Showdown

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.”