Don't Go Changing

Most people would agree that change is a healthy,

Illustrations By Victor Juhasz

Love Schwab Institutional or hate it - and most financial advisors seem to be in one camp or the other - the mammoth asset custodian is rarely quiet. Or dull. The same goes for the annual Schwab conference, which lets company executives trot out their latest, greatest ideas, and gives advisors the opportunity to react or overreact accordingly. In 1998, for example, advisors at

the Orlando conference collectively blanched to hear company executives describe their organization as a "full-service" brokerage firm. Where does that leave us, advisors wondered aloud. Were they to become mere asset-gatherers for Charles Schwab & Co.? Or had Schwab leaders just gotten confused when their company, a Wall Street darling, had seen its market capitalization shoot past that of Merrill Lynch, the embodiment of the old-line, full-service firm?

Last fall, however, at the 1999 conference in San Francisco - where the theme was Change Is The Only Constant - the biggest change was that Schwab appeared once more content to be considered a discount brokerage (albeit a massive discount brokerage). Or maybe the head honchos were just enjoying the fact that Merrill Lynch, Morgan Stanley Dean Witter, and other wirehouses, in the sincerest form of flattery, had begun to tout their own credentials as discounters, offering reduced commissions for online trading and free trades for customers with a certain level of assets. As Schwab Executive Vice President Dan Leemon pointed out, the Wall Street firms are also doffing their hats to independent advisors, providing advice for an annual fee instead of charging commissions.

(In the months following the Schwab conference, the "full service" handle was back on display, as the company first announced that it would begin offering advice for a fee - see page 72 - and then paid $2.7 billion in stock to buy U.S. Trust, creating what a company spokesman described as an "organization positioned to serve the investment and wealth management needs of investors at every stage of their financial growth." For more on the latter development, see In the News, page 15.)

To judge by the trappings of its conference - which Leemon himself dubbed "Schwabapalooza" - you would never guess that "discount" is how Schwab made its name. Held in San Francisco's Moscone Center, with an exhibit hall that should have come complete with a shuttle bus, or maybe a cobbler to repair worn-out shoes, the conference catered to about 1,500 advisors and over 250 exhibitors. The opening general session was heralded by blue lights and smoke, as if for a rock concert. This hall, too, was positively cavernous. And the audience was treated throughout the conference to the sight of speechmakers on massive video screens, far larger than life and somehow reminiscent of Apple's 1984 commercials, as a well-trained drill team of Schwab employees with microphones tracked down questioners in the crowd so that their queries could be heard by the vast multitude - questions that ran the gamut from queries for keynoter Mario Cuomo about his views on medical care to questions about what technology improvements Schwab was planning.

But back to basics. The general session was opened by Charles Schwab himself, who announced that assets under management at Schwab from advisors total nearly $200 billion. Schwab's huge success, he asserted, is the reason for the sudden change in the ads of other brokerage houses as they scramble to announce that they are now discount brokers, too.

Schwab the organization is now a target, proclaimed Schwab the man. "Our solution is to stick to our guns, to reinforce the principles and values that made us so successful over these years.

"We are committed to fair and very competitive pricing and to objective unbiased advice," he said. Schwab stressed how optimistic the firm is about its partnership with advisors. He and other Schwab luminaries seemed at pains to reassure advisors that the company indeed saw them as partners, not competitors. This apparently worked; the advisors we spoke with seemed generally much more at ease with their relationship with Schwab, citing individual, relatively minor concerns (occasional botched transactions and the like) rather than any serious turf battles.

The opening session by Leemon concentrated on change and its inevitability, the tremendous gain that stands to be made from baby boomers (according to him, 90% of the gain in assets to come will be from the boomer sector of investors), and the movement among full-service brokers to target the clients of discount brokers. There was a lot of full-service-broker-bashing, some of it very amusing, as Leemon pointed out flaws in ads that claimed to lower costs for investors. In reality, he said, the new pricing structure would be even more profitable for full-service brokers than the old has been, but in the new packaging, clients might not recognize that.

Leemon also talked about investors and their strategies, and how those strategies are changing. Through films of client focus groups, he addressed the idea that many clients who formerly might have been content to leave everything in the hands of their advisors now prefer to retain some control over a portion of their assets, and often fail to disclose the very existence of those assets to advisors. The focus group films also showed clients preoccupied with returns; Leemon offered some ideas on how advisors can cope with that attitude, and also suggested that they concentrate on bringing clients' "hidden" assets under management.

The conference was divided into three subject areas. Monday was "Exploring the Changing Environment," with sessions on everything from diversification to GenXers and how to approach them, exchanges without floors, and building lasting relationships with clients. Tuesday was billed as "Preparing Your Firm to Compete," with sessions on hiring the right help, differentiating yourself from the crowd, alliances and mergers, and the evolution of the active fund trader. Wednesday's half-day theme was "Building Your Offering," and covered such strategies as wealth transfer, charitable giving, and using the Web to help clients.

Monday and Tuesday offered, in addition, a forum with Schwab management, in which advisors could bring up any questions or problems they had. Co-CEO David Pottruck and Schwab Institutional President John Coghlan offered answers to advisors, or deferred to technology people or others in the firm who could answer specialized questions. Both "town meetings" were quite positive, with most advisors prefacing their questions or complaints with compliments on how Schwab generally handled things. After each session, someone from Schwab spoke with the questioners to get particulars on their problems and learn technical details about what had gone wrong.

In general, advisors seemed favorably impressed with the offerings and with the conference itself, although sessions did vary a bit in quality. The session on effective presentation, for one, seemed to be an example of "do what I say, not as I do," as presenters, Lee Hecht and Denise Winchar, repeatedly violated the rules they laid out for attendees.

Copycat Crime

On December 8, Schwab announced that it would begin offering, for a fee, two levels of personalized advice for investors, thus going head-to-head with advisors for the business of clients who seek out planning assistance. According to articles that ran in the San Francisco Chronicle and the San Francisco Examiner, the two-level plan was already in beta testing and would be rolled out through the branch offices sometime this spring.

When asked about the new offering, advisors didn't seem to care much. Most were sanguine, recognizing that sooner or later everyone would offer fee advice of a sort and doubting that anyone would mistake the snapshot-for-a-fee as anything approaching real financial planning services.

Schwab itself says that it in no way competes with advisors, because it is only a two-level program and it is less detailed than what an advisor would offer a client. "Our aim as a firm," said Schwab's Glen Mathison, "is to become a fully rounded, full-service brokerage firm that provides services to advisors as well as to clients. We're not talking about adding ongoing money management in our branch offices at this time. There are qualitative differences from what advisors offer."

Although advisors don't seem to feel threatened by the new Schwab program, they were surprised, commenting that Schwab hadn't broadcast the launch of the new program very loudly. The news was apparently mentioned in some official communications sent to advisors, but not given a prominent position.

Carol Lee Royer, a CFP in Memphis, was pleased with what she saw, and offered the suggestion that in the future Schwab might want to consider a few sessions or even a track directed more at the employees of financial planning firms rather than at planners themselves.

Steven Kaye of Watchung, New Jersey, also a CFP, mentioned that he would have liked to see a little more challenging material about high-end portfolio management.

Laura Tarbox, a CFP from Orange County, California, remarked that the session on Compensation that Inspires Greater Performance "was really bad; it was directed more toward the 'huge mutual fund companies under management' type firm. Everybody was shaking their heads, saying, 'This isn't us.' There were three panelists and none of them was talking to us." Bob Gore of Towers, Perrin, Rajiv Gokhale of SCA Consulting, and Diane Lerner of Wason Wyatt offered hints geared more toward large companies with 50-100+ employees, and even more or less apologized for the fact that they usually offered strategies for big mutual fund companies and big trust companies with hundreds if not thousands of employees, rather than for small investment advisory firms. The only things that applied, said Tarbox, were basic strategies such as tying employee compensation to company performance.

But Tarbox felt sessions about managing client expectations hit home. "It's nice to know," she said, "that others are facing the same issues. Some advisors were talking about how much turnover they've had, and how many clients they've lost. We've lost about 5% - I've talked to advisors who have lost 30% to 40% of their client base. There was a lot of talk about that, and how to manage expectations. We think we're doing a good job till we get the phone call." Much of the talk, of course, was along the lines of "We're here to help you sleep at night, not beat the market," but in this market often that is not enough to satisfy clients.

Some attendees were unhappy with this facet of the conference, though. Rather than managing expectations - essentially, they complained, helping clients accept mediocre performance - they would have appreciated help managing returns, so that clients would be satisfied, and wouldn't be inclined to make those phone calls Tarbox mentions. Said one, "Implicit in 'managing expectations' is that there should be expectations. Who determines what's a reasonable expectation? If you had a Moscone Center full of clients, I would say they'd want to know why they're not making any money. This issue was totally absent from discussions at the conference."

But despite these few sour notes, most advisors had mostly good things to say - about Schwab itself, about the steps taken in the past year to lessen the distance between advisors and the company, and about the strides Schwab has taken to advance technology and service.

Technology was a heavy presence at the conference. Peter Leyden, author of The Long Boom: A Vision for the Coming Age of Prosperity, talked about the "new economy" - one that is shot through with technology. "Exchanges Without Floors" also talked about technology. There were thrice-daily technology workshops on various Schwab features, the Internet, Advent Axys, and Centerpiece. Gatekeepers at the technology workshops carefully checked registrants on the way in to try to be sure there were enough computers so that attendees would actually be able to use the technology they'd signed up to learn.

Workshop sessions weren't the only technical arenas drawing attention. Any booths in the exhibitors' hall having to do with technology attracted crowds throughout the conference, particularly when they offered demonstrations. The Schwab section (in the thick of things, right in the middle of the exhibitors' hall, instead of at the far end as it was last year) was overflowing with advisors for demos, lectures, and question-and-answer sessions.

Other exhibitors had mixed results. Many were very satisfied with the traffic drawn to their booths; others, perhaps less well-known or with less of a budget for spectacular giveaway items and big banners, lamented the fact that although there were scads of people going through the exhibit hall, not too many of them stopped at their booths. But in most cases, there seemed to be fair-sized audiences whenever a fund manager was available to speak at a fund's booth, and a reasonably satisfying amount of foot traffic to many booths.

With the likes of Mario Gabelli, Maureen Allyn, and Michael Price at the Monday lunch, George Will speaking at breakfast Tuesday, and Mario Cuomo at lunch later, there was no lack of interesting topics. Will and Cuomo, in particular, made for a particularly fascinating juxtaposition of philosophies, as well as a break in the financial subject matter. Fund managers addressed small groups in the exhibitors' hall; breakout sessions brought people together on lots of subjects.

With the emphasis on change, particularly changing technologies, the 1999 conference covered many currently cutting-edge topics bound to be old news by the time the Schwab 2000 conference comes around. But the big question is not whether next fall's meeting will break new ground, but whether Schwab and the advisors it works with will still be on as good terms as they seemed to be in 1999.

Tales Out of School

Forget the politics. Impact '99 had some memorable educational sessions

by Eric L. Reiner

The session on "Wealth Transfer Strategies" imparted solid fundamentals - what's included in the taxable estate, how the deduction for a closely-held family business works, etc. - although the speaker, Steve Akers, with Ernst & Young's Center for Family Wealth Planning, clearly had the expertise to go a lot deeper.

Akers offered Impact '99 attendees a number of strategies for reducing estate tax, including the irrevocable life insurance trust. If a client owns a life policy, Akers pointed out, the proceeds are part of the client's taxable estate. But death taxes are avoided if an ILIT owns the policy.

The technique can be used even when a client already owns life insurance. In that case, have the client gift the policy into the trust. "When the gift is made, you look at the value of the policy at that time to determine how much gift there is," said Akers. "Typically we're going to be looking at something akin to the cash surrender value of the policy. If we're dealing with a term policy, it probably has very low values - just the unearned premium for that year."

After the trust is established, the client gifts cash into the trust each year - hopefully less than the gift-tax-free annual exclusion amount - so that it can pay the premiums on the policy it owns. At death, the policy pays off in the trust, not the estate, skirting estate tax. "We can even arrange this so that the insured's surviving spouse can be a beneficiary of that trust and whatever's not used at the spouse's death passes free of estate tax," Akers said.

Compared to Akers' review of tried-and-true techniques, the compellingly titled, multi-speaker session "Staying Competitive with Separate Accounts" did a far better job of tilling new soil. The separate account business is up 20% in the last three years, we were told by experts who believe that separate accounts will, going forward, snag market share from mutual funds, especially among the affluent. "Mutual funds really have no image of exclusivity, and that's actually increasingly important in the high-net-worth segment," said one speaker. Said another: "When you're dealing with a high-net-worth investor, saying you have a product that is targeted at people with $300,000 or more to invest has a certain cachet."

A separate account, also known as a managed account, is little more than a large, individually tailored portfolio managed by a pro to meet a client's specific needs. Like a mutual fund, a separate account offers discretionary portfolio management, diversification, and liquidity. Managed account fees are about equal to the cost of a fund, at least for accounts of half a million dollars or more, said Len Reinhart, head of Lockwood Financial Group, a leading firm in the separate account business.

Managed accounts shine in tax efficiency. "What percentage of unrealized gains are realized each year?" Reinhart asked the audience. "Managed account: 5% to 25%. Average mutual fund: 50%." The bottom line is that separate accounts are managed with an eye on after-tax return to the individual client, as opposed to the total return approach of most mutual funds.

It's the after-tax focus of managed accounts that's sparking interest in them, even though the lack of defined standards for after-tax performance makes it difficult for separate account money managers to publish performance data. "Fifty percent of the money we're placing is going to managers that have no published track record," Reinhart reported. "Clients are buying based on the concept of running it after-tax. When the client goes into it with that premise, they become much stickier assets."

Indeed, the players in the separate account business are happy to avoid the performance game, which has had deleterious effects on the mutual fund industry. "Back in 1993, about 65% of net flows into equity funds were into four- and five-star rated funds," said Guy Maszkowski of Salomon Smith Barney. "By 1998, that had reached 90%, and for the first seven months of 1999, astonishingly enough, 120% of net flows into equity mutual funds went into four- and five-star funds, which means that almost by definition, if a fund is rated one, two, or three stars, it's in net redemptions." Meanwhile, Reinhart's three-year-old firm is taking in $250 million a month in new separate account assets.

Currently, mutual fund accounts are a heckuva lot easier to administer than separate accounts. But that will change soon, Reinhart believes. "You're going to see some strides in the next 12 months that will make separately managed accounts much easier to set up and use. There's a lot of technology going on behind the scenes right now."

For more information on separate accounts, Reinhart referred advisors to the literature and conferences of the Investment Management Consultants Association and the Institute for Certified Investment Management Consultants.

Fortune tech stock columnist Adam Lashinsky did a fabulous job of moderating "Valuation in the High-Tech Sector," wherein a couple of the money managers-cum-panelists revealed that they prefer analyzing price-to-sales rather than price-to-earnings when scrutinizing tech. (They didn't mention what price-to-sales numbers they like, though.)

What about the staggering P/Es in some of the young tech companies? One panelist who likes the prospects of the Internet said, "Unlimited shelf space and unlimited reach gives these online companies some of the multiples that we're all looking for them to grow into."

Kevin Landis, chief investment officer of Silicon Valley-based Firsthand Funds, explained tech stocks' high market multiples via concepts from academia. "I believe what one of my finance professors told me, which is, 'Stocks trade at a reasonable multiple of future earnings.' What's a reasonable multiple? Well, that's gone up, but interest rates have come down, so according to the capital asset pricing model, that's okay. When it appears that a stock is trading at a hundred times current revenues, what you're getting is a more reasonable multiple times future earnings, but it's pushed out five, maybe six years. And to me that's one of the ways of measuring the risk," said Landis, who piloted three of Firsthand's funds to triple-digit performance in 1999. "The more years I have to wait to get the earnings per share that justifies today's stock price, the wider the window that some new competitor can drive through."

With the type of probing/annoying questions only a journalist can devise, Lashinsky prodded the panelists into telling the crowd why they can't believe everything Wall Street says - or at least what the Street says in print. Investment banking drives the business these days, the panel agreed. That's why the vast majority of analyst recommendations are either "buy" or "hold," and only rarely do you see "sell." Then panelist Bill Burnham, a former equities analyst, explained how Wall Street really works. "If there's a company that's an investment banking client of the firm's and they're performing poorly, they'll kid-glove the company in their published, written research. This is why access to the analysts is so important," Burnham said. "Analysts may publish one thing, but you call 'em up and their tone may be markedly different. They may be incredibly negative about the stock."

Equally fetching were the savvy investment theses proffered. Tony Weber, portfolio manager of Alleghany/Veredus Aggressive Growth Fund (total return of 113% in '99), likes the cable area, both cable modems - "Terayon Communications would be a name there" - and cable operators. The latter will soon be deriving revenues from multiple sources, including local telephony, according to Weber. "The revenue per subscriber that cable companies can go after is going to go up by a factor of six or seven over the next 18 months," he said in November, naming Insight Communications as a holding of his. Paul Cook of Munder Capital Management hailed opportunities in the business-to-business segment of the e-commerce arena. By 2003, he said, business-to-business transactions over the Internet will total $1.3 trillion, which is "about a 10-to-1 ratio above where we'll see business-to-consumer at that time."

Former equities analyst Burnham, now a partner in Softbank Capital Partners, a late-stage venture capital fund, was a perfect choice for the tech sector panel. Think about it: Burnham's a guy who spends his time studying companies on the hot ramp from privately held to IPO, i.e., companies in businesses most of us won't hear about for years. What's next beyond the horizon?

Digital rights management.

"Ultimately, lots of content - music, books, any kind of printed material - will be digitized on the Internet," Burnham explained. "That whole system for managing rights and royalties, to make sure authors and publishers get paid, and access privileges, to prevent copying, is going to have to be created. That's guaranteed to happen in the next five to 10 years, so we're investing a lot in that space," Burnham said, later noting that most digital rights management companies are currently pre-public.

That stellar panel session - a big round of applause came at the end - outshone the one entitled "Market Cap in Investment Selection." True, a last-minute change of moderator worked against the market-cap session; still, the panelists - famed money man Tom Marsico, INVESCO's Tim Miller, Van Kampen's Gary Lewis - ended up talking more about how they run their funds than about the role of market capitalization in the investment process.

Miller, lead manager of the mid-cap-oriented INVESCO Dynamics Fund, may have done the best job of adhering to the topic at hand. He argued that the mid-cap segment of the market is the most attractive because it contains "the fastest-growing, most exciting companies, and you have more companies to choose from. And academic studies have shown over a long period of time that mid-cap returns are about equivalent to small-cap with much less volatility."

Marsico, the large-cap pundit on the panel, rejoined that he doesn't like small- and mid-caps because when they miss earnings, the stock can fall off a cliff. Gorilla-sized market leaders that suffer a poor quarter take much less of a hit in stock price, in Marsico's experience.

Perhaps the best question from the floor was whether equity style boxes impact the three panelists' investment decisions.

One fund manager said yes.

One said no.

One said sometimes.

Van Kampen's Lewis opined that style boxes may actually keep today's pros from beating the market. Did Peter Lynch establish his track record at Magellan by staying within the prescribed bounds of a style box? Nah. "He didn't have a style box to worry about," said Lewis. "I think the style box probably is affecting the overall mutual fund business in that we can't deliver great-performing funds in all seasons. You'll get outperformance during periods when your style is in favor, and when it's not in favor, there's nothing you can do about it because you've got to stay with that style."

The session also yielded prescient investment ideas. Marsico, eyeing the economic recovery in Asia, likes large-caps Citigroup and Merrill Lynch because both have invested in the Japanese securities business, and Four Seasons Hotels because of its 12 Asian properties. But in the end, "Market Cap in Investment Selection" strayed too far from its advertised topic to get the highest mark.

Ditto for "Tools for Charitable Giving," which had everything to do with private foundations and little to do with other vehicles of philanthropy.

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