Discount Brokers Initiation

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H RBC Capital Markets, LLCBulent Ozcan, CFA (Analyst)(212) [email protected]

March 26, 2015

Initiating on Discount Brokers: From Robo-Advisorsto Breakaway BrokersFavorable secular trends bode well for discount brokersWe initiate coverage on the discount brokers with a favorable outlook. This initiation includes coverageof 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 forecastingaverage earnings growth (CAGR) of 21.5% over the next three years for these three companies, givensecular trends driving assets to the Discount Brokers, as well as the forecast increase in short-terminterest rates that should benefit money market fund earnings.

Discount brokers are uniquely positioned to grow their client base as more investors aretaking 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 investableassets of $250,000 or less or accept lower payouts. The increase in independent RegisteredInvestment 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 stickyassets. 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 conclusiveevidence as to whether volumes could increase from here on. Our conclusion is investors should lookat 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) costbenefits 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 wesee the firm as a potential takeover target. However, we believe (1) TD Ameritrade is too dependenton trading commissions; (2) has the lowest asset sensitivity among peers; (3) has limited shareholdervoting 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 of advice 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 of financial advice was no longer worth it

Didn't trust my advisor anymore, felt they were putting own interests

ahead of mine

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 FeesBetterment 0.15% – 0.35% /annuallyFutureAdvisor 0.5% /annuallyJemstep Free for first $25k, $17.99 – $69.99/month depending upon

balanceLearnVest $89 – $399/setup and $19/monthMarketRiders $14.95/month + trading feesMotif Investing $9.95/tradePersonal Capital 0.49% – 0.89% /annually depending the amount invested

Rebalance IRA 0.50%/annually, $250 setup fee, and trading fees, min

$500/yearSchwab Intelligent Portfolios None, but minimum investments of $5kSigFig $10/monthTradeKing Advisors 0.25% /annually – Core

0.50% /annually – MomentumVanguard Personal Advisor Services 0.30% /annually

Wealthfront Free for first $10k, 0.25%/annually for anything higherWiseBanyan 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

01/1

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005

07/1

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005

01/1

0/2

006

07/1

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006

01/1

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007

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010

07/1

0/2

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07/1

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0/2

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01/1

0/2

014

07/1

0/2

014

+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 $75.535–44 $147.6 $133.3 $143.7 $196.5 $260.0 $300.0 $326.3 $217.4 $347.245–54 $276.4 $268.9 $296.7 $363.8 $486.3 $543.9 $662.2 $573.0 $530.155–64 $307.8 $338.0 $383.5 $532.7 $733.3 $848.6 $941.8 $880.5 $798.465–74 $279.8 $286.5 $348.7 $466.7 $678.5 $691.0 $1,015.7 $848.4 $1,057.075 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

% o

f A

dvis

ors

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 accountsHouseholds 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

# of funds beating benchmark 1449 1518 1404 1572 2022 1363 2040 1838 2917 2332 1720 2736 2457

# of funds with data 2933 3089 3253 3434 3637 3921 4234 4523 4811 5031 5354 5731 5800

% of funds beating benchmark 49.4% 49.1% 43.2% 45.8% 55.6% 34.8% 48.2% 40.6% 60.6% 46.4% 32.1% 47.7% 42.4%

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-

07

May

-07

Sep

-07

Jan-

08

May

-08

Sep

-08

Jan-

09

May

-09

Sep

-09

Jan-

10

May

-10

Sep

-10

Jan-

11

May

-11

Sep

-11

Jan-

12

May

-12

Sep

-12

Jan-

13

May

-13

Sep

-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. Source: ICI, RBC Capital Markets

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. Source: ICI, RBC Capital Markets

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

547465

686

886934

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

AU

M (

$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

2.141.97

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*

Shar

es (

Trill

ion

s)

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-14S&

P 5

00

To

tal R

etu

rn In

de

x V

alu

e

Avg

Pri

ce p

er

Shar

e T

rad

ed

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

Trad

ing

Vo

lum

e (T

rilli

on

s o

f Sh

ares

)

Trad

ing

Vo

lum

e ($

Tri

llio

ns)

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

Vo

lati

lity

(%

)

Mo

nth

ly T

rad

ing

Vo

lum

e (

Bil

lio

ns

of

Sh

are

s)

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

Turn

ove

r %

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

Per

form

ance

(P

erce

nti

le R

ank

vs. P

eers

)

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

Act

ive

Sh

are

(%

)

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

ETF

Mar

ket

Cap

as

a %

of

Tota

l Mar

ket

Cap

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

Blen

d Fu

nd A

sset

s as

% o

f Tot

al E

quit

y Fu

nd A

sset

s


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

An

nu

al P

ort

folio

Tu

rno

ver

%

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)

020406080

100120140160180200220240

Jan

-13

Feb

-13

Mar

-13

Ap

r-1

3M

ay-1

3Ju

n-1

3Ju

l-1

3A

ug-

13

Sep

-13

Oct

-13

No

v-1

3D

ec-1

3Ja

n-1

4Fe

b-1

4M

ar-1

4A

pr-

14

May

-14

Jun

-14

Jul-

14

Au

g-1

4Se

p-1

4O

ct-1

4N

ov-

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-J

an-0

4

15

-Ju

n-0

5

24

-No

v-0

6

9-M

ay-0

8

20

-Oct

-09

1-A

pr-

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

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120

31-J

an-0

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-

10,000

20,000

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80,000

NYSE Volume 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. Source: Morningstar; RBC Capital Markets

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-J

an-0

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an-0

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-

2,000

4,000

6,000

8,000

10,000

12,000

14,000

NYSE Group 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-J

an-0

4

31-J

an-0

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an-0

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an-0

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31-J

an-0

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an-0

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an-1

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an-1

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31-J

an-1

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an-1

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an-1

4

31-J

an-1

5

$-

$10

$20

$30

$40

$50

$60

$70

VIX (Price, RHS)

NYSE Group 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 $1.58P/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

04/2

1/2

003

11/1

3/2

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10/2

4/2

014

P/E

Multip

le

Source: FactSet; RBC Capital Markets

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


Valuation $36

Valuation - PV $33Value of DTA 2


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) $951Assumed 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 $78.1Discount 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): $751.6Haircut: 10%Estimated DTA value: $676.4Shares 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

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90.0x

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P/E

Multip

le

Priced as of market close ET, March 24, 2015. Source: FactSet; RBC Capital Markets

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

Balance sheet growth below our expectation could lead to an earnings miss Changes in average balances, especially client margin, could impact operating results. Revenues could fall short of our expectation were balance sheet growth to slow significantly or decline.

The company has significant exposure to mortgage loans, which could result in losses E*TRADE had a loan portfolio of $6.4 billion as of the end of 2014. This figure includes a home equity loan portfolio of about $2.8 billion and a one-to-four-family loan portfolio of about $3.1 billion. Performance of the loan portfolio can vary and the provisions for loan losses might not be adequate. Deteriorating performance could impact customer retention, earnings, book value and valuations of the company’s common shares.

Sharp decline in securities markets & deterioration in credit markets/housing A sharp decline in securities markets could lead to losses as the value of collateral held in connection with margin receivables would decline. This could create collection issues with the margin receivable accounts, which could lead to an earnings shortfall. Likewise, the company continues to have sizeable exposure to the housing market via its portfolio of one- to four-family loans, home equity loans, and consumer loans. Deteriorating credit/housing markets could lead to a sharp increase in provisions and a decline in earnings.

Deferred tax assets might not be realized The firm has about $1.2 billion of deferred tax assets. E*TRADE might have to establish a valuation allowance against these reserves if it determines that not all of these assets will be realized. This could negatively impact earnings and valuation.


March 26, 2015 44

TD Ameritrade Holding Corporation Our 12-month price target for TD Ameritrade is $43. We arrive at our price target using a price-to-earnings multiple of 24.0x on our 2016 calendar year earnings estimate of $1.92 per diluted weighted average shares. We then discount the resulting valuation using a cost of equity of 8.9%. The discount rate is based on a beta of 1.24x, 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 $43.

Exhibit 42: Price target based on one-plus-a-half methodology

Valuation


Valuation $46.01


Source: Company reports; RBC Capital Markets estimates

Our $43 base case scenario valuation is based on these assumptions for 2016: Net interest margins of 163 basis points by the year 2016; average spread-based balances of $110.5 billion; average market fee-based investment balances of $187.4 billion; daily average revenue trades of 457,873; average revenue per revenue trade of $12.50; a pre-tax margin of 41.0%. We believe a 24x P/E multiple is justified given historical valuation.

Exhibit 43: While P/E multiples have declined post the financial crisis, we have seen an improvement over the past 2 years

Priced as of market close ET, March 24, 2015. Source: FactSet; RBC Capital Markets

We have looked at P/E multiples going back to April 2003. On average, shares of AMTD have traded at a 24.2x P/E multiple. The average P/E multiple prior to 2008 was 25.9x. As for the period post the financial crisis, our data shows that AMTD has been trading at an average P/E multiple of 18.5x. We believe that the decline in the average P/E multiple post the financial crisis is due to the fact that the company’s revenues are significantly exposed to trading


March 26, 2015 45

volume. With an improvement in consumer sentiment and trading volume, we have seen an uptick in the P/E multiple. Currently, the shares are trading at a 25.5x P/E multiple. Thus, we believe taking a longer-term view and using the historical average of 24x P/E multiple is appropriate.

Price target impediments Drop in consumer confidence & commissions A decline in trading volume and commission rates could negatively affect 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.

Prolonged period of low interest rates A prolonged low interest rate environment could compress net interest margins. We assume 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 the firm’s 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 changes could impact profitability TD Ameritrade is “lightly” regulated compared to its peers, as it outsources its banking activities to TD Bank. TD Ameritrade is considered a non-bank subsidiary of TD Bank under the Bank Holding Company Act of 1956. Should the firm be subject to tighter regulation, we would expect it to change its stated capital return policy of 40 percent to 60 percent of its earnings to investors. This would result in a decline in dividends and share buybacks, negatively affecting valuation. Regulatory changes are difficult to predict and the outcome of any review is uncertain. The SEC is currently investigating the “payment for order flow” practice and whether broker–dealers provide best execution. An elimination of this practice could affect revenues. The firm received $304 million in payment for order flow in 2014.

Balance sheet growth below our expectation could lead to an earnings miss Changes in average balances, especially client margin, credit, insured deposit account, and mutual fund balances affect operating results. Revenues could fall short of our expectation were balance sheet growth to slow significantly or decline.

There are certain benefits that the firm derives from its relationship with TD Bank. Earnings could decline should TD Bank terminate/modify its relationship with TD Ameritrade TD Ameritrade has entered an insured deposit account agreement with TD Bank, which allows the firm to generate revenues without having to hold a significant amount of capital against client deposits. Net revenues related to this agreement contributed about 26% of total revenues in 2014. TD Ameritrade would have to hold a significant amount of capital should this agreement be terminated. Revenues would decline, as TD Ameritrade would have to move the cash into segregated cash accounts. These tend to have much lower yields than what the firm can generate by using TD Bank as its sweep option.

Sharp decline in equity markets A sharp decline in equity markets could lead to loss of consumer confidence and a reduction in daily revenue trades, below our estimate. This could affect earnings negatively as trading revenues comprise about 43% of total net revenues.


March 26, 2015 46

Valuation Matrix

`

Market Current Price 52-week Div. Enterprise Implied

Company Ticker Rating Cap ($m) Price Target High Low Yield Value ($m) 2014A 2015E 2016E 2014A 2015E 2016E 2014A 2015E 2016E Total Upside

Discount Brokers

Charles Schwab Corp SCHW Outperform $39,056 $29.79 $38 $31.73 $23.35 0.81% $19,224 $0.95 $1.10 $1.58 $0.95 $1.09 $1.54 24.5x 26.9x 18.9x 28.4%

TD Ameritrade Holding Corp AMTD Sector Perform 20,247 37.25 43 38.74 28.34 1.61% 16,285 1.46 1.61 1.92 1.46 1.67 2.09 20.8x 23.4x 18.6x 17.0%

E*Trade Financial Corp ETFC Outperform 7,996 27.59 35 28.65 18.20 0.00% 11,954 1.12 1.29 1.55 1.12 1.12 1.47 22.5x 24.1x 18.3x 26.9%

Interactive Brokers Group, Inc IBKR -- 1,978 33.83 -- 34.56 20.35 1.18% (10,777) -- -- -- 0.51 1.24 1.45 25.6x 26.6x 22.7x --

Mean -- -- -- -- -- 0.81% -- -- -- -- -- -- -- 23.4x 25.3x 19.7x 24.1%

Median -- -- -- -- -- 0.81% -- -- -- -- -- -- -- 23.5x 25.4x 18.8x 26.9%

Min -- -- -- -- -- 0.00% -- -- -- -- -- -- -- 20.8x 23.4x 18.3x 17.05%

Max -- -- -- -- -- 1.61% -- -- -- -- -- -- -- 25.6x 26.9x 22.7x 28.4%

S&P 500 $18,512,397 $2,091.50 $2,119.59 $1,814.36 2.01% na na na na na na na na na na na

S&P 500 / Asset Mgmt & Custody Banks 239,328 $224.32 229.79 188.92 1.81% na na na na na na na na na na na

S&P Comp. 1500 / Asset Mgmt & Custody Banks 263,626 $242.91 247.39 205.51 1.84% na na na na na na na na na na na

S&P Mid Cap 400 / Asset Mgmt & Custody Banks 20,718 $433.34 439.45 352.88 2.26% na na na na na na na na na na na

S&P 500 / Financials 3,000,214 $328.61 337.84 286.83 1.81% na na na na na na na na na na na

Bulent Ozcan, CFA (212) 863-4818

Priced as of market close ET, Mar-24-2015 [email protected]

Source: Company reports, FactSet, RBC Capital Markets estimates

P/EConsensus CY EPSCY EPS Estimates

Discount Brokers Coverage


March 26, 2015 47

Required disclosuresConflicts disclosuresThe analyst(s) responsible for preparing this research report received compensation that is based upon various factors, includingtotal revenues of the member companies of RBC Capital Markets and its affiliates, a portion of which are or have been generatedby investment banking activities of the member companies of RBC Capital Markets and its affiliates.

Please note that current conflicts disclosures may differ from those as of the publication date on, and as set forth in,this report. To access current conflicts disclosures, clients should refer to https://www.rbccm.com/GLDisclosure/PublicWeb/DisclosureLookup.aspx?entityId=1 or send a request to RBC CM Research Publishing, P.O. Box 50, 200 Bay Street, Royal Bank Plaza,29th Floor, South Tower, Toronto, Ontario M5J 2W7.

RBC Capital Markets, LLC makes a market in the securities of TD Ameritrade Holding Corporation.

A member company of RBC Capital Markets or one of its affiliates received compensation for products or services other thaninvestment banking services from TD Ameritrade Holding Corporation during the past 12 months. During this time, a membercompany of RBC Capital Markets or one of its affiliates provided non-securities services to TD Ameritrade Holding Corporation.

RBC Capital Markets has provided TD Ameritrade Holding Corporation with non-securities services in the past 12 months.

RBC Capital Markets, LLC makes a market in the securities of E*TRADE Financial Corporation.

RBC Capital Markets, LLC makes a market in the securities of The Charles Schwab Corporation.

Royal Bank of Canada, together with its affiliates, beneficially owns 1 percent or more of a class of common equity securities ofThe Charles Schwab Corporation.

A member company of RBC Capital Markets or one of its affiliates received compensation for products or services other thaninvestment banking services from The Charles Schwab Corporation during the past 12 months. During this time, a membercompany of RBC Capital Markets or one of its affiliates provided non-investment banking securities-related services to The CharlesSchwab Corporation.

A member company of RBC Capital Markets or one of its affiliates received compensation for products or services other thaninvestment banking services from The Charles Schwab Corporation during the past 12 months. During this time, a membercompany of RBC Capital Markets or one of its affiliates provided non-securities services to The Charles Schwab Corporation.

RBC Capital Markets has provided The Charles Schwab Corporation with non-investment banking securities-related services in thepast 12 months.

RBC Capital Markets has provided The Charles Schwab Corporation with non-securities services in the past 12 months.

Explanation of RBC Capital Markets Equity rating systemAn analyst's 'sector' is the universe of companies for which the analyst provides research coverage. Accordingly, the rating assignedto a particular stock represents solely the analyst's view of how that stock will perform over the next 12 months relative tothe analyst's sector average. Although RBC Capital Markets' ratings of Top Pick (TP)/Outperform (O), Sector Perform (SP), andUnderperform (U) most closely correspond to Buy, Hold/Neutral and Sell, respectively, the meanings are not the same becauseour ratings are determined on a relative basis.RatingsTop Pick (TP): Represents analyst's best idea in the sector; expected to provide significant absolute total return over 12 monthswith a favorable risk-reward ratio.Outperform (O): Expected to materially outperform sector average over 12 months.Sector Perform (SP): Returns expected to be in line with sector average over 12 months.Underperform (U): Returns expected to be materially below sector average over 12 months.Risk RatingAs of March 31, 2013, RBC Capital Markets suspends its Average and Above Average risk ratings. The Speculative risk rating reflectsa security's lower level of financial or operating predictability, illiquid share trading volumes, high balance sheet leverage, or limitedoperating history that result in a higher expectation of financial and/or stock price volatility.


March 26, 2015 48

https://www.rbccm.com/GLDisclosure/PublicWeb/DisclosureLookup.aspx?entityId=1

https://www.rbccm.com/GLDisclosure/PublicWeb/DisclosureLookup.aspx?entityId=1

Distribution of ratingsFor the purpose of ratings distributions, regulatory rules require member firms to assign ratings to one of three rating categories- Buy, Hold/Neutral, or Sell - regardless of a firm's own rating categories. Although RBC Capital Markets' ratings of Top Pick(TP)/Outperform (O), Sector Perform (SP), and Underperform (U) most closely correspond to Buy, Hold/Neutral and Sell, respectively,the meanings are not the same because our ratings are determined on a relative basis (as described below).

Distribution of ratings

RBC Capital Markets, Equity Research

As of 31-Dec-2014

Investment Banking

Serv./Past 12 Mos.

Rating Count Percent Count Percent

BUY [Top Pick & Outperform] 897 52.92 290 32.33

HOLD [Sector Perform] 686 40.47 137 19.97

SELL [Underperform] 112 6.61 6 5.36


March 26, 2015 49

References to a Recommended List in the recommendation history chart may include one or more recommended lists or modelportfolios maintained by RBC Wealth Management or one of its affiliates. RBC Wealth Management recommended lists includethe Guided Portfolio: Prime Income (RL 6), the Guided Portfolio: Large Cap (RL 7), the Guided Portfolio: Dividend Growth (RL 8),the Guided Portfolio: Midcap 111 (RL 9), the Guided Portfolio: ADR (RL 10), and the Guided Portfolio: Global Equity (U.S.) (RL 11).RBC Capital Markets recommended lists include the Strategy Focus List and the Fundamental Equity Weightings (FEW) portfolios.The abbreviation 'RL On' means the date a security was placed on a Recommended List. The abbreviation 'RL Off' means the datea security was removed from a Recommended List.

Equity valuation and risksFor valuation methods used to determine, and risks that may impede achievement of, price targets for covered companies, pleasesee the most recent company-specific research report at https://www.rbcinsight.com or send a request to RBC Capital MarketsResearch Publishing, P.O. Box 50, 200 Bay Street, Royal Bank Plaza, 29th Floor, South Tower, Toronto, Ontario M5J 2W7.


March 26, 2015 50

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Conflicts policyRBC Capital Markets Policy for Managing Conflicts of Interest in Relation to Investment Research is available from us on request.To access our current policy, clients should refer tohttps://www.rbccm.com/global/file-414164.pdfor send a request to RBC Capital Markets Research Publishing, P.O. Box 50, 200 Bay Street, Royal Bank Plaza, 29th Floor, SouthTower, Toronto, Ontario M5J 2W7. We reserve the right to amend or supplement this policy at any time.

Dissemination of research and short-term trade ideasRBC Capital Markets endeavors to make all reasonable efforts to provide research simultaneously to all eligible clients, havingregard to local time zones in overseas jurisdictions. RBC Capital Markets' equity research is posted to our proprietary websiteto ensure eligible clients receive coverage initiations and changes in ratings, targets and opinions in a timely manner. Additionaldistribution may be done by the sales personnel via email, fax, or other electronic means, or regular mail. Clients may alsoreceive our research via third party vendors. RBC Capital Markets also provides eligible clients with access to SPARC on the Firmsproprietary INSIGHT website, via email and via third-party vendors. SPARC contains market color and commentary regardingsubject companies on which the Firm currently provides equity research coverage. Research Analysts may, from time to time,include short-term trade ideas in research reports and / or in SPARC. A short-term trade idea offers a short-term view onhow a security may trade, based on market and trading events, and the resulting trading opportunity that may be available. Ashort-term trade idea may differ from the price targets and recommendations in our published research reports reflecting theresearch analyst's views of the longer-term (one year) prospects of the subject company, as a result of the differing time horizons,methodologies and/or other factors. Thus, it is possible that a subject company's common equity that is considered a long-term'Sector Perform' or even an 'Underperform' might present a short-term buying opportunity as a result of temporary selling pressurein the market; conversely, a subject company's common equity rated a long-term 'Outperform' could be considered susceptibleto a short-term downward price correction. Short-term trade ideas are not ratings, nor are they part of any ratings system, andthe firm generally does not intend, nor undertakes any obligation, to maintain or update short-term trade ideas. Short-term tradeideas may not be suitable for all investors and have not been tailored to individual investor circumstances and objectives, andinvestors should make their own independent decisions regarding any securities or strategies discussed herein. Please contactyour investment advisor or institutional salesperson for more information regarding RBC Capital Markets' research.

Analyst certificationAll of the views expressed in this report accurately reflect the personal views of the responsible analyst(s) about any and all ofthe subject securities or issuers. No part of the compensation of the responsible analyst(s) named herein is, or will be, directly orindirectly, related to the specific recommendations or views expressed by the responsible analyst(s) in this report.

The Global Industry Classification Standard (“GICS”) was developed by and is the exclusive property and a service mark of MSCI Inc. (“MSCI”) and Standard & Poor’s Financial ServicesLLC (“S&P”) and is licensed for use by RBC. Neither MSCI, S&P, nor any other party involved in making or compiling the GICS or any GICS classifications makes any express or impliedwarranties or representations with respect to such standard or classification (or the results to be obtained by the use thereof), and all such parties hereby expressly disclaim all warrantiesof originality, accuracy, completeness, merchantability and fitness for a particular purpose with respect to any of such standard or classification. Without limiting any of the foregoing,in no event shall MSCI, S&P, any of their affiliates or any third party involved in making or compiling the GICS or any GICS classifications have any liability for any direct, indirect, special,punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages.

Disclaimer

RBC Capital Markets is the business name used by certain branches and subsidiaries of the Royal Bank of Canada, including RBC Dominion Securities Inc., RBCCapital Markets, LLC, RBC Europe Limited, RBC Capital Markets (Hong Kong) Limited, Royal Bank of Canada, Hong Kong Branch and Royal Bank of Canada, SydneyBranch. The information contained in this report has been compiled by RBC Capital Markets from sources believed to be reliable, but no representation or warranty,express or implied, is made by Royal Bank of Canada, RBC Capital Markets, its affiliates or any other person as to its accuracy, completeness or correctness. Allopinions and estimates contained in this report constitute RBC Capital Markets' judgement as of the date of this report, are subject to change without notice andare provided in good faith but without legal responsibility. Nothing in this report constitutes legal, accounting or tax advice or individually tailored investmentadvice. This material is prepared for general circulation to clients and has been prepared without regard to the individual financial circumstances and objectives ofpersons who receive it. The investments or services contained in this report may not be suitable for you and it is recommended that you consult an independentinvestment advisor if you are in doubt about the suitability of such investments or services. This report is not an offer to sell or a solicitation of an offer to buyany securities. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. RBC CapitalMarkets research analyst compensation is based in part on the overall profitability of RBC Capital Markets, which includes profits attributable to investment bankingrevenues. Every province in Canada, state in the U.S., and most countries throughout the world have their own laws regulating the types of securities and otherinvestment products which may be offered to their residents, as well as the process for doing so. As a result, the securities discussed in this report may not beeligible for sale in some jurisdictions. RBC Capital Markets may be restricted from publishing research reports, from time to time, due to regulatory restrictions and/or internal compliance policies. If this is the case, the latest published research reports available to clients may not reflect recent material changes in the applicableindustry and/or applicable subject companies. RBC Capital Markets research reports are current only as of the date set forth on the research reports. This report is


March 26, 2015 51

not, and under no circumstances should be construed as, a solicitation to act as securities broker or dealer in any jurisdiction by any person or company that is notlegally permitted to carry on the business of a securities broker or dealer in that jurisdiction. To the full extent permitted by law neither RBC Capital Markets norany of its affiliates, nor any other person, accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or the informationcontained herein. No matter contained in this document may be reproduced or copied by any means without the prior consent of RBC Capital Markets.

Additional information is available on request.

To U.S. Residents:This publication has been approved by RBC Capital Markets, LLC (member FINRA, NYSE, SIPC), which is a U.S. registered broker-dealer and which acceptsresponsibility for this report and its dissemination in the United States. Any U.S. recipient of this report that is not a registered broker-dealer or a bank acting ina broker or dealer capacity and that wishes further information regarding, or to effect any transaction in, any of the securities discussed in this report, shouldcontact and place orders with RBC Capital Markets, LLC.To Canadian Residents:This publication has been approved by RBC Dominion Securities Inc.(member IIROC). Any Canadian recipient of this report that is not a Designated Institution inOntario, an Accredited Investor in British Columbia or Alberta or a Sophisticated Purchaser in Quebec (or similar permitted purchaser in any other province) andthat wishes further information regarding, or to effect any transaction in, any of the securities discussed in this report should contact and place orders with RBCDominion Securities Inc., which, without in any way limiting the foregoing, accepts responsibility for this report and its dissemination in Canada.To U.K. Residents:This publication has been approved by RBC Europe Limited ('RBCEL') which is authorized by the Prudential Regulation Authority and regulated by the FinancialConduct Authority ('FCA') and the Prudential Regulation Authority, in connection with its distribution in the United Kingdom. This material is not for generaldistribution in the United Kingdom to retail clients, as defined under the rules of the FCA. However, targeted distribution may be made to selected retail clients ofRBC and its affiliates. RBCEL accepts responsibility for this report and its dissemination in the United Kingdom.To Persons Receiving This Advice in Australia:This material has been distributed in Australia by Royal Bank of Canada - Sydney Branch (ABN 86 076 940 880, AFSL No. 246521). This material has been preparedfor general circulation and does not take into account the objectives, financial situation or needs of any recipient. Accordingly, any recipient should, before acting onthis material, consider the appropriateness of this material having regard to their objectives, financial situation and needs. If this material relates to the acquisitionor possible acquisition of a particular financial product, a recipient in Australia should obtain any relevant disclosure document prepared in respect of that productand consider that document before making any decision about whether to acquire the product. This research report is not for retail investors as defined in section761G of the Corporations Act.To Hong Kong Residents:This publication is distributed in Hong Kong by RBC Capital Markets (Hong Kong) Limited and Royal Bank of Canada, Hong Kong Branch (both entities which areregulated by the Hong Kong Monetary Authority ('HKMA') and the Securities and Futures Commission ('SFC')). Financial Services provided to Australia: Financialservices may be provided in Australia in accordance with applicable law. Financial services provided by the Royal Bank of Canada, Hong Kong Branch are providedpursuant to the Royal Bank of Canada's Australian Financial Services Licence ('AFSL') (No. 246521). RBC Capital Markets (Hong Kong) Limited is exempt from therequirement to hold an AFSL under the Corporations Act 2001 in respect of the provision of such financial services. RBC Capital Markets (Hong Kong) Limited isregulated by the HKMA and the SFC under the laws of Hong Kong, which differ from Australian laws.To Singapore Residents:This publication is distributed in Singapore by the Royal Bank of Canada, Singapore Branch, a registered entity granted offshore bank licence by the MonetaryAuthority of Singapore. This material has been prepared for general circulation and does not take into account the objectives, financial situation, or needs of anyrecipient. You are advised to seek independent advice from a financial adviser before purchasing any product. If you do not obtain independent advice, you shouldconsider whether the product is suitable for you. Past performance is not indicative of future performance. If you have any questions related to this publication,please contact the Royal Bank of Canada, Singapore Branch. Royal Bank of Canada, Singapore Branch accepts responsibility for this report and its disseminationin Singapore.To Japanese Residents:Unless otherwise exempted by Japanese law, this publication is distributed in Japan by or through RBC Capital Markets (Japan) Ltd., a registered type one financialinstruments firm and/or Royal Bank of Canada, Tokyo Branch, a licensed foreign bank.

.® Registered trademark of Royal Bank of Canada. RBC Capital Markets is a trademark of Royal Bank of Canada. Used under license.Copyright © RBC Capital Markets, LLC 2015 - Member SIPC

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