From the October 2002 issue of Investment Advisor • Subscribe!

Showdown

Wrestling with questions about which custodian to

The stock market's instability, coupled with corporate accounting scandals, have caused investors' confidence to drop to an all-time low. But independent investment advisors have become a haven for investors since the stock market's doldrums settled in this past year. Ask most advisors how business is, and they'll tell you their phones are ringing off the hooks. Recent data from the online research firm AdvisorBenchmarking.com bear out advisors' success amid the market turmoil: Advisors at all asset levels increased their client bases by 8.18% last year. Their assets under management jumped nearly 22% over 2000, and their revenues shot up by 5%.

But individual investors aren't the only ones with a renewed sense of appreciation for advisors. Brokerage firms are counting on them for more help these days as well. As investor confidence and retail trading volumes have plummeted over the past two years, financial services firms with institutional arms are looking to shore up weak revenue streams with more stable advisor assets. Indeed, now that advisors' fee-based, consultative approach to serving clients has proven itself amid tough economic times, the battle is on to retain existing advisor clients and bring new ones aboard.

This battle for advisor dollars has become particularly visible among the top three advisor custodians--Charles Schwab Institutional, Fidelity Investments Institutional Brokerage Group, and TD Waterhouse Institutional. Each of the top three has been jockeying for position by adding new and revamped services with alacrity. And the contest has heated up amid gripes by some Schwabbies that the San Francisco-based discount broker's revamped advisor services compete with their own practices or compromise their cherished independence. Just peruse the pages of Investment Advisor or other trade publications, and you'll see ads from Fidelity and TD Waterhouse that vow to keep advisors independent.

Schwab Still Leads

But while Fidelity, the world's largest mutual fund group, and TD Waterhouse, a unit of Canada's huge Toronto-Dominion Bank, are running hard, Schwab still holds the bulk of advisor assets. Schwab Institutional serves 5,800 advisors and has a whopping $230 billion in advisor assets--nearly 30% of Schwab's total customer asset base. Fidelity, by contrast, custodies $66.3 billion in advisor assets for 1,393 advisors--a $16 billion jump from the $50 billion the Boston-based firm held for 600 fewer advisors only 18 months ago. And Waterhouse holds $17 billion in advisor assets among 2,600 clients, pulling in about $4 billion in new assets this year.

Why has winning more advisors assets become so vital to the top three custodians? For one, advisors' assets tend to be stickier than assets gleaned from retail clients--especially when a bear market hits. Just look at how Schwab's pretax operating income in its retail business has gotten clobbered: From $834 million in 2000, retail operating income plummeted to just $245 million in 2001--a 70.6% decline. The severe decline in retail operating income is directly tied to a falloff in trading volumes. Advisor dollars in the institutional business, meanwhile, were far less fickle. Schwab's operating income in its institutional business totaled $290 million in 2000, compared with $272 million in 2001--only a 6% drop. Remember that a big part of any custodian's revenues are transaction fees on advisors' customer accounts, as well as fees levied on mutual funds to be listed in the firms' supermarkets.

The other two custodians are also seeing direct retail volumes decline. As of July, TD Waterhouse's total customer assets were $124 billion, a 5% decline from the previous month, and a 9% decrease from last year. And retail accounts at Fidelity fell from $440 billion in June to $421 billion in July. The firm is also seeing less activity in its online accounts: It had $288 billion in assets in June, but only $266 billion in July.

With advisors and their businesses sharply in the spotlight, how do they feel about the war being waged on their behalf? How and why do advisors choose a custodian? Why does an advisor abandon one? Does it really matter which custodian an advisor uses? And which custodians besides the top three are winning over advisors? We set out to answer these questions with an informal nationwide poll of advisors conducted by e-mail and phone. We also chatted with the heads of the advisor divisions at Schwab, Fidelity, and Waterhouse to see how they think their tactical maneuvers are faring these days--and to see what new tricks they have up their sleeves. And to help advisors get a better sense of which firms are offering what types of services--and at what price--Research Editor Liana Camporeale compiled an exclusive directory of custodians' offerings which appears on page 52.

There's no question that technology is making it easier for advisors to do business with multiple custodians. And new entrants to the custodial business are cropping up to challenge the big three. Broker/dealers, including Raymond James Financial Services and Bear Stearns, have each started advisor divisions. EAInvest, which bills itself as "the independent financial advisor's platform," is gaining adherents. Advisors are also choosing to custody at trust companies including National Advisors Trust Company and Trust Company of America. Vanguard, SEI Investments, and DATAlynx remain longtime players in the custodial game. And top executives of AIG Advisor Group, the B/D unit of American International Group, hint they might head in this direction as well.

One of the most common reasons advisors are choosing to spread clients' assets among multiple back-office providers is to avoid being bound to one firm. Matt McGinness, the Cerulli & Associates analyst responsible for the recent study, "The State of the Registered Investment Advisor Market," says he has seen a rise, especially in the past two years, in advisors' use of multiple custodians. "Advisors who have relationships with Schwab are hedging their bets," he argues. Cerulli estimates that nearly half of all RIAs custody clients' assets at more than one firm.

"There is a uniform concern [among advisors] about being beholden to any one provider, and particularly Schwab, because it has made a commitment to participate in our territory," concurs Harold Evensky, of Evensky, Brown & Katz in Coral Gables, Florida. That "territory," many advisors say, is the space also occupied by such wealth management services as U.S. Trust and Schwab Private Client.

Shifting Assets

Evensky's firm, which has $360 million in assets, moved its clients' assets from Schwab to Fidelity two years ago. Evensky believes that "larger advisors [will be] spreading assets around and becoming as independent of any platform as possible." But another advisor who still custodies the bulk of his clients' assets at Schwab says that while the discounter's services are topnotch, he's uncomfortable with Schwab services he sees as encroaching on his turf. Schwab "is in direct competition with us," says George Middleton, a CFA with Limoges Investment Management in Vancouver, Washington. "There is no doubt in my mind that if [Schwab] could dominate the marketplace and put us out of business, it would." Middleton says his firm is considering putting some client assets at DATAlynx, specifically because it doesn't currently provide competing services.

Plenty of advisors share Middleton's view. Take Scott Leonard, president of Leonard Wealth Management in Santa Monica, California. He says he used to be a "big supporter of Schwab," but that has changed. He's now "actively searching for a custodian that does not have a retail or institutional presence."

But for all the grumbles, there has been no mass exodus of advisor assets from Schwab. "Schwab has not lost any ground," says Cerulli's McGinness, who estimates that the San Francisco firm continues to control more than 70% of the custodial market even if advisors are putting new client money at other firms. "Schwab's a great provider," he maintains. "Frankly, it's hard to argue that there are firms out there that are doing a substantially better job than Schwab is in the business of providing clearing and custody."

Many advisors roundly concur. Bernie Kiely, of Kiely Capital Management in Morristown, New Jersey, for example, thinks advisors' gripes about Schwab are "overblown." Other advisors argue that Schwab, as a public company, has every right to fiddle with its business model as it sees fit. Still other advisors--and industry watchers--argue that competing with service providers is par for the course these days, and advisors had better live with it. In fact, "The Future of the Business," a recent report by CEG Worldwide in New York, argues that wealth management will dominate all other business models, and that competition will continue to be a big issue for planners going forward.

Business Is "Remarkable"

And what of it? Schwab Co-CEO David Pottruck told Investment Advisor during a recent conversation that "Schwab's business serving advisors, in spite of all this noise [among advisors], is quite remarkable." He continued: "We're not in the business [of serving advisors] without competition; no one has to do business with us. They do business with us because we offer compelling advantages, and we offer great service at a fair price."

While Schwab still maintains a healthy lead, advisors say strides being made by Fidelity and Waterhouse to offer new technology and other services are powerful selling points. So are both firms' pledges to respect advisors' independence--at least for now. TD Waterhouse appears to be winning converts with cheap prices, good customer service, and a more accommodating attitude in dealing with advisors. And both Waterhouse and Fidelity have secured relationships with advisors by supplying them with Advent software. Fidelity also gets kudos for its new lineup of services, technology offerings, and a flexible platform.

Roy Diliberto, former Financial Planning Association chairman and president of RTD Financial Advisors in Philadelphia, recently decided to ditch Schwab for TD Waterhouse. He especially likes TD Waterhouse's open platform. His firm, which has $170 million in client assets, likes "the fact that [Waterhouse] is partnering with outside vendors to offer their services to their advisors. There's an arm's-length relationship between TD Waterhouse and the vendor, as opposed to Waterhouse owning the service themselves," alluding to Schwab's recent decision to stop selling its proprietary portfolio management and accounting program, Centerpiece, to advisors who don't custody assets at Schwab. "I feel more comfortable with that kind of [open platform] arrangement because it offers us more independence."

"Glacial Shifts"

Dennis Gallant, an industry analyst who co-wrote the Cerulli study with McGinness, says the research firm "is seeing glacial shifts of market share [among all of the custodians]. We're not seeing rapid drops [in advisor assets] anywhere." Why? Part of the reason is because switching custodians is a pain in the neck. And advisors are also loath to take on the task of moving assets for fear "the same conflicts are going to manifest themselves" at another custodian, he says.

After all, neither Fidelity nor Waterhouse has promised not to offer competitive services in the future. And what if one custodian's service turns out to be just as bad as another one? And "even though newer players can start off with lower technology and hopefully have an easier time obtaining margin without scale, a new custodian does raise concerns among many advisors," Gallant says. "They are saying, 'I might try it, but what happens if [the firm] decides this isn't a viable market for them or they shift their market focus? Then I have to shift the back-office again.'"

What it boils down to, Gallant argues, is that "advisors consider clearing and custody to be a component of their business," but feel that choosing the wrong custodian won't "put them out of business; but inertia is a very powerful factor" in choosing not to move to another custodian.

So what does Pottruck think of the hubbub about Schwab Private Client, Schwab Advisor Network (previously called Advisor Source), and U.S. Trust? In Pottruck's view, adding these wealth management services is "not out of character" with Schwab's historical business model of adding services to match clients' needs. "We have always been a company that services clients, and [have been focused on] adding services and innovation that meet a need that's not being met by anybody else," Pottruck says.

Pottruck says Schwab is now focused on serving every segment of the wealth market through its U.S. Trust, Private Client, and Advisor Network services. The goal of Schwab's private client service is still to woo the self-directed investor, but also help steer Schwab toward a non-discretionary business model. "I think what has people feeling less comfortable" is that Schwab is now serving "this market in the middle called 'validators'--those people who make their own [investing] decisions, but want a little bit of help," Pottruck says.

When Schwab was serving just the self-directed investor and the "delegators"--investors who allow an advisor to manage their portfolio, "it was very clear what we did and what we didn't do," he says. But "there was this big gulf in the middle [that] is actually half of the market of investors," he says, "and we didn't feel we could continue to only go after half of the market." Pottruck says Schwab has been working on its private client business for nearly two years, "long before all of the investment banking scandals that have made this type of model now one that everyone else is trying to copy. We saw that opportunity and decided to go after it."

Pottruck says he's heard complaints from advisors about the private client service "for a real long time, and we've tried to manage the details of execution very thoughtfully because the business opportunities for advisors, and for us, is so huge."

When told of an advisor's view that Schwab was willing to lose some advisors in order to push its business model forward, Pottruck responded: "We worry a lot about losing advisors. We have billion-dollar advisor relationships with lots of competitors clamoring for business from the advisors, so for us to not to continue to invest and put resources into our advisor business would be crazy for us."

According to Schwab's latest quarterly report, released in July, since launching the private client service in May, more than 1,300 clients with average assets of $770,000 have signed up. Pottruck says that Schwab is on track to reach its goal of $3 billion to $5 billion in assets in the private client business by year-end--with the figure probably being closer to $5 billion. And net new client assets placed at Schwab through the private client service, accounts managed by investment advisors, and U.S. Trust accounts totaled $6 billion as of the second quarter, and total assets in these accounts equaled $348 billion.

Deborah McWhinney, president of Schwab Institutional, says with the private client service as well as U.S. Trust and Advisor Network, Schwab is reacting to client requests for a more hands-on, full-service advisory relationship with the firm. "Investors who thought they were really smart in the 1990s aren't feeling so smart now," she says. And "they have pulled us to be a little more professional about how we provide them with advisory services."

Pottruck says for Schwab customers who want "a delegated investment manager solution," Schwab "sends them to our partners in the Schwab Advisor Network. And we also run advertising that supports the whole concept of going to a fee-based independent investment manager."

Fee Hike

To be sure, some advisors have been objecting to the new fees that Schwab is levying to be in Advisor Network. Until recently, Schwab charged advisors a minimum of $8,000 to obtain referrals from local branch managers. Now, Schwab charges advisors 15% of any advisory fees they earn off clients referred through Advisor Network, with a minimum of $10,000. If advisors participate in other custodians' referral programs, however, the fee jumps to 18%. And if an Advisor Network client moves to another custodian, Schwab will charge a 75-basis-point termination fee on the entire account.

Through its new Advisor Network fee structure, Schwab is "building an annuity into your firm," says Tom Gryzmala, president of Alexandria Financial Associates in Alexandria, Virginia. "That's ludicrous." Moreover, adds Dan Moisand, president of Optimum Financial Group in Mel- bourne, Florida, by levying exit fees on clients, "once they've got their hooks into you like that, that's a complete compromise of your independence. Schwab has decided to try to maintain its market share using handcuffs, instead of their old tactic of doing a better job than their competitor."

Pottruck, however, maintains that the referral program's fee-splitting arrangement is a "win-win for all parties." In fact, says McWhinney, "I've got more [advisors] wanting to get into the program than who want to leave." Last year, she says, Schwab referred $5.3 billion to advisors, and expects to reach $6 billion this year. "We've referred more dollars to advisors than one of our major competitors has in total in their institutional business," she says. "The revenue and profit that we send advisors' way is probably fivefold or tenfold what we charge for the fees to be in the referral program," Pottruck adds.

Moisand also objects to "the potential for increased involvement with the client from the Schwab branch personnel." He says Schwab is now allowed to "check up" on the client. The worry? "We are the ones responsible for virtually everything that happens with the client because we are the ones taking the fiduciary responsibility and are being paid by the client to do that," Moisand says. "And as such, we don't need outside personnel to be involved with gaining client satisfaction. It also increases the chances the client will get confused [about] who's doing what."

But Pottruck says that when Schwab refers an individual to an independent advisor, "it's a shared client," so Schwab has every right to be involved. "When we win a client and then refer that client to an advisor, we have a shared relationship, we're not ceding the client to the advisor," he says. "On the other hand, when an advisor brings a client to Schwab, that is uniquely the relationship of that advisor. And no one's got better policies around these issues than we do; nobody sweats the details of respecting the sanctity of the advisor/client relationship better than we do because nobody has as much to lose as we do."

Shuffled Deck

McWhinney argues that advisors using the referral program are able to take advantage of the Schwab brand, which adds "credibility" to advisors' practices, and provides them with help in marketing their firms. "As much as our [advisor] clients would love to believe that [investors] know that they're out there, they don't. That's one of the biggest issues that [advisors] face is they don't have the marketing might to advertise, and quite honestly many of our investors thought of an advisor as a mom and pop shop."

Schwab has also been shuffling its executive ranks of late by moving John Coghlan to head Schwab's retail business. Coghlan ran the RIA business since 1987, and was replaced by William Atwell. Pottruck says Schwab does not "favor one enterprise or approach [within Schwab] over another," and that advisors should feel they have an "advocate in the chief executives of the retail business" now that Coghlan's on board. Coghlan "built the advisor business from scratch and wants to see it continue to thrive and prosper."

So what's tops on Schwab's plate for next year? McWhinney says the top priorities are rolling out its improved portfolio accounting product Centerpiece as well as its new Advisor Branded Web Service. Advisors have been displeased with Schwab's decision to only offer Centerpiece to advisors custodying assets at Schwab. But McWhinney says Schwab clients have been "very positive" about it. "The reality is that in order to convert someone from the old Centerpiece system to the new [Internet-based server], it will take resources. And for us to sell and commit those resources to clients who don't do business with us and have our really great loyal clients who we are trying to help be more scalable stand in line behind someone else, certainly didn't make sense to me or our big clients."

Open Platform

It's easy to see Fidelity is posturing its firm as one that doesn't see eye to eye with Schwab. Although not commenting directly on advisors' concerns that Schwab is offering constricting services, Jay Lanigan, executive VP in charge of the RIA business at Fidelity, concedes that Fidelity is bent on promoting its open platform. "Clearly as you look at the market today, there's been an opportunity for us to not necessarily tell a new story, but reiterate our approach to the business for the last 10 years, and to make sure it's communicated a little bit more directly. That's what you're seeing running today in terms of the ads we're putting out in the marketplace," he says. "They focus on our platform that provides open choice in terms of products and services on the technologies that either we will provide directly, or if those are things that we think a third party demonstrates better, we will provide that as well." All of the services, he says, support "the independence and the objective nature of the advisor."

Over the past few years, Fidelity has stepped up service offerings for advisors in the areas of technology, services, and human resources, Lanigan says. In the last year alone, Fidelity partnered with the NaviPlan wealth-planning software suite and began offering alternative investments through its Private Offerings Program, and administrative trustee services via Fidelity Personal Trust Company. Lanigan says Fidelity is now working on its administrative trustee capabilities through the Personal Trust Company "in terms of holding the assets" for companies. Fidelity is also looking at how to support advisors who work "within a trust record-keeping environment," he says.

Fidelity also rolled out this year two new versions of it Web-based trading platform, AdvisorChannel.com, including a new product called Account View, a consumer Web technology that Fidelity now provides to advisors. And the brokerage firm is improving its turnkey marketing program for advisors called Practice Advantage.

An additional strategic move for Fidelity has been to offer separate accounts through an alliance with Frank Russell. In the third quarter, Fidelity plans to launch Manager Marketplace, a supermarket of separate accounts. It is also providing account aggregation through ByAllAccounts.

Finally, it opened Wealth- Access, a comprehensive platform providing RIAs and Fidelity's correspondent broker/dealers with access to wealth planning tools, trust services, managed products, and corporate executive liquidity management services.

When asked if Fidelity would ever launch services that compete with advisors, Lanigan responded: "Today we do not provide advice on direct instruments or provide access to our retail customers on separate accounts." But Fidelity does provide guided advice on its mutual funds. Like Waterhouse's Tom Bradley, he says it's important that Fidelity is "honest and direct" with advisors about his inability to predict what might happen.

Lanigan says Fidelity refers clients seeking direct advice to advisors in its referral program, Advisor Access, which has no fee-sharing arrangement. Since launching the service last June, Fidelity has referred $620 million to advisors, with the average new client account a little above $1 million.

No Competition--for Now

Meanwhile, Waterhouse last year referred 3,100 clients to advisors through its own Advisor Direct program, which also has no fee sharing arrangement. Clients had average assets in the $800,000 range, which translates into $1.7 billion in referred assets last year. "We are on track to do a little more this year," says Bradley.

Like Lanigan at Fidelity, Bradley says advisors are becoming increasingly drawn to Waterhouse because it doesn't offer services that compete with them--even though he constantly reminds clients that he can't guarantee TD Waterhouse won't compete with them in the future. "Waterhouse is a registered investment advisor, it has its own money market funds, and provides guidance to its self-directed customers," he says. "[Waterhouse] doesn't compete with advisors; but how do I know that in 10 years we won't go out and buy a trust company?"

Waterhouse's service attitude, flexibility in product offerings and providers, as well as its VEO online trading platform, are also drawing converts, he says. "Advisors love the way we serve them in personal teams of relationship managers," he says. "Our technology is as good as, or better, than any of our competitors and our technology is really fantastic." He says Waterhouse just added research to VEO, and can now distribute Advent's software to its advisors via the platform. By January, Waterhouse hopes to provide advisors with performance reporting through Advent's product, Axys. And by next summer, Waterhouse plans to offer MOXY, Advent's trade management product, as well as Qube, its contact management service.

"No one else has brought together the portfolio management, the trade management (sophisticated trade management), and contact management on a brokerage platform," Bradley argues. "This is going to be an extremely compelling platform," he says, "and a very compelling reason for advisors to move all of their business to TD Waterhouse because it's going to be an integrated platform: All of this technology that they may have on their desktops today will be consolidated in one place. The reconciliation of accounts will be done for them, and they will be able to significantly reduce their internal costs."

For TD Waterhouse, Fidelity, and, of course, Schwab, there is no higher-stakes game than the advisor business. Between retail stock trading volume falling and assets flowing out of once-lucrative equity mutual funds, direct retail investor channels are in a mighty funk. Contrast that to the advisor channel, where business remains strong and clients remain loyal. Serving the advisor channel has been a winning strategy for Schwab for years. Now its major rivals, plus a bunch of other contenders, want a bigger piece of the action.

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