February 1, 2000

Reel Deal

Will Schwab use U.S. Trust to help advisors expand

Illustrations by Regan Dunnick

It was the second headline-grabbing "new-buys-old" acquisition in less than a week. On the heels of the news that American Online planned to purchase its more traditional media cousin, Time Warner, one of the nation's most innovative financial services firms announced that it planned to acquire its more traditional cousin, a 147-year-old asset management, estate planning, and financial planning firm serving affluent Americans. With the acquisition of U.S. Trust, Charles Schwab & Company gets immediate entr?e into a new market - and steps into direct competition with the 5,500 independent advisors who use Schwab's custody services and are already serving the same high-net-worth market.

Schwab, the nation's largest online brokerage, has for years walked a fine line in the independent advisor industry by serving as a back office for investment managers while also offering discount brokerage services directly to retail clients. Schwab's traditional customer has been the self-directed investor, and Schwab has gone to great pains in recent years to assure advisors that it was not marketing to investors who feel they need an advisor. But Schwab's plan has evolved, and the $2.7 billion purchase of the nation's second-largest trust company crosses the line and heightens the concern among some advisors that Schwab is trying to steal away their clients.

The Schwab-U.S. Trust deal is triggering a schizophrenic reaction among independent advisors affiliated with Schwab Institutional. Some say they perceive it as an advantage that will allow a small advisory firm to offer trust services. They point out that the Schwab-U.S. Trust alliance could allow them to become successor managers of trusts, enabling them to continue managing a client's assets after the client dies. Clients generally name a bank trust department as a corporate trustee to ensure prudent management by an enduring institution after they die. But when the assets shift into the bank's care, the advisor loses his management fee.

"I believe it will enhance my ability to serve high-net-worth clients, add to my offering, and give me a chance to ally myself with a strong brand name," says Curt Weil of Weil Capital Management in Palo Alto, California.

Ron Rog?, an advisor in Bohemia, New York, says he recently lost business to a large trust company because the larger firm could offer access to investment deals that he could not. "We're bumping into situations where individuals have lots of wealth and we're not set up to handle them," says Rog?.

Most advisors say they already saw Schwab as a competitor, and the U.S. Trust acquisition just helps it become a more formidable threat. In particular, larger advisory firms aiming for the millionaire market and marketing their firms as family offices for multiple families see U.S. Trust as direct competition. These firms typically handle total wealth management for individuals with $1 million to $10 million. Their target client base overlaps with U.S. Trust's, where the average account is $7 million.

"This is a watershed," says one advisor who is currently with Schwab but is planning to take his clients' assets elsewhere. "This reinforces my view that Schwab will be more and more full-service and that the firm will pursue opportunities that are directly counter to my firm's best interests." The advisor, who asked not to be named, accused Schwab of "relying on people's trust and relying on inertia to keep as much as possible status quo with advisors, while at the same time moving to compete with them."

Schwab Institutional CEO John Coghlan says U.S. Trust will be offered as an alternative in its AdvisorSource branch referral program. With Advisor-Source, advisors who are invited to participate pay up to $10,000 a year per branch to be listed among possible referrals. Schwab retail branch employees make referrals to advisors when they see a good fit with a client. Adding an in-house planning firm like U.S. Trust is sure to create discord among advisors who rely on AdvisorSource for referrals. Those who compete for business with large trust companies say the sales presentations put forth by large trust companies and the sweep of their services can make a independent advisory firm look like a miniscule competitor.

With 1,900 employees, U.S. Trust manages about $77 billion in assets and includes a staff of 250 private bankers and 250 advisors, plus 22 domestic stock analysts and three international analysts. U.S. Trust has 24 offices nationwide situated in leading wealth centers. In a conference call after the acquisition was announced, Coghlan told the hundreds of advisors listening in that U.S. Trust planned to add 10 to 12 new locations in the next three or four years, and that it may expand by acquiring existing advisor firms.

The advisors most concerned about Schwab's purchase of U.S. Trust worry Schwab will use the database of Schwab advisors' clients to solicit new business for U.S. Trust. Advisors in the past have alleged that Schwab employees improperly contacted their clients to solicit the clients' business. Schwab has said those instances were accidents or the work of overzealous employees, and has established a series of rules and training procedures governing retail employees' contacts with clients.

"I am sure that at some level at Schwab, someone is doing an analysis of whether it is more profitable to go after advisor clients or maintain the status quo," says one advisor who asked not to be named. "It's a business decision."

Coghlan, in an interview, sought to calm such fears. "It is not a business decision; it's an ethical decision," Coghlan said. "We are willing to commit as a firm to never use any data-mining of the information we have about advisor clients to market to those clients in any way."

Schwab is prepared to take steps to allay advisors' concerns. "We have now opened up our 'Advisor-Only Account,' which we have created for advisors who do not want a client's account to be accessible by any Schwab retail personnel," says Coghlan. He says this feature, originally developed for advisors hired by celebrity clients who wanted privacy, will now be rolled out across Schwab Institutional. "The accounts are shielded from everyone except Schwab Institutional employees and compliance officers," says Coghlan. - AG


Boxed Out

Today's strange stock market is wreaking havoc, even with Morningstar style rankings

Everybody knows that Morningstar Inc. makes great software for researching and analyzing mutual funds, and criticizing the Chicago company's work is almost un-American. But the stock market's unusual behavior in recent months has exposed a small weakness in the program. The style box categorization - a grid on which funds are designated as small-cap growth, say, or large-cap value - can be slightly off for a few funds. Although it's a minor glitch, John Rekenthaler, Morning-star's research director, agrees it's something advisors should be aware of.

Fund companies, of course, are notorious for playing name games - creating a U.S. Government Bond that has a third of its portfolio in junk bonds, or a World-wide Fund with 80% domestic assets. That's one reason advisors turn to the Morningstar style box. But even there, to cite one example, Legg Mason Value Trust shows up as a value fund, even though it is loaded with growth stocks.

Legg Mason Value Trust had America Online as its number one position, according to the August 31, 1999, data in the December 1999 release of Principia Pro, with 11% of assets in AOL. Its second-largest position was Dell. Gateway was third. Among the fund's top 25 positions, 27% of the assets were in tech stocks. Yet the fund is classified as a large-cap value fund.

How can this be? The answer, according to the help section in the Morningstar software, is that style box scores are calculated by ranking the stocks in a fund's portfolio by price/earnings and price-to-book ratios, and then calculating an average weighted P/E score and an average weighted P/B score from the stocks in the middle quintile.

The trouble with that, according to Paul Greenwood of Frank Russell Company in Tacoma, Washington, is that using the middle quintile to classify a fund's style is too narrow. "Let's say you're a fund manager who likes stocks with moderate valuations, but then due to severe underperformance, you capitulate and put 10% to 15% in really racy Internet stocks," says Greenwood. "Under this style classification, that is barely going to show up at all."

"We didn't design the style box as the ultimate symbol of style purity; we designed it as an instructive tool for indicating where most of the portfolio assets lay," says Rekenthaler. He points out that if a fund's middle quintile of stocks indicates it is a value-oriented fund, then the fourth and fifth quintiles will contain stocks with an even stronger value tilt. "To be classified as a value fund, the fund must have at least a majority of its assets in value stocks," says Rekenthaler. "It's not an 80% test or 90% test; it's really a 60% test.

"I grant that a fund with 10% or 20% in growth stocks is getting a big kick from those stocks, and you wouldn't know that from the style box," he says. "But I don't view this as a flaw of the style box. Rather, it's something of an accident of the current times, with the NASDAQ 100 having its best performance in history in 1999." - AG


Easy Riders

Additions to LTC policies bring benefits, but at a price. When are they worth the cost?

Let's face it: Long-term care insurance policies and their riders are complicated and confusing - and not just to clients. Many advisors who don't sell LTC insurance quickly find themselves out of their depth. Here are a few of the basics:

Inflation Riders. "A simple inflation rider is calculated solely on your original benefit amount," says Robert Israel, CLU, of Long Island Planning Group in Uniondale, New York. "If inflation is 5% a year and you have a $200-a-day benefit, then after a year, you'd be entitled to $200 in benefits, followed by $210 in year two and $220 in year three." After 20 years, your benefit would be $400, and after 30 years, $500.

With a compound inflation rider, in contrast, each year's increase is calculated from the previous year's benefit. In this case, with a 5% annual increase, benefits would reach $532 per day after 20 years, and $866 per day after 30. But this protection costs more. Premiums for a Travelers LTC 4 policy for a 55-year-old in good health might run about $1,840 per year with a simple inflation rider, but $2,340 with a compound inflation rider. With no inflation protection, you could pay less than $1,000.

A third type of inflation rider, offered by a limited number of carriers, is called CPI protection. With this rider, additional insurance can be purchased by paying a premium increase pegged to the Consumer Price Index. This rider generally makes sense only for older clients, since premium rates can rise dramatically over long periods.

Homemaker Benefits. Generally, to receive homemaker benefits under an LTC policy - for cooking, cleaning, shopping, etc. - the policy owner must require assistance in at least two of six "activities of daily living" such as dressing or bathing, or must have suffered a cognitive impairment and must incur expenses from a licensed caregiver or facility. If a spouse can take care of the policyowner but needs to hire someone to help with cleaning and cooking, the cost probably won't be covered, says Peter Kelly of New York Long-Term Care Brokers in Clifton Park, New York.

Assisted Living Benefits. Similarly, until recently, many LTC policies would not pay for a stay in an assisted living facility, but that's beginning to change. In fact, some LTC policies now cover assisted living and home care exclusively, and annual premiums can be more than $1,000 cheaper than for standard nursing home coverage. - AG


Step Right Up

This spring, Assante Corporation, the Canadian parent company of American asset manager Reinhardt Werba Bowen, expects to announce merger deals with 20 independent advisor firms, including some of the nation's best-known companies.

John Bowen, president and CEO of Assante Capital Management, has spent months meeting with dozens of independent advisors, asking about their merger, acquisition, and succession plans, and he has devised a formula to merge the firms into a single entity. Assante has plans to cut deals with 100 independent advisory firms over the next three years.

Bowen, who declined to name specific merger partners, plans to structure the merger agreements as put options in which the advisory firm has five years in which to sell to Assante at a previously negotiated multiple of EBITDA (earnings before interest, taxes, depreciation, and amortization). EBITDA is a measure of profitability often applied to companies that have been subject to leveraged buyouts.

"We'll give the advisor an acquisition agreement so you know what the value of your firm is at any point in time," says Bowen. "You can put your firm to us anytime for five years. And if you die or become disabled, you or your estate can put the firm to us."

While the advisor will not be locked into the deal and can sell to another acquirer if a better offer is found, Assante will have the right of first refusal. Advisors will remain independent, yet benefit from economies of scale, Bowen says. The advisory firms Assante is eyeing, he notes, are those that have moved toward the family office model.

According to Bowen, Assante has secured a $50 million credit line from four Canadian banks. Assante stock, which trades under the symbol LMS (for Life Management Systems, its former name), went public with an initial public offering in May 1999 at $9.50 a share and recently traded at $7.50 (Canadian dollars). Assante's market capitalization stood at close to $400 million. Bowen says acquisitions will be made with a combination of stock and cash, and he expects most of the deals to be closed at between five and eight times the acquired company's EBITDA. - AG


Short Positions

Fidelity Institutional, the advisor custodial arm of Fidelity, is pilot-testing a referral program that will send high-net-worth clients who walk into branches to the 600-plus RIAs affiliated with Fidelity. The program is akin to Schwab's AdvisorSource referral system. . . . Aetna has announced that it will split off its health insurance services from its financial services. Domestic and international health insurance will combine into Global Health, while its new Global Financial Services unit will take in the old group insurance business (life, disability, and long-term care products) that formerly fell under Aetna U.S. Healthcare, as well as the former Aetna Financial Services. . . . Now that Charles Schwab has announced it will offer limited, two-tier advice-for-a-fee to its retail clients, E*Trade has more or less followed suit. The online broker has announced a partnership with Direct-Advice.com, an automated online financial advice services company that offers financial plans, what-if scenarios, mutual fund recommendations, live real-time help, and advice and feedback forums. The services, normally $75 per year, will be free to E*Trade's best customers. E*Trade also has announced that its application to acquire Telebanc, an Internet bank, has been approved. . . . New England Funds L.P., has announced a name change to Nvest Funds L.P., effective February 1, 2000. According to the company, this will more clearly reflect its affiliation with Nvest L.P., an investment management company with $127 billion in assets under management as of September 30, 1999. . . . The Cruelty-Free Value Fund, after failing to attract substantial assets and producing negative returns since its inception, has sent out proxy materials to shareholders to vote on closing down the fund.

Hitting It Big

If you've ever wanted to run your own fund portfolio, this might be your chance

Who says that little guys finish last? Reserve Funds, which has a total of $90 million in six stock funds, has been building a fund family using the money management expertise of small, independent advisory firms. And the idea seems to be working.

Of the six funds, two get five stars from Morningstar Inc., three rate four stars, and the sixth is too new to be rated. The Reserve Informed Investors Growth Fund, with a 1999 gain of 130%, was sixth among 645 large-cap growth funds. It is ranked in the third percentile versus its peers over three years and in the eighth percentile over five years. Reserve Small Cap Growth, with its 1999 gain of 135.8%, was 26th among 375 small cap growth funds rated by Morningtar, and was in the 11th percentile among its peers over three years and the fifth percentile over five years. Two of the three remaining Reserve funds are in the top quartile of performance among their peers. Only Reserve Large Cap Growth has lagged, ranking in the 95th percentile in 1999 and the 88th for three years.

"We're trying to serve investors by giving them a vehicle built around a money manager they do not typically have access to because of high minimums," says Bruce Bent, CEO of Reserve. "We look for advisors who have consistently demonstrated skill and shown they have good ideas. Then we bring that to investors."

Traditionally, fund companies have sought out subadvisor relationships with managers in charge of at least $1 billion and with experience in running institutional money. In contrast, several of the advisory firms used by Reserve Funds were managing assets in the $300 million to $400 million range when first tapped to manage mutual funds.

Bent says he tries to find advisors who want to run funds but who do not want the hassle of distribution, administration, and regulation of the fund company. Reserve handles all of the business issues of running the fund, including marketing, so that the advisor firm can continue to focus on its strength: money management. "There are plenty of top managers out there we could build a mutual fund structure around without injuring their current management style," he says. "We ask them not to change a thing - just do exactly what they've been doing, but do it for a mutual fund."

Among the independent firms managing funds for Reserve are Trainer Worth & Company, T. H. Fitzgerald & Co., Pinnacle Associates Ltd., and Roanoke Asset Management Corp., all of New York; Siphron Capital Management of Beverly Hills, California; and Condor Capital of Martinsville, New Jersey. - AG

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