Bad Time for Markets Has Been Good for BrokeragesIt was a tough quarter for small investors in stocks. But for shares of mass-market advisers and brokerages, it was pretty great.Shares of online brokerage providers such as Charles Schwab, SCHW 1.86% Interactive Brokers Group IBKR -0.33% and Robinhood Markets were all up by double digits in the third quarter, as were brokers providing investment advisory and management services such as LPL Financial and Raymond James. Morgan Stanley, owner of E*Trade, was up almost 4%. Meanwhile, the KBW Nasdaq Bank index was down 5% in the quarter.What is powering mass-market brokerage stocks isn’t a bullish reawakening among small traders. The most recent data, from August, showed month-over-month upticks in activity. But levels are still subdued from the ebullient past couple of years. Instead, a major tailwind may be that these firms as a group remain exposed to the upside of higher interest rates.Like banks, brokers also face pressure from customers who want to earn more on their cash as rates rise. The phenomenon is known as cash sorting, referring to when customers opt to put uninvested cash into something like a money-market fund rather than letting the broker hold the cash and invest it itself.Worry about this yield-seeking behavior among depositors is one reason bank stocks have stopped rising in tandem with Treasury yields. But generally speaking, customers who keep some of their cash with brokers and advisers tend not to be as aggressive in seeking out yield. Brokerage customers want to put that cash into the market eventually—even if not at this very moment.Some brokers such as Schwab have their own banks, while others such as Robinhood work with partner banks to sweep in uninvested cash from brokerage accounts. During the previous cycle of rising rates, from late 2015 to mid-2019, yields on wealth accounts under $250,000 subject to cash sweeps rose only 10% as much as the Federal funds rate, according to Curinos’s CDA Wealth data. But online savings accounts and one-year certificate-of-deposit rates rose 58% and 80% as much, respectively.Plus, because brokers don’t typically do a lot of the longer-term lending that banks do, such as with mortgages, their assets tend to be shorter-term. When rates are rising quickly, it is good to be in a shorter-duration portfolio that can more rapidly be reinvested at higher yields. This played out during the last rate cycle, too: Net interest income of mass-market brokerages tracked by Wolfe Research roughly tripled from the end of 2015 to late 2018 as the benchmark Fed funds rate rose 2 percentage points, versus a 25% gain across all Federal Deposit Insurance Corp. insured banks, according to Wolfe. “Retail brokers are a cleaner play on rates right now,” says Wolfe analyst Steven Chubak.Also partially offsetting the effects of cash sorting can be strong inflow of new assets to brokers, which has continued. Independent and online brokers logged organic asset growth—meaning inflows of funds rather than changes in asset levels due to market moves—of more than 6% in the 12 months through the second quarter, while big banks’ wirehouse brokers averaged closer to 3%, according to figures compiled by Wolfe.And to the extent customers are chasing cash yield, this can be an opportunity to draw in more assets that may eventually turn into trading volume. Robinhood, for example, is now offering a 3% cash rate to some of its customers who pay for its Gold service that offers more tools for active traders.Of course, a pause in Federal Reserve rate increases could hit brokers, because customers may continue to seek out higher cash yields while the ability of the brokers to keep investing at ever-higher yields wanes. It would also likely mean that the economy is struggling, and people would be even less interested in actively trading. But compared with a lot of other financial stocks, brokers may be a surprisingly good way to wait out a turbulent market.Write to Telis Demos at [email protected]Copyright ©2022 Dow Jones & Company, Inc. All Rights Reserved. 87990cbe856818d5eddac44c7b1cdeb8