fee, and trading fees, min
$500/year
Schwab Intelligent Portfolios None, but minimum investments of $5k
SigFig $10/month
TradeKing Advisors 0.25% /annually – Core
0.50% /annually – Momentum
Vanguard Personal Advisor Services 0.30% /annually
Wealthfront Free for first $10k, 0.25%/annually for anything higher
WiseBanyan None (currently in beta)
Source: Investorjunkie.com; RBC Capital Markets
We, too, view this segment of the market as a growth business. It appeals to investors who
are cost conscious, might not have the necessary wealth to be serviced by the larger
established advisors, like to take control over their financials, or just like the convenience of
being able to do their investing on the go. While baby boomers are moving from the
accumulation phase to the capital preservation phase, wealth managers will need to look for
the next growth opportunity. Robo-advisors could appeal to this group, the Generation X and
Millennials.
March 26, 2015 6

What is the potential here? Consider this: Wealthfront launched its services at the end of
December 2011. Today, the firm manages about $1.5 billion of assets (as of the end of
October 2014). Their product also includes daily tax-loss harvesting to maximize investment
returns. In a push for growth, their services have been extended to 501c organizations with
fees on the first $1 million in AUM being waived.
However, one should not think about the “robo-advisor” opportunity as solely a product that
appeals to the mass market. Research by Spectrem Group titled “Advisor Relationships and
Changing Advice Requirements” shows that younger investors across the wealth spectrum –
the mass affluent, the millionaires and the ultra-high net worth investors with investable
assets in excess of $ 5 million – are less satisfied with their advisors than older investors are.
As for the mass affluent, while on average 69 percent of the surveyed expressed satisfaction
with their advisors, that figure dropped to only 56% of the subgroup between the ages of 36
to 44.
Will robo-advisors put human advisors out of work? We do not believe so, but “human
advisors” will have to work harder to retain assets if they are targeting the mass affluent
segment. There could also be fee pressure on them unless human advisors can demonstrate
that they are providing genuine value. However, make no mistake, we believe advisors who
were in the asset gathering business could lose assets. They will have to rethink their
approach and refocus on providing value-added advice.
As for the millionaires and high-net-worth clients, we get the sense that their client base is
looking for more than just financial advice. Talking to high-net-worth advisors, it seems that
half of their time is spent on listening to their client’s personal problems and comforting
them. Furthermore, the average age of this client group is higher than that of the mass
affluent investor. They tend to be less technologically savvy. However, as mass affluent
investors accumulate wealth and become millionaires and high net-worth clients, they might
decide that they want to stay in the driver seat. With continued advancement in technology,
moving to a wirehouse might not be as appealing as it once was. Robo-advisors are already
providing basic tax strategies to minimize the impact of taxes on returns. The next
generation of financial planning software could provide features that even high-net worth
clients might find appealing.
Could discount brokers win the hearts and money of Millennials
and Generation X? Yes, as long as Millennials and Generation X
remain unprofitable for advisors to pursue
Discount brokers, with their low cost structure and heavy usage of technology, could
appeal to Millennials and Generation X, who tend to be self-directed and cost-conscious.
We believe that discount brokers are well positioned to grow their market share. As
discussed earlier, Millenials (formerly known as Generation Y and describing individuals born
in the 1980s and 2000s) and Generation X are tech savvy. Both generations have gone
through various boom and bust cycles, with the dot-com bubble and the recent financial
crisis impacting their views on investments. While views had been expressed just after the
financial crisis of 2008 that baby boomers’ retirement plans were in peril, today, new
research shows that baby boomers may be better off than any generation before them.
Consider this: The S&P 500 at its high before the financial crisis (October 9, 2007) was at
1,565.15. Then the markets started declining. Had you enough liquidity to pay your expenses
and remained invested in the markets owning an index tracking the S&P 500 index, your
portfolio would be up 30% as of January 1, 2015.
Discount brokers are
uniquely positioned to
service the Millennials and
Generation X given their
familiarity and usage of
technology. These ignored
generations could benefit
from a transfer of wealth
as baby boomers age
March 26, 2015 7

Exhibit 3: S&P 500 gained over 30% since its highest point in 2007
Source: FactSet; RBC Capital Markets
However, were you forced to monetize your portfolio, you would have not participated in
this recovery. A study published by the Pew Charitable Trusts titled “Retirement Security
Across Generations” found that early and late baby boomers lost about 28% and 25%,
respectively, of their median net worth from 2007 to 2010. However, Generation X lost
about 45% of their wealth during the same period. Certainly, part of this development can be
probably explained with baby boomers having less equity market exposure as many of them
were nearing retirement age.
The aforementioned study also found that the early boomers might be the last cohort on
track to retire with enough assets. They have acquired enough wealth to replace on average
70% to 80% of their pre-retirement income. This compares to 60% for late boomers and
about 50% for generation X. As for the Millennials, their financial situation is probably worse
as they had a difficult time finding work after leaving college and building net worth.
So should wealth advisors target Generation X and the Millennials? The answer would
depend on their cost structure. Organizations with large overhead costs are better off
focusing on wealthier clients, which is one reason the wirehouses are pushing their advisors
to focus on the wealthier segment. However, discount brokers that rely heavily on
technology could benefit from economies of scale as they are adding accounts.
The Federal Reserve Board’s triennial Survey of Consumer Finances shows that while
Generation X has still a long way to go before it can catch up to latter cohort of baby
boomers, the trend is positive. The average net-worth of households where the age of the
household is between 35 years and 44 years has increased over 6%. This is the strongest
increase among the various cohorts in the study. This growth should bode well for wealth
managers target this cohort – and their custodians.
-
500
1,000
1,500
2,000
2,500
01/10/2005
07/10/2005
01/10/2006
07/10/2006
01/10/2007
07/10/2007
01/10/2008
07/10/2008
01/10/2009
07/10/2009
01/10/2010
07/10/2010
01/10/2011
07/10/2011
01/10/2012
07/10/2012
01/10/2013
07/10/2013
01/10/2014
07/10/2014
+30.6%
Discount brokers have an
edge over traditional
brokers in that their cost
structure allows them to
effectively service the mass
affluent
March 26, 2015 8

Exhibit 4: Average family net worth of 35-44 year old increased over 6% since 2007 ($ in thousands)
Age of head (years) 1989 1992 1995 1998 2001 2004 2007 2010 2013
Less than 35 $46.8 $45.4 $43.2 $63.9 $90.7 $73.5 $106.0 $65.3 $75.5
35–44 $147.6 $133.3 $143.7 $196.5 $260.0 $300.0 $326.3 $217.4 $347.2
45–54 $276.4 $268.9 $296.7 $363.8 $486.3 $543.9 $662.2 $573.0 $530.1
55–64 $307.8 $338.0 $383.5 $532.7 $733.3 $848.6 $941.8 $880.5 $798.4
65–74 $279.8 $286.5 $348.7 $466.7 $678.5 $691.0 $1,015.7 $848.4 $1,057.0
75 or more $241.6 $214.2 $258.3 $310.8 $469.1 $528.1 $638.3 $677.9 $645.2
Source: Federal Reserve Board, Survey of Consumer Finance; RBC Capital Markets
As for the Millennials, they have seen a significant decline in their net worth. Relative to
2007, the median net worth of families lead by individuals 35 years of age or younger
declined by over 28%. So why should wealth advisors go after this group? Because this group
represents a nearly untapped market.
Historically, advisors have shunned this market as it was not profitable given the structure of
the organizations they were affiliated with. However, discount brokers that rely on large
numbers to realize economies of scale could find the Millennials and Generation X a lucrative
market for growth given technological innovations. Independent RIAs who work with these
discount brokers view robo-advisors as an additional revenue stream from a market that
they had not tapped before.
A recent study by Merrill Edge had some interesting findings about the Millennials:
 While most of the mass affluent began saving for retirement at age 33, about 54% of the
Millennials started saving for retirement between the ages of 18 to 24. About 36% of the
Millennials were motivated to save once they started their first jobs. This compares to
15% for the baby boomers.
 As their income level rises, so does their propensity to save. About 28% of the
Millennials reported that a raise or a promotion at work was a motivator to start saving
for retirement. This compares with 10% for baby boomers.
So why aren’t Merrill Lynch and other wirehouses pursuing this target market with more
vigor? Because of their cost structure. While they are casting a net trying to lure mass
affluent customers with certain product offerings to appeal to this group, we get the sense
that wirehouses will continue to provide different level of services based on the client’s net
worth.
Our point is this: While Millennials and Generation X might not be an attractive target
market for wirehouses, this group could boost asset growth at discount brokers that are
willing to provide better service to investors falling below the “$250,000 in investable assets”
threshold. The discount brokers’ heavy use of technology to interact with their clients should
appeal to this group. While the traditional wealth managers are unwilling to service
households below a certain wealth level, discount brokers can do so. As we will discuss
below, this unwillingness has led to the departure of advisors, with an increasing percentage
choosing to become independent instead of moving to another wirehouse. Could Generation
X move “up market” and work with wirehouses once they exceed a certain wealth threshold?
Maybe, but we think it is improbable. Discount brokers are starting to offer advice through
consultants, referral services and some, such as Charles Schwab, provide a full-time money
manager if the client needs more attention. We would expect discount brokers to expand
their product offerings to complement their services to retain clients accumulating wealth –
that is, clients whose needs have evolved.
Our bottom line is this: If advisors are not doing better than the market, we wonder how
long they can attract and retain skeptical investors. With technological advancements, we
would expect the pressure on professional money managers to increase.
March 26, 2015 9

We expect more advisors to leave wirehouses, choosing independence and
open architecture instead. This could fuel asset growth at discount brokers
Discount brokers such as Charles Schwab and TD Ameritrade serve as custodians to
independent Registered Investment Advisors (RIAs). They offer operational support, trading
platforms and, most importantly, a large number of products to chose from, i.e., an open
architecture. Advisors like this as they do not have to push certain mandated products, which
sometimes puts them in a position that could conflict with their fiduciary duties. An increase
in the number of independent advisors should lead to AUM and earnings growth for the
custodians. Likewise, we expect discount brokers to benefit from a move by RIAs to a fee-
based revenue model. This is a “win-win-win” situation in our view as clients, custodians and
advisors all stand to benefit.
Could growth of Independent Registered Investment Advisors
(RIAs) continue? Certainly, and this trend could even accelerate
We expect more advisors to leave wirehouses. This should bode well for discount brokers
that provide custodian services and trading platforms to independent RIAs.
The RIA industry is growing very rapidly as more advisors are leaving the wirehouses for
various reasons: These advisors want to retain more of the revenues they would otherwise
have to share. They leave because they like the open architecture firms such as Charles
Schwab Corp (SCHW) and TD Ameritrade Holding Corp (AMTD) can provide. They do not
want to deal with the pressure put upon them by the wirehouses to eliminate less-profitable
clients or have their clients being serviced by call centers instead.
Some advisors who left the wirehouses complained that the push to move upmarket makes
it less profitable for the advisor to serve the mass affluent clients. Merrill Lynch, for example,
is implementing rules in 2015 that will negatively impact brokers’ payouts if they have a large
number of clients with under $250,000 in household assets. Regulatory changes/scrutiny are
also contributing to departures as some do not like the additional compliance and
administrative burdens that come with being part of a wirehouse.
According to InvestmentNews, a leading provider of news, data, research and events
targeting financial advisors, adviser-move activity is expected to pick up in 2015. They project
that there will be an increase in the assets moving by an average of about 15%. Thus,
assuming that the same ratio of advisers decide to leave the wirehouse channel as in 2014,
there could be a record $64.3 billion of assets these advisers will take with them, as Exhibit 5
below shows.
Advisor-move is expected
to pick up in 2015. This
should provide further
tailwind to discount
brokers, who have been
growing their balance
sheets at a rapid pace
March 26, 2015 10

Exhibit 5: Wirehouse departures could accelerate in 2015 ($ in billion)
$27.1
$35.7
$62.6
$58.7
$55.9
$64.3
$0
$10
$20
$30
$40
$50
$60
$70
$80
2010 2011 2012 2013 2014 2015E
0%
10%
20%
30%
40%
50%
60%
70%
80%
Amount of Total AUM Leaving Wirehouses As % of Total AUM Moving
Source: InvestmentNews; RBC Capital Markets estimates
In addition, existing RIAs are growing their practices faster and adding assets, which helps
their custodians (including discount brokers). RIA assets grew by 19.2% in 2013, following an
increase of 15.5% in 2012, according to InvestmentNews. While some of the growth was
attributable to movements in the markets, a larger portion of the growth seems to be driven
either by new assets that the RIAs did not manage before or an increase in the assets
provided by their existing clients. About 45% of the new assets were from new clients and
another 16% were from existing clients in 2013. As a comparison, about 39% of new assets
were from new clients and 22% of assets were from existing clients in 2012.
We estimate that the assets managed by RIAs were about $2 trillion by the end of 2012.
Assuming a 19.2% growth in 2013, assets would have been around $2.4 trillion. Using the
same assumptions for 2014 and 2015, we would expect RIA assets under management to be
around $3.4 trillion by the end of 2015.
March 26, 2015 11

Exhibit 6: Assets managed by RIAs could reach $3.4 trillion by 2015 ($ in trillions)
$2.0
$2.4
$2.8
$3.4
$-
$0.5
$1.0
$1.5
$2.0
$2.5
$3.0
$3.5
$4.0
2012 2013 2014E 2015E
Source: InvestmentNews; RBC Capital Markets estimates
This estimate could be somewhat conservative if we assume that the growth rate for all RIA
corresponds to what the top 50 RIAs have been able to achieve. Data collected by
InvestmentNews shows that the AUM grew at a CAGR of 23% over the past two years. While
the top 50 fee-only RIAs had assets of $277.8 billion in 2012, that figure increased to nearly
$416.9 billion by 2014.
Exhibit 7: Fee-only IRAs are managing more assets than a few years ago ($ in millions)
Total AUM of the top 50 fee-only RIAs
$277,767
$310,579
$416,855
$-
$50,000
$100,000
$150,000
$200,000
$250,000
$300,000
$350,000
$400,000
$450,000
2012 2013 2014
Source: InvestmentNews; RBC Capital Markets
The increase in assets managed by RIAs could benefit the discount brokers as they act as
custodians for them. Exhibit 8 below shows a ranking by number of RIA clients. While
Schwab (SCHW) and TD Ameritrade (AMTD) were ranked No. 1 and No. 3 in 2012, today,
March 26, 2015 12

these two discount brokers hold the top two ranks as measured by the number of RIA clients.
Discount brokers use the custodian relationship to generate revenue growth through trading
commissions and sale of investment products and services.
Exhibit 8: SCHW and AMTD are top two custodians based on number of RIA relationships
($ in billion)
# of RIA
clients
RIA Assets in
Custody
Schwab Advisor Services 7,000 $1,081.0
TD Ameritrade Institutional 4,500 $300.0
Fidelity Institutional Wealth Services 2,948 n/a
Trade-PMR Inc. 1,525 n/a
Interactive Brokers 1,388 $150.0
Shareholders Service Group 1,255 n/a
Scottrade Advisor Services 1,100 n/a
Pershing Advisors Solutions 562 $106.4
Folio Institutional 325 n/a
Raymond James Investment Advisors Division 285 $100.0
LPL Financial LLC 282 $78.0
Source: InvestmentNews; RBC Capital Markets
Discount brokers as custodians to independent RIAs can benefit in multiple ways. They earn a
custody fee based on AUM and they earn 12b-1 fees when RIAs buy or sell funds. They can
charge service fees if the transaction was placed through a broker; custody fees for certain
type of products (alternative investments, nontransferable securities, physical certificate
custody fees); and referral fees when the broker refers a client to an RIA (which can be up to
25% of fees paid by the client to the RIA). Discount brokers can also charge the fund
manufacturer a “platform fee” for offering the product commission free to clients and, most
importantly, they can earn a net interest margin on the assets the RIA brings with her/him.
March 26, 2015 13

Will discount brokers benefit as RIAs transition from a
commission based to a fee based business model? We believe
so: RIAs have an incentive to grow assets under management
We expect asset growth at discount brokers to remain strong as RIAs transition away from
a transaction oriented business model to a fee based business model. With stickier assets
and a structure that assesses fees based on AUM, we think discount brokers stand to
benefit.
Over the past few years, we have seen an increase in usage of wrap accounts. Under a wrap
account, clients pay an annual or a quarterly fee based on the assets that are being
managed, in lieu of transaction-based commissions. Wrap fees range from 1% to over 2%,
based on the assets the client brings with him or her.
Fee-based assets under management (which includes separately managed accounts, mutual
fund advisory programs, exchange-traded fund advisory programs, unified managed
accounts and brokerage-based managed accounts) have increased from $2.8 trillion in 2012
to about $3.5 trillion in 2013, according to Cerulli Associates. This could be a function of
more advisors becoming independent and opting for a fee-based model. Other reasons could
be that the money is sticky and recurring, more than in a business based on commissions
only. In fact, we came away from discussions with advisors that the commission-based
revenue model could lead to excessive trading, negatively affecting a client’s portfolio return.
These advisors believe that the fee-based model does a better job aligning the client’s
interest with the advisor’s, as both benefit when assets under management rise.
PriceMetrix Insights published a note in 2012 providing some insight into the fee-based
model, which points a growth opportunity. Only 1% of these advisors who participated in the
survey had 90% or more of their clients’ assets in fee-based accounts. Half of the advisors
participating in the survey reported having about 20% of client assets in wrap accounts.
Consequently, there is room to grow. We would expect that this ratio would have increased
by now. There is momentum, as Exhibit 9 below shows the change in of wrap account assets
under management as percentage of total advisor assets under management from 2009 to
2012. Close to 70% of respondents said they have increased usage of fee-based wrap
accounts.
A fee-based business
model provides better
return on assets. Expect
continued adoption of fee-
based models by advisors.
Discount brokers such as
Schwab and TD Ameritrade
are large custodians and
could benefit from cross-
selling opportunities
March 26, 2015 14

Exhibit 9: Fee-based assets as percentage of total assets managed have increased since from
2009 to 2012
10%
21%
33%
15%
17%
4%
0%
5%
10%
15%
20%
25%
30%
35%
Decreased by
more than 5%
Decreased by
less than 5%
Increased by
less than 5%
Increased by
5% to 10%
Increased by
10% to 25%
Increased by
25% or more
%ofAdvisors
Source: PriceMetrix; RBC Capital Markets
Usage of fee-based wrap accounts could grow further from here on, despite the SEC
investigating cases of “reverse-churning”. The SEC complained that there are some cases, in
which a client would have been better off using a discount broker rather than paying wrap
account fees. The advisors failed to demonstrate that they actively managed the account and
thus, charged fees in excess of what the client would have paid in brokerage costs to a
discount broker.
Nonetheless, the economics would indicate that advisors have an incentive to increase usage
of wrap accounts. Not only do wrap accounts lead to more stable earnings, they also seem to
boost revenues. PriceMetrix found out that advisors who increased their usage of fee-based
accounts by 25 percentage points or more have also experienced a revenue growth of 47%
from 2009 to 2012. This compares favorably versus the average growth rate of 25% for all
advisors. Thus, advisors who were more aggressive in moving their clients from a
transactional pricing to a fee-based model benefited from a significant pick-up in revenues.
Revenue on assets can be
boosted significantly by
increasing fee-based assets
March 26, 2015 15

Exhibit 10: Advisors increasing fee-based assets by 25 percentage points or more or saw
average revenue growth of 47% from 2009 to 2012
19%
25%
31%
47%
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
Increased by less than
5%
Increased by 5% to
10%
Increased by 10% to
25%
Increased by 25% or
more
The average fee-based account is 46% larger than a commission-based account ($256,400 vs.
$175,200) and generates revenues that are more than 3x as large ($2,900 vs. $870). Based on
this PriceMetrix study, advisors can significantly boost their revenue on assets, irrespective
of the assets they are managing. Exhibit 11 below shows the increase in revenue on assets
for various cohorts.
Exhibit 11: Advisors increasing fee-based assets by 25 percentage points or more or saw
average revenue growth of 47% from 2009 to 2012
0.92%
0.73%
0.68%
0.59%
0.36%
1.62%
1.48%
1.33%
1.19%
0.79%
0.0%
0.2%
0.4%
0.6%
0.8%
1.0%
1.2%
1.4%
1.6%
1.8%
Less than $100k $100k - $250k $250k - $500k $500k - $1MM $1MM or more
RoA
Households with no fee-based accounts
Households with fee-based accounts
Household investable assets
March 26, 2015 16

We believe that the increase in usage of wrap accounts will benefit discount brokers who
serve as the RIAs custodians. Discount brokers can use the relationships to cross-sell other
products. As more advisors move to a fee-based business model, we would expect an
increase in usage of passive products, such as ETFs.
The use of ETFs can help improve returns in a portfolio due to tax efficiency and lower
expense ratios. A more recent fee-based account product has been the exchange-traded
fund wrap. This is similar to a mutual fund wrap product, with the difference being that the
underlying securities are ETFs versus mutual funds. An ETF Wrap can be discretionary or non-
discretionary, the difference being that the investor decides the asset allocation mix for the
latter. Fees charged for ETF wraps tend to be lower, which could lead to a higher uptake rate.
However, whether the ETF is a component of a wrap account or is a wrap account, we would
expect an increase in growth of passive investing.
March 26, 2015 17

Increased popularity of Exchange-Traded Funds could lead to AUM and
revenue growth at discount brokers
While the advent of ETFs has been a game changer for traditional asset managers, putting
pressure on fees and eventually leading to outflows, we view this as a positive trend for
discount brokers, who could benefit from growth in ETFs. These firms charge the ETF
provider for shelf space and earn fees on commissions when RIAs buy ETFs through a broker
not owned by the discount broker (trade-away fees). Discount brokers also function as
custodians, generating earnings based on the assets they are managing. Schwab, for
instance, earns a “program fee” for up the $250,000 for each ETF on its platform that
participates in ETF OneSource. It also earns an annual asset fee of up to 15 basis points on
the total ETF asset purchased by customers.
How will growth of passive investing impact discount brokers?
We believe that ETFs could add to AUM and revenue growth for
discount brokers
We expect an increase in allocation to ETFs to benefit discount brokers because (1) Schwab
offers its own proprietary ETFs; (2) discount brokers charge commissions if the ETF is not
part of a commission-free platform; (3) discount brokers receive a platform fee from the
manufacturer (revenue sharing); (4) increased popularity of ETFs allows discount brokers to
cross sell other products to those RIAs, who use ETFs to construct client portfolios.
We would expect continued growth in the usage of exchange-traded funds and indexed
funds. As Eric Berg, our asset management analyst has written in his 2015 outlook piece, we
are continuing to see a majority of active asset managers underperform their benchmark.
Performance in 2014 continued to decline.
Exhibit 12: Active managers continued to underperform in 2014
ALL US open-ended funds
Nov-13 Dec-13 Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14 Nov-14
# of funds beating benchmark 2550 2598 2522 2599 2524 2457 2318 2530 2416 2397 2315 2213 2083
# of funds with data 5904 5959 5964 5968 5972 5977 5979 5985 5987 5989 5995 5996 5995
% of funds beating benchmark 43.2% 43.6% 42.3% 43.5% 42.3% 41.1% 38.8% 42.3% 40.4% 40.0% 38.6% 36.9% 34.7%
ALL US open-ended FIXED INCOME funds
ALL US open-ended EQUITY funds
Note: 1-year returns ending in the month. Benchmark used is the primary prospectus benchmark for each fund. Actively managed US mutual funds, ex-index funds. Fund returns exclude sales charges, but include
management, administrative, and 12b-1 fees.
Source: Morningstar, RBC Capital Markets
March 26, 2015 18

Exhibit 13: In only two years did a majority of active managers beat their benchmark
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Note: Benchmark used is the primary prospectus benchmark for each fund. Actively managed US mutual funds, ex-index funds. Fund returns exclude sales charges, but include management, administrative, and
12b-1 fees.
Source: Morningstar, RBC Capital Markets
There are many reasons for this underperformance net of fees: Poor stock picking, incorrect
asset allocation, or simply managers “hugging” their benchmark.
Thus, there could be continued outflows from mutual funds and into passive products,
especially in equities. In fact, we have seen continued outflows from actively managed
domestic equity funds, with domestic equity index funds seeing inflows.
Exhibit 14: Passively funds received $795 billion of inflows cumulatively since 2007 ($ in
billion)
$(800)
$(600)
$(400)
$(200)
$-
$200
$400
$600
$800
$1,000
Jan-07M
ay-07Sep-07Jan-08M
ay-08Sep-08Jan-09M
ay-09Sep-09Jan-10M
ay-10Sep-10Jan-11M
ay-11Sep-11Jan-12M
ay-12Sep-12Jan-13M
ay-13Sep-13
Index domestic equity mutual funds
Domestic equity ETFs
Actively managed domestic equity mutual funds
Note: Cumulative flows and net share issuance to domestic equity funds..
Source: ICI, RBC Capital Markets
While flows into domestic equity actively managed mutual funds have been weak and for the
most part negative, flows have been positive into domestic equity index funds and into
domestic equity ETFs. The column charts below in Exhibit 15 depict this. The result of these
net flows into domestic equity index funds is that index funds tracking either the S&P 500
index or other domestic stock indexes now represent 70% of the assets in index funds.
Moreover, with money consistently flowing into domestic equity index funds, index funds
investing in equities now represent nearly 20% of all assets invested in equity funds.
As active managers
underperform their
benchmarks, ETFs should
see increased demand.
Discount brokers could
benefit from ETF trading
activity
March 26, 2015 19

Exhibit 15: Indexed equity funds are growing
Index fund net flows have been increasing
$21 $18 $17
$31 $28
$11 $14
$28 $31 $25
$14 $18 $15
$52$2 $1 $2
$2 $6
$8
$11
$17
($6)
$4 $19 $17 $16
$28
$2 $8 $7
$2 $7
$8
$8
$16
$10
$27 $24 $20 $29
$34
($20)
$0
$20
$40
$60
$80
$100
$120
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Domestic equity World equity Bond and hybrid
Funds indexed to the S&P 500 held one-third of index mutual fund assets
World equity
12%
Bond and hybrid
18%
Other domestic
equity
37%
S&P 500
33%
c
Note: Net flows shown in $B. Total AUM for indexed mutual funds was $1.7 trillion in 2013.
Exhibit 16: Funds indexed to the S&P 500 held one-third of index mutual fund assets
9.5%
10.2%
10.9%
11.4% 11.7% 11.5% 11.6% 11.8%
13.4%
14.1%
14.9%
16.4%
17.3%
18.4%
5%
7%
9%
11%
13%
15%
17%
19%
21%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Note: Total AUM is $1.7 trillion for indexed mutual funds in 2013.
We believe that the reason domestic equity flows have been negative in three of the four
years ended with 2013 is that more money has been flowing out of actively managed
domestic equity mutual funds than has been coming into the category through domestic
equity index funds. We would expect this trend to continue.
What are the implications? Growth in ETFs could benefit discount brokers, as they benefit
from a move to a fee-based business model by RIAs. Schwab, for instance, offers its own ETFs
and lets customers trade commission free ETFs. TD Ameritrade, on the other hand, allows
customers to trade around 100 ETFs commission free. The motivation is simple. These firms
charge the ETF provider for shelf space and expect to cross-sell other products to the RIAs.
Discount brokers also function as custodians, generating earnings based on the assets they
are managing.
March 26, 2015 20

Schwab, for example, is the custodian serving Mutual Fund Store clients. This is an
interesting story, as Mutual Fund Stores had been a stringent opponent of ETFs until late
2014. More recently, this independent RIA decided to add ETFs to its product offering
starting in 2015. The company, based in Overland Park, Kansas (home of Waddell & Reed)
currently manages about $9.5 billion in client assets and one could expect several hundred
millions of these assets to move into ETFs.
Based on an article published in InvestmentNews in January 5, 2014, Schwab could benefit
from this move. The article mentions, “through its growing OneSource platform and in the
defined-contribution retirement account space, Schwab is one of the biggest players in the
rise of ETFs usage by retail customers.” It allows clients to trade commission free on select
set of funds. Schwab pays Mutual Fund Store a fee for the assets it directs to OneSource, and
gets compensated by the ETF Sponsor for the shelf space. Higher ETF assets under
management could translate into higher earnings. The chart below shows total net assets for
passively managed ETFs in the US.
Exhibit 17: ETF assets under management have grown at a CAGR of 22.7% since 2005
Passively Managed, Long-term ETF AUM
276
382
547
465
686
886
934
1,201
1,474
1,735
0
200
400
600
800
1,000
1,200
1,400
1,600
1,800
2,000
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
AUM($B)
Source: Morningstar; RBC Capital Markets
While assets under management have grown at a compounded growth rate of 22.7% since
2005, assets for actively managed US open ended funds have grown at a rate of 8.5% for the
same time period. As of the end of 2014, ETFs composed about 15% of the combined assets.
We believe there is further growth momentum.
Furthermore, with the proliferation of robo-advisors, we would expect sales of ETFs to
increase. These robo-advisors use ETFs to make asset allocation decisions. There have been
various papers on whether stock selection or asset allocation would result in superior
performance. A recent study by Professor Raghavendra Rau of the University of Cambridge
came to the conclusion that asset selection is indeed resulting in better returns for investors.
Looking at data going back 20 years (1991 to 2011), the author concluded that “asset
allocation strategies yield a superior dispersion in returns than security selection strategies”.
Moreover, asset allocation becomes even more important during times of economic crisis.
This, in turn, seems to favor exchange-traded funds over mutual funds as advisors use these
products for tactical asset allocation strategies.
Despite recent growth, we
estimate that ETFs
comprise only about 15%
of total retail assets in the
US. There is room for
growth
March 26, 2015 21

Investors should not take a position in discount brokers in hopes of higher
trading volume
Having analyzed potential reasons that could explain why trading volumes have declined, we
concluded that while there do not seem to be structural changes, there is also little to
suggest that trading volumes should increase from here on. Recommending shares of a
discount broker in hopes of higher trading volumes would be a difficult proposition. While
we like the optionality of higher trading volumes adding to earnings, we stay away from
basing our investment thesis on the prospect of increasing trading volumes.
We have attempted to answer the question whether trading volumes are down due to
structural changes – which would be a permanent issue – or whether trading volumes could
increase from here on. Tackling this issue from various angles, we were not able to find
conclusive evidence that there are structural changes. This is good news. However, while
investor sentiment has been improving, we have not seen a meaningful improvement in
trading volume. We believe volatility remains the main factor driving trading volume and we
would not expect volatility to increase along with consumer confidence. We simply do not
have a strong conviction that trading volumes will increase.
A) Will trading volumes improve from here on? Difficult to have
a strong conviction that they will
Trading volume is an important revenue metric for discount brokers. As volume rises, so do
the revenues at brokers. As part of our industry note, we wanted to analyze factors that
might have led to a reduction in trading volume witnesses since 2007 and whether this is
temporary, cyclical or structural (i.e., permanent).
A return of volatility to the market could certainly help improve trading volume. However,
there are enough structural changes taking place in the market – the rise of relatively
inactive blend funds, a belief on the part of certain mutual-fund companies that by trading
less they will perform better – that there is reason to think that the malaise in trading
volume will be around for a while. A study undertaken with RBC Asset Management research
sheds light on several important aspects of this complex issue and provides some insights
into what might be behind the dramatic decline in trading volume on Wall Street.
Since the market bottomed in 2009, share trading volume has declined 34%. This includes
trading on all venues in the US: Stock exchanges, dark pools, and the “upstairs” crossing of
trades (privately negotiated transactions executed away from the open markets).
We have not found
structural changes that
could account for declining
trading volume
March 26, 2015 22

Exhibit 18: Volumes in US markets have been declining significantly since 2009
2.46
2.14
1.97
1.59 1.56 1.62
-
0.5
1.0
1.5
2.0
2.5
3.0
2009 2010 2011 2012 2013 2014 YTD*
Shares(Trillions)
Trading volume in US markets across all venues to eliminate impact of volumes migrating between venues
*May-14 YTD annualized, seasonally adjusted
Source: RBC Capital Markets
Focusing on dollar amount of volume only might lead to a false conclusion. Here is why:
Despite the decline in share trading volume, the bull market has increased the average value
of shares traded, and resulted in the dollar amount of volume remaining unchanged since
2009, as shown in Exhibit 19 below.
Exhibit 19: Increasing index levels have led to an increasing average share price
-
500
1,000
1,500
2,000
2,500
3,000
3,500
4,000
$15
$20
$25
$30
$35
$40
$45
Jul-09 Jul-10 Jul-11 Jul-12 Jul-13 Jul-14 S&P500TotalReturnIndexValue
AvgPriceperShareTraded
Avg Share Price Traded
Market Level (SPXT)
Source: BATS; Bloomberg; RBC Capital Markets
March 26, 2015 23

Exhibit 20: Despite the decline in share trading volume, dollar trading volume has remained
constant
-
0.5
1.0
1.5
2.0
2.5
3.0
3.5
-
$10
$20
$30
$40
$50
$60
$70
Jul-09 Jul-10 Jul-11 Jul-12 Jul-13 Jul-14
TradingVolume(TrillionsofShares)
TradingVolume($Trillions)
Total Trading Volume ($T) - LTM
Total Trading Volume (Shares T) - LTM
Source: BATS; RBC Capital Markets
While this could be interpreted as an indication that trading volume has been flat, we think
differently. Consider the following example: if an investor purchased one share of stock for
$1,700 in 2009, and sold it in 2014 for $3,400, that investor would be generating one share
of trading in both 2009 and 2014, but that same initial investment now generates double the
dollar trading volume in 2014 because the value of his investment has appreciated. Following
this line of reasoning, it is clear that share volume is more indicative of underlying “trading
volume” than is dollar volume: the investor did not trade more in 2014, he traded the same
amount as he did in 2009 – one share.
B) Would we need increased volatility to see an uptick in trading
volume? It would help, but only with a positive economic
backdrop
Volatility would help, but it does not entirely explain what drives volume. It is well known
among those on Wall Street that when volatility increases, trading volume improves as well.
Our analysis found that while the two are highly correlated, changes in volatility over the
past six years only explains about half of the changes in trading volume. In fact, as we looked
at the relationship more closely, we found that from 2009 to mid 2014, there have been 27
months in which volatility finished the month at a higher value than it started, and in only 21
of them (78%) did trading volume also increase. Put another way, in almost a quarter of the
instances in our study, volumes did not increase when volatility increased.
We estimate that volatility
explains about 78% of
trading volume. While a
strong driver of
commission revenues at
discount brokers, volatility
in combination with
prolonged declining
markets could be
detrimental
March 26, 2015 24

Exhibit 21: Volume and volatility are highly correlated, but the correlation is far from perfect
-
10
20
30
40
50
60
70
80
90
-
50
100
150
200
250
300
Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14
Volatility(%)
MonthlyTradingVolume(BillionsofShares)
Total Trading Volume (Shares B)
S&P 500 30-Day Historical Volatility
Source: BATS; Bloomberg; RBC Capital Markets
As we examined this relationship more closely, we surfaced an academic paper written by
two Australian PhDs who studied this very subject, concluding that volatility might not be the
ultimate cause of trading volume. The PhDs posit that the true relationship is actually that
both volume and volatility depend on the same underlying news flow.
“Our results support the bidirectional (...) causality between volatility and volume.
(...) where volatility and trading volume are driven by the same underlying latent
news arrival or information flow variable.”
- Hassan Shahzada, Trading Volume, Realized Volatility and Jumps in the Australian
Stock Market, 5/9/2014, Journal of International Financial Markets & Money
So what does this mean? News flow will drive volatility. Absent material events, trading
volumes could remain low. We are in a steady but slow recovery. Thus, we would not expect
much in terms of positive surprises that could lead to higher, sustainable volatility. And we
are not sure whether uncertainty in the markets will lead to consistently higher trading
volumes.
March 26, 2015 25

C) Could increased demand for ETFs result in more frequent
trades by active managers in order to differentiate themselves
from their respective benchmarks? We would have expected it,
but the opposite seems to be happening
Surprisingly, active mutual fund managers are trading less today than in the past. As
investors are increasingly put more of their money into ETFs, one would think that active
mutual fund managers would pursue a more active strategy as a way to differentiate their
fund from passive ETFs. This, in turn, could help trading volumes. However, we found quite
the opposite to be true: Almost all mutual fund sponsors are trading less now than they did
in 2009. Turnover is a metric that tells an investor how much discretionary trading (when a
portfolio manager actively decides to change the weighting of positions in the fund) a fund
manager is doing. Turnover is essentially the percentage of assets in a fund that are sold and
then used to purchase new positions in the same year. Below is a representative sample of
how drastic the decline in turnover has been at several select sponsor firms.
Exhibit 22: Mutual fund sponsors are trading less, some over 50% less, today than they did in
2009
0
10
20
30
40
50
60
70
80
90
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Turnover%
MFS JPMorgan BlackRock Funds Fidelity
One could argue that fund managers trade less in order to generate better performance, i.e.,
expenses are the enemy of returns and alpha generation. If a fund manager decides to trade
less, one would hope he is making this decision because it is in the best interest of the fund’s
investors. The goal should be to improve fund performance. While it is true that trading less
will reduce brokerage commissions paid by the fund, providing a boost to the fund’s NAV,
managers need to weigh this carefully against the cost of holding on to a position that could
be a drag on performance. Put it differently, holding on to shares that are fairly valued could
potentially negatively impact a fund’s performance, more than offsetting savings from
commissions. To test the common hypothesis that less trading (lower turnover) leads to
better fund performance, we sampled over 4,000 mutual funds looking for a relationship
showing that funds with lower turnover perform better than those with higher turnover. Our
Active managers are
trading less today than in
the past, despite the
popularity of ETFs. One
would have expected them
to pursue a more active
trading strategy. So far,
less trading has not
generated better
performance for active
managers
March 26, 2015 26

unexpected finding: We found no relationship between trading level (turnover) and fund
performance.
Exhibit 23: Less trading does not translate into better performance
0
20
40
60
80
100
0 50 100 150 200
Performance(PercentileRankvs.Peers)
Turnover %
Therefore, we do not believe that fund managers could have reduced portfolio turnover in
order to generate performance for their fund. To us, there seems little relationship between
performance and trading volume.
An attempt to reduce fund costs by portfolio managers does not contribute to a decline in
trading volume.
March 26, 2015 27

D) If you can’t beat them, join them? Did “benchmark hugging”
negatively impact trading volumes? Again, the data is
inconclusive
During the decade from 1998 to 2008, fund managers consistently invested a larger
percentage of their fund’s assets in positions that aligned with their benchmark. Active share
is a metric that indicates what percentage of a portfolio is invested differently than the
fund’s respective benchmark index. Active share falls when a fund manager chooses to invest
in positions similar to their benchmark index, a practice known as “benchmark hugging.”
We used a sample of the 30 largest funds in each of the three large cap equity style boxes
and observed how the active share in these funds changed over the past 16 years. The
results were, again, unexpected. Active share declined from 1998-2008 while trading volume
increased; as for the period from 2009-2014, active share remained constant while trading
volume fell. It would make sense that as active share declines, fund managers have fewer
shares to turn over as they reallocate their active selections, so trading volume would
decline. However, this hypothesis simply does not seem to hold true.
Exhibit 24: Benchmark hugging increased from 1998-2008, while trading volume was
increasing, but remained flat as trading volume fell from 2009-2014
40
45
50
55
60
65
70
75
80
85
Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Jan-14
ActiveShare(%)
Large Blend Large Growth Large Value Asset-Weighted Avg (All Equity Style Boxes)
Source: Morningstar; RBC Capital Markets sample of 30 largest funds in each equity style box
So far, we believe that the decline in trading volumes was not driven by the money
managers’ attempt to improve performance by cutting expenses (asset turnover), nor by
“hugging a benchmark,” which should have resulted in lower volumes as there is no need to
trade frequently with this strategy.
We were not able to find a
correlation between
“benchmark hugging” and
a decline in trading
volumes
March 26, 2015 28

E) So did the popularity of ETFs contribute to a decline in trading
volume, which would be a permanent issue in our view? We
believe that ETFs might have actually helped volumes
Exchange-traded funds have been greatly increasing in popularity over the past several years.
ETFs are created simply to mirror indices and thus turn over their positions significantly less
than actively managed funds. Put these two observations together and it seems intuitive that
ETFs would contribute to the decline in trading volume.
Exhibit 25: ETFs have quadrupled their market share over the past decade
0%
2%
4%
6%
8%
10%
Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14
ETFMarketCapasa%ofTotalMarketCap
Source: Bloomberg; RBC Capital Markets
Exhibit 26: ETFs have significantly lower turnover than do mutual funds
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Open-Ended Funds 45% 42% 45% 45% 51% 54% 45% 44% 38% 38% 38%
ETFs 10% 12% 11% 13% 14% 28% 18% 18% 16% 16% 17%
However, taking a closer look at ETFs, we found that the actual impact they have on trading
volume is much less clear-cut. While ETFs certainly have lower turnover within their fund
assets, the ETF shares themselves are traded frequently. In fact, the most frequently traded
ETF (SPY) trades more shares each day than the most frequently traded equity (AAPL).
Additionally, a growing community of ETF arbitrageurs makes a living from taking orders for
ETF shares on one side and buying or selling the underlying basket of shares on the other
side in order to capture minute differences that can emerge between the price of an ETF and
its underlying basket. This simple role they play as intermediaries amplifies trading volume
because when an arbitrageur takes a client order for an ETF share, they necessarily make
another trade in the securities underlying the ETF, effectively doubling the trading volume
that would have existed had a simple ETF share buyer and seller met in the marketplace.
ETFs have lower turnover
within their funds, but the
ETF shares are traded
frequently
March 26, 2015 29

F) Could another product have contributed to a decline in trading
volume? Potentially, yes, but this would not have impacted
volumes significantly
We think that the popularity of blend funds might have contributed somewhat to a decline in
trading volume. Blend funds, mutual funds that combine value and growth stocks in a single
portfolio, control an increasing percentage of all equity mutual fund assets and turnover
their assets significantly less than either their value or growth-focused peers. This migration
of assets from higher-turnover value and growth funds into blend funds with lower turnover
necessarily contributes to the decline in trading volume.
Exhibit 27: In vogue: blend funds control an increasing share of equity mutual fund assets
40%
42%
44%
46%
48%
50%
52%
54%
56%
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
BlendFundAssetsas%ofTotalEquityFundAssets
Exhibit 28: Portfolio turnover is significantly lower in blend funds
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
AnnualPortfolioTurnover%
Growth Funds
Value Funds
Blend Funds
Answering some of the questions posed above, we arrive at a conclusion that seems to
support traditional assumptions. Trading volume picks up with volatility. However, we also
find that professional money managers are trading less than they have in the past. Part of
The increase in popularity
of blended funds could
have contributed to lower
trading
March 26, 2015 30

this change can be attributed an increase in popularity of products such as blend funds.
However, there are also conclusions we drew that might surprise our readers. A reduction in
asset turnover does not translate into better fund performance and the increase in
popularity of ETFs has not contributed to a decline in trading volume, in our view.
Our conclusion: Trading volumes are unlikely to bounce back.
We would not base our investment thesis on increasing volumes
As shown above, we were not able to come to a conclusion on the question we posed above.
We simply do not have an answer as to whether there have been structural changes that
could permanently lead to lower trading volumes. This could be good news. All we could
prove is that a significant portion of changes in trading volume is impacted by market
volatility. Thus, we would expect retail investors to behave like professional money managers
and trade more as volatility increases. While we have seen an uptick in trading volume
towards the end of last year, it is early to argue that volumes will increase from here on. It is
not always the case that trading volumes increase as volatility rises, as depicted below by the
red circles. The circles below depict periods when trading volume did not change with the
move in volatility.
Exhibit 29: While 2014 had one of the best months in terms of trading volume, it also had
one of the worst we have seen since 2013 (monthly trading volume in billion shares)
0
20
40
60
80
100
120
140
160
180
200
220
240
Jan-13
Feb-13
Mar-13
Apr-13
May-13
Jun-13
Jul-13
Aug-13
Sep-13
Oct-13
Nov-13
Dec-13
Jan-14
Feb-14
Mar-14
Apr-14
May-14
Jun-14
Jul-14
Aug-14
Sep-14
Oct-14
Nov-14
Dec-14
$-
$2
$4
$6
$8
$10
$12
$14
$16
$18
$20
Trading Volume in Billions (LHS) Avg. Closing Price VIX (RHS)
Source: BATS; RBC Capital Markets
In fact, we compared volumes on the New York Stock Exchange over time and found out
volumes have not caught up with historical figures, despite the fact that we are in a period of
higher market volatility.
We do not see structural
changes. Trading volume
will continue to be driven
by volatility. However,
prolonged period of
volatility could have a
negative impact on
consumer confidence,
ultimately resulting in
lower trading commission
revenues
March 26, 2015 31

Exhibit 30: Volumes are still subdued despite increased volatility
-
1,000
2,000
3,000
4,000
5,000
6,000
7,000
8,000
2-Jan-04
15-Jun-05
24-Nov-06
9-May-08
20-Oct-09
1-Apr-11
12-Sep-12
27-Feb-14
$-
$20
$40
$60
$80
$100
$120
NYSX Volume (in million shares LHS) VIX (Price -RHS)
Source: New York Stock Exchange; FactSet; RBC Capital Markets
Our thinking is this. Volatility is good for trading, but a prolonged period of market volatility
has had a negative impact on volumes.
Retail investors are still not fully engaged in the markets despite consumer confidence having
improved significantly since 2009. Exhibit 31 below shows the Conference Board’s Consumer
Confidence Index from 2004 to 2014 and trading volume on New York Stock Exchange
excluding block trades, which is institutional in nature versus retail volumes.
Exhibit 31: Consumer Confidence Index has been rising since 2009
0
20
40
60
80
100
120
31-Jan-04
31-Jan-05
31-Jan-06
31-Jan-07
31-Jan-08
31-Jan-09
31-Jan-10
31-Jan-11
31-Jan-12
31-Jan-13
31-Jan-14
-
10,000
20,000
30,000
40,000
50,000
60,000
70,000
80,000
NYSEVolume excl. Block Volume (RHS in million)
Consumer Confidence Index (LHS)
Source: The Conference Board; RBC Capital Markets
March 26, 2015 32

More recent data shows an improvement in consumer confidence, with the Index now
standing at 96.4 in February, up from 93.1 as of the end of December. Thus, given current
levels of market volatility and with an increase in consumer confidence, we would have
expected stronger client engagement.
It used to be the case that when equity markets moved up, retail investors would allocate
more capital to equity mutual funds. Likewise, if equity markets were declining, investors
would pull money out of equities and invest in other asset classes.
This was the case for a long time. Using Morningstar data, we tracked US equity mutual fund
flows going back to 1994. We then overlaid this with changes in the S&P 500. The picture
that emerged is interesting. This pattern described above, with equity values and inflows
going hand in hand, seemed to hold until early 2010. However, starting in 2010, a disconnect
occurred. Equity values continued to rise but flows into equity mutual funds were negative.
Exhibit 32: Retail equity fund flows have not tracked equity market performance since 2010
($15)
($10)
($5)
$0
$5
$10
$15
$20
Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12
-60%
-40%
-20%
0%
20%
40%
60%
Domestic equity net flows, $ bn (lhs) y/y % chg in S&P 500 (rhs)
Note: Retail US equity mutual fund flows shown, excluding ETFs and fund of funds.
Could this break in the historical pattern potentially point to pent-up demand for equities?
We would not put our money to work hoping that there could be pent-up demand.
How does the above data compare to more recent history? While we have seen periods of
allocation to equities, investors continue to be underinvested in equities. Exhibit 33 below
shows net flows into domestic and international mutual funds – we included international
here as this strategy has seen inflows over the past year – and the level of the S&P 500 Index.
While consumer
confidence has improved,
we have not seen large
inflows into equities.
Consumers continue to
hold back
March 26, 2015 33

Exhibit 33: Retail investors are still not engaged in the markets ($ in millions)
$(25,000)
$(20,000)
$(15,000)
$(10,000)
$(5,000)
$-
$5,000
$10,000
$15,000
$20,000
$25,000
Jan-12 Jun-12 Dec-12 May-13 Nov-13 Apr-14 Oct-14
-
400
800
1,200
1,600
2,000
2,400
Mutual Fund Equity Flows (LHS) SPX-Index (RHS)
Source: Investment Company Institute; RBC Capital Markets
Our conclusion on trading volumes is this: While there seem to be no meaningful structural
changes that resulted in lower volumes, we would not rely on increasing trading volumes
from here on in developing an investment thesis.
Consumer confidence is increasing and market performance remains strong. Our Chief US
Market Strategist, Jonathan Golub, expects the S&P 500 to end 2015 at 2,325. That would be
an increase of 12.9% for the year, and this performance could potentially re-engage the retail
client. However, it is also a fact that retail clients remained mostly on the sidelines when the
S&P Index had other great years, such as in 2009, 2010 and 2012 through 2014.
Instead, we would recommend investors focus on value drivers besides trading volume and
accept higher trading volume as an optionality. Historical patterns do not seem to hold in the
current period. Here is why: Exhibit 34 below shows that while consumer confidence has
been rising, trading volumes remain subdued. This becomes evident comparing the period
from 2004 to 2006 to the period post the financial crisis. Furthermore, Exhibit 35 shows that
while the volatility remains elevated compared to the period prior to the financial crisis,
volumes are not back to levels seen prior to the crisis.
March 26, 2015 34

Exhibit 34: While consumer confidence has been rising, we have not seen an increase in
trading activity
0
20
40
60
80
100
120
31-Jan-04
31-Jan-05
31-Jan-06
31-Jan-07
31-Jan-08
31-Jan-09
31-Jan-10
31-Jan-11
31-Jan-12
31-Jan-13
31-Jan-14
-
2,000
4,000
6,000
8,000
10,000
12,000
14,000
NYSEGroup Block Share Volume (RHS, in millions)
Consumer Confidence Index (LHS)
Source: The Conference Board; NYSE; RBC Capital Markets
Exhibit 35: Volatility remains elevated (VIX), but trading volumes are still low relative to the
period prior to the financial crisis
-
2,000
4,000
6,000
8,000
10,000
12,000
14,000
31-Jan-04
31-Jan-05
31-Jan-06
31-Jan-07
31-Jan-08
31-Jan-09
31-Jan-10
31-Jan-11
31-Jan-12
31-Jan-13
31-Jan-14
31-Jan-15
$-
$10
$20
$30
$40
$50
$60
$70
VIX (Price, RHS)
NYSEGroup Block Share Volume (LHS, in millions)
Source: FactSet; NYSE; RBC Capital Markets
March 26, 2015 35

We expect rising interest rates to lead to significant earnings growth
We believe that investors anticipating rising interest rates ought to consider discount
brokers. Having analyzed three publicly traded discount brokers, we do expect a significant
increase in earnings as rates move higher.
Given our economist’s constructive view on the economy and expectation of higher interest
rates this year, we would be buyers of discount brokers. Our outlook is for the three-month
treasury rate to rise to 90 basis points (bps) by the end of 2015 and to 280 bps by the end of
2016. Tom Porcelli, our Chief US economist at RBC Capital Markets, also expects the two-
year Treasury note to move from 66 bps as of the end of 2014, to 200 bps in 2015 and
further to 320 basis points by 2016.
Discount brokers tend to have a portfolio duration of around two years, allowing them to
benefit fairly quickly from rising interest rates. Michael Cloherty, Head of US Rates Strategy
at RBC Capital Markets, expects that the Fed could start increasing rates slowly as early as
this summer. Cloherty argues that the Fed will be treading carefully in order not to negatively
impact the economic recovery and that it needs to learn to use its new tools like the Interest
on Excess Reserves (IOER) and Reverse Repurchase Agreements (RRPs) in an utterly changed
regulatory environment. Furthermore, the massive volatility we saw on October 15, 2014
suggests the market will not be able to handle rapid tightening, and as the Fed can't move
rapidly without shocking the markets, it will need to start tightening its monetary policy well
before inflation appears. Thus, it is our rate strategist’s view that a slow controlled monetary
tightening could be implemented before the economy encounters significant inflationary
pressure.
How would higher interest rates impact discount brokers? There are two components of
earnings sensitivity. Charles Schwab, for instance, earns management fees on its proprietary
money market funds. The firm had to waive management fees in order to ensure that
investors would not be left with negative yields after taking management fees into
consideration. Thus, higher rates would result in lower fee waivers and higher earnings.
Furthermore, discount brokers manage their balance sheets similar to banks in that they
generate spread-based earnings by using their clients’ deposits to earn a portfolio yield. An
increase in interest rates could lead to net interest margin expansion.
We have modeled the earnings sensitivity around a 50 bps increase in interest rates, and the
results are shown in the chart below.
March 26, 2015 36

Exhibit 36: Estimated impact on 2014 normalized EPS with a 50 bps rise in interest rates
32.6%
21.4%
8.9%
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
35.0%
SCHW ETFC AMTD
Source: RBC Capital Markets estimate
The analysis assumes a margin of 75% on incremental revenues and a 38% tax rate.
Accordingly, we would expect Charles Schwab to be the main beneficiary of higher rates.
However, one should not ignore the impact on earnings for all three discount brokers. As the
exhibit above shows, earnings could pick up significantly due to rising interest rates. We
would recommend that investors positioning their portfolios for higher rates consider this
sector. Additionally, there are also secular trends that should drive strong earnings growth.
We discuss these below.
March 26, 2015 37

Valuation framework
We value are valuing Discount Brokers using a forward-looking P/E multiple approach. We
understand that there are biases to this approach as P/E multiples can be overly high during
bull markets and depressed during bear markets. We are trying to compensate for this by
applying a long-term average P/E multiple. We are calculating our price target by applying
the multiples on 2016 estimated earnings. We are then discounting the resulting valuation
such that our price target is where we would expect the shares to trade 365 days from today.
The Charles Schwab Corporation
Our 12-month price target for The Charles Schwab Corporation is $38. We arrive at our price
target using a price-to-earnings multiple of 26.0x on our 2016 calendar year earnings
estimate of $1.58 per diluted weighted average shares. We then discount the resulting
valuation using a cost of equity of 10.7%. The discount rate is based on a beta of 1.68x, a risk-
free rate of 4%, and a market premium of 4%. The discount period is 0.8 years. This leads us
to our price target of $38.
Exhibit 37: Price target based on one-plus-a-half-methodology
Valuation
CY 2016 EPS $1.58
P/E Multiple 26.0x
Valuation $41
Price target - PV $38
Source: RBC Capital Markets estimates
Our $38 base case scenario valuation is based on these assumptions for 2016: Net interest
margins of 175 bps by the year 2016; interest-earning assets of $162.9 billion; total funding
sources of $158.3 billion; daily average revenue trades of 319,000; average revenue per
revenue trade of $12.05; and a pre-tax margin of 44.7%. We believe a 26x P/E multiple is
justified given historical valuation.
March 26, 2015 38

Exhibit 38: Historical P/E multiple averages prior and post the financial crisis are fairly similar
0.0x
10.0x
20.0x
30.0x
40.0x
50.0x
60.0x
04/21/2003
11/13/2003
06/15/2004
01/10/2005
08/08/2005
03/07/2006
10/02/2006
05/02/2007
11/27/2007
06/25/2008
01/22/2009
08/19/2009
03/18/2010
10/13/2010
05/11/2011
12/06/2011
07/05/2012
02/04/2013
08/30/2013
03/31/2014
10/24/2014
P/EMultiple
We have looked at P/E multiples going back to April 2003. On average, shares of SCHW have
traded at a 26.4x P/E multiple. The average P/E multiple prior to 2008 was 26.3x, as well. As
for the period post the financial crisis, our data shows that SCHW has been trading at an
average P/E multiple of 25.6x. We are utilizing a long-term historical average of 26.0x P/E
multiple to arrive at our price target.
Price target impediments
Prolonged period of low interest rates
Our price target assumes that interest rates will rise. The company is the most asset-sensitive
among its peers in our view. Consequently, we would have to adjust our price target and our
earnings estimate should interest rates remain low for a prolonged period. This could lead to
a decline in net interest margins. Furthermore, should interest rates remain low for a
prolonged period and the economic recovery slow down or reverse, clients could move their
investments back onto the company’s balance sheet in the form of cash. The firm would
have to hold additional capital for these assets.
Unforeseen regulatory changes could impact profitability
The Dodd-Frank Act had a tremendous impact on the financial services industry. With the
elimination of the Office of Thrift Supervision, The Charles Schwab Corporation came under
the supervision of the Federal Reserve and the OCC became the primary regulator of Schwab
Bank. As the company points out, there are multiple studies mandated by the new legislation
that could result in additional legislative or regulatory action. This could affect how the
company conducts its business, the growth trajectory, and ultimately profitability.
Balance sheet growth below our expectation could lead to earnings shortfall
The discount brokerage business is characterized by intense competition. Peers may attempt
to gain market share by reducing trade commissions, offering higher yields on deposits and
lower interest rates on loans, or reducing the fees they are charging for services. The firm
also faces competition from wirehouses and traditional banks. Increased competition could
lead to lower asset growth and a decline in profitability.
March 26, 2015 39

Losses from credit exposure could negatively impact shares
The company is subject to counterparty risk. Its exposure results from margin lending,
clients’ options trading, securities lending, and mortgage lending. The firm has exposure to
credit risk through its investments in US agency and non-agency mortgage-backed securities,
corporate debt securities, and commercial paper, among others. Loans to clients are in the
form of mortgages and home equity lines of credit. A deterioration of the credit portfolio
could result in increased loan provisions and charge-offs, and could negatively impact the
company’s share price.
Drop in consumer confidence
A decline in trading volume could negatively impact commission revenues and earnings.
Trading volume is to a high degree dependent on market volatility. However, a prolonged
period of market volatility in declining markets could lead to a decrease in consumer
confidence and thus trading activity.
Sharp decline in equity markets
The firm earns asset management-related revenues based on assets it manages in its
proprietary funds and through fees on RIA assets. A sharp decline in markets could lead to
lower asset management-related earnings. Furthermore, clients could start withdrawing
funds based on fears about the direction of the market. This would result in lower topline
growth, a decline in margins, and earnings growth below our projection.
March 26, 2015 40

E*TRADE Financial Corporation
Our approach for E*TRADE Financial is slightly different in that we are adding the value of
the deferred tax assets to our P/E multiple based valuation methodology.
Our 12-month price target for E*TRADE is $35. We arrive at our price target using a price-to-
earnings multiple of 23.0x on our 2016 calendar year earnings estimate of $1.55 per diluted
weighted average shares. We then discount the resulting valuation using a cost of equity of
11.0%. The discount rate is based on a beta of 1.9x, a risk free rate of 4%, and a market
premium of 4%. The discount period is 0.8 years.
Furthermore, we discount the $951 million of deferred tax assets (DTAs) assuming that these
will be realized over a four-year period. We discount the DTAs using a cost of equity of
11.0%. Furthermore, we take a 10% haircut to compensate for a margin of error in respect to
the timing. We estimate that the DTAs could be worth approximately $2. This leads us to our
price target of $35.
Exhibit 39: Price target based on one-plus-a-half-methodology
Valuation
CY 2016 EPS $1.55
P/E Multiple 23.0x
Valuation $36
Valuation - PV $33
Value of DTA 2
Price target - PV $35
Source: Company reports; RBC Capital Markets estimates
Our $35 base case scenario valuation is based on these assumptions for 2016: Net interest
margins of 283 basis points by the year 2016; average enterprise interest-earning assets of
$47.8 billion; daily average revenue trades of 175,776; average revenue per revenue trade of
$11.00; a pre-tax margin of 34.0%. We believe a 23x P/E multiple is justified given historical
valuation.
Deferred tax assets valuation
E*TRADE Financial Corporation had $951 billion of deferred tax assets (DTAs) as of 4Q/14.
DTAs were driven by the losses the company had to take on its investment portfolio, which
had peaked at $32 billion in 2007, and a debt exchange of zero coupon convertible
debentures for interest bearing debt in 2009. Today, about $323 million of the approximately
$1 billion of DTAs are at the parent company. E*TRADE Financial expects its subsidiaries to
reimburse the parent for the use of its deferred tax assets. There is value to the DTAs as they
can be used to offset income.
The company has not established an allowance against its federal deferred tax assets, which
in our view is an indication that management believes the full DTA amount is available for
use. In fact, the firm expects to realize the majority of its existing federal deferred tax assets
within the next four years.
DTAs are a source of future cash that, ultimately, will be held at the parent company, as
subsidiaries will have to reimburse the parent for using the DTA. The following exhibit shows
the impact of the DTAs on cash tax expenses. The company showed GAAP tax expenses of
$159 million for 2014. However, cash outlays to meet the tax liabilities were only about $4
million for this period. We expect the firm to fully utilize the deferred tax assets by 2018.
Thus, we estimate the value of the DTAs to be about $2 per share.
We estimate that deferred
tax assets (DTAs), which we
have incorporated into our
valuation, should be worth
about $2 per share
March 26, 2015 41

Exhibit 40: We estimate the present value of DTAs per share to be around $2
Valuation of Potential Deferred Tax Assets
DTA, net ($ mm) $951
Assumed discount rate (cost of equity): 11.0%
Assumed utilization period 4.0 years
($ in million) 1 2 3 4
Est DTA usage $233.3 $275.9 $363.7 $78.1
Discount factor 0.90 0.81 0.73 0.66
Discounted cash flow $210.2 $224.0 $266.0 $51.5
PV of cash flows ($ mn): $751.6
Haircut: 10%
Estimated DTA value: $676.4
Shares outstanding (in million): 294
PV of DTA assets per share $2.30
Years
Source: RBC Capital Markets estimates
To arrive at our valuation, we assumed that the firm would be able to use up the deferred
tax assets of $951 million over a period of four years. In addition, to be conservative, we
used a 10% haircut in order to adjust for any timing errors. We discounted the resulting cash
savings by the company’s cost of equity, which we estimate to be around 11.0%.
Why we chose a PE multiple of 23.0x
We have looked at P/E multiples going back to April 2003. On average, shares of ETFC have
traded at a 23.1x P/E multiple since April 2003. The average P/E multiple prior to 2008 was
15.9x. As for the period post the financial crisis, our data shows that ETFC has been trading at
an average P/E multiple of 32.9x. However, P/E multiples have been elevated recently given
weak earnings and investor expectations that there could be some positive catalysts
regarding the firm’s capital management plans. The shares of ETFC have been trading at an
average P/E multiple of 23.1x since the beginning of this year. More recently, we have seen
an uptick in the P/E multiple, which stands at 25.7x as of March 10
th
. However, we are taking
a longer term view and believe that the 23.0x P/E multiple is appropriate.
March 26, 2015 42

Exhibit 41: ETFC’s current P/E multiples seem elevated relative to the period leading to the
financial crisis
0.0x
10.0x
20.0x
30.0x
40.0x
50.0x
60.0x
70.0x
80.0x
90.0x
04/21/2003
11/12/2003
06/10/2004
01/05/2005
08/02/2005
02/28/2006
09/22/2006
04/23/2007
11/14/2007
06/12/2008
01/07/2009
08/04/2009
03/02/2010
09/24/2010
04/20/2011
11/14/2011
06/12/2012
01/09/2013
08/06/2013
03/04/2014
09/26/2014
P/EMultiple
Priced as of market close ET, March 24, 2015.
Price target impediments
Drop in consumer confidence & commissions
A decline in trading volume and commission rates could negatively impact commission
revenues and earnings. Trading volume is, to a high degree, dependent on market volatility.
Usually, higher volatility would contribute to higher trading volume. However, a prolonged
period of market volatility in declining markets could lead to a decrease in consumer
confidence and thus trading activity. E*TRADE could be forced to reduce commission rates
for its most active customers. Furthermore, margin borrowing/lending could decline
significantly, leading to earnings shortfall.
Prolonged period of low interest rates
A prolonged low interest rate environment could compress net interest margins. We are
assuming a gradual increase in interest rates over the coming years. A sharp increase in
short-term interest rates could be detrimental to the firm, as its assets seem to have a longer
duration than its liabilities. This could lead to a net interest margin compression and earnings
below our estimate.
Unforeseen regulatory constraints could impact valuation
E*TRADE is a highly regulated entity. The holding company depends on dividend payments
from its subsidiaries to pay for its debt obligations. Any regulatory action that could limit the
company’s ability to “dividend-up” capital to the holding company could negatively impact
the firm’s financial condition and have a direct impact on the firm’s ability to buy back shares
or pay dividends. While the firm does not pay dividends at this time, we are assuming that
the firm will commence paying dividends in 2016.
March 26, 2015 43

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