Schwab study states case for sole custody

With $250 billion under custody and the 5,800 financial advisers it calls its own, Charles Schwab & Co. Inc. has to plug a lot of dikes.

Schwab’s advisers frequently move portions of their assets to competitors such as TD Waterhouse Group Inc. of New York, Ameritrade Inc. of Omaha, Neb., and Fidelity Investments of Boston in the name of custody diversification.

Schwab executives don’t like the outflows, but how do you tell advisers it’s better to put all their eggs in one basket? Easy: Schwab has just released a study with Moss Adams LLP in Seattle showing that those who diversify pay a steep price.

more profit?

By using multiple custodians, advisers realize operating profits of only 7.5% versus the 15.8% enjoyed by the those who consolidate assets with one custodian.

The study defines consolidated advisers as those with more than 90% of their assets with a single custodian. Custodians with multiple custodians have less than 50% of assets with their primary custodian.

The 111% difference in the profitability of the two identified groups was derived from the income statements of 90 randomly selected firms of the 1,000 blindly surveyed in the study.

“We want advisers to understand there’s a cost associated with custodian diversification,” says Timothy D. Welsh, director of marketing for Schwab Institutional.

J. Thomas Bradley, president of TD Waterhouse Institutional Services, concedes that during the past five years, his company has been a major benefactor of advisers’ diversifying assets to his firm from San Francisco-based Schwab.

But he says he’ll probably encourage his sales force to carry a copy of his competitor’s study with them as they call on advisers. Waterhouse has evolved into the one-stop shop the study extols because of its lower fees and supermarket of 12,000 mutual funds, Mr. Bradley adds.

“We were thrilled about the study,” he says. “The next step is for advisers to step back and really decide” where to consolidate assets.

Dan Flaherty, a Fidelity spokesman, says his company takes a laissez-faire approach to the consolidation issue. “We want advisers to consolidate more assets at Fidelity, but we recognize we have to earn that right.”

James Wangsness, senior vice president of Ameritrade Advisor Services, says Schwab’s findings make more sense on paper than in reality.

“For the $200 million-or-less player, given the lack of a steady-state environment – Waterhouse may be up for sale, Vanguard closing down and Schwab raising fees – you lose control of your own destiny” by putting all assets with one vendor, he says.

When these sudden events strike, Mr. Wangsness says, advisers often have short deadlines to move assets and change systems, thus it is prudent to have a relationship with other providers.

Gary Pollock, president of Bay Isle Financial LLC in Oakland, Calif., says: “I’m beyond worrying about a second supplier. If you’re making widgets, you might want three or four vendors. This is different. The actual assets are someplace. The supplier is access to information about those assets.

“Advisers get concerned about a second supplier even though there’s a difference in the characteristics of the relationship.”

Michael S. Finer, principal with Major League Investments Inc. in Salem, Mass., is in the process of diversifying his $16 million in assets to Fidelity to bring his mix closer to 70% Schwab and 30% Fidelity.

He says he started out with 100% at Fidelity but then went to 100% Schwab 18 months ago because of its superior separate-accounts platform. Now Mr. Finer has 10% of his assets with Fidelity because he missed the marketing edge the Boston-based custodian gave him with local clientele.

Mr. Finer, a financial planner who is also a certified public accountant, asks whether it is cost effective to diversify, replying: “Absolutely not. But it’s all about sales for us right now. I look at it as more of a marketing expense than an operating expense.”

But Bay Isle Financial is headed in the opposite direction. A few years ago, it had diversified 25% of the $450 million it manages for individuals – largely with Fidelity.

But since then, the firm has consolidated so that Schwab holds 95% of its assets. Bay Isle also manages $650 million for institutions, and those assets are held by more than two dozen custodians because institutions dictate the custodian relationship.

Stanford Young, president of Financial Clarity Inc. of Palo Alto, Calif., which manages $650 million, is also consolidating at every turn.

“What’s the benefit of multiple custodians?” asks the adviser. “I don’t see benefits; I only see negatives. There are hidden costs that pop up and bite you.

“If you consolidate into two or three, you still haven’t consolidated; you still have two or three systems. You still need twice as many people or more systems, and each one has its own quirks.”

Matthew McGinness, senior consultant with Cerulli Associates Inc. in Boston, says his own studies show that after several years of diversification, advisers are starting to consolidate again.

The reasons behind the momentous cost reductions from consolidation are not mysterious. There are fewer systems to learn, fewer account-opening forms to fill out and fewer people to manage it all, the Moss Adams study states.

Still, Robert Powell III, a Boston-based consultant, says the study isn’t as groundbreaking or useful as it appears.

“I don’t think the big players will change because of Schwab coming out with a self-serving study, ” Mr. Powell says. “Advisers have been around the mulberry bush on this, and I think they’re fully aware of the increased cost.

“The big players generally think the benefits [of custody diversification] outweigh the increased costs,” he says.

Indeed, firms managing less than $200 million used an average of 3.7 custodians, according to the study. Firms managing $200 million to $500 million averaged 6.1 custodians, and advisers managing more than $500 million had an average of 16.8 custodians.

advantages

By straddling different vendors, Mr. Powell says, advisers get to keep an eye on different technologies, capitalize on the best features of various custodians and increase their negotiating leverage at the same time.

But Mr. Welsh of Schwab questions whether advisers always put a sharp pencil to the perceived benefits of diversification.

The study’s findings “make it more of a business decision,” he says.

The study adds that advisers who cut costs by consolidating get a better return on the accounts of less affluent clientele.

This is shown by the fact that the group of consolidated advisers on average had more clients than the more diversified pool (294 compared with 214) and slightly lower assets managed ($136 million compared with $158 million).

“This suggests that consolidated firms can profitably take on smaller clients” – those with portfolios averaging $486,000 versus average portfolios of $738,000 for firms using multiple custodians, the study states.

Mr. Welsh believes that custody consolidation can help his firm. “Things that benefit the industry tend to benefit us.”