Schwab's Secret Success

Schwab may be a lot of things to a lot of different clients, from custodian to fund supermarket. But fund manager?

What do you think of when you hear the name Charles Schwab? Discount brokerage pioneer? Mutual-fund superstore? RIA platform? Business rival? The ubiquitous, weirdly-animated “Talk to Chuck” ad campaign?

Whatever the name conjures, you probably don't think “asset-management powerhouse.” Charles Schwab Investment Management (CSIM), the company's house brand fund operation, is rarely mentioned in the same breath as elite money managers — and it is not considered even a remote threat to the asset-management operations of rival Fidelity Investments, which has $1.2 trillion under management.

Yet, Schwab's money-management business has grown from a niche supplier of money market funds to a diversified platform with 67 products and $160 billion in assets. That's enough to make it No. 13 in the industry, ahead of household names like Merrill Lynch and Dreyfus, according to the Investment Company Institute.

“They are a big success story that doesn't get a lot of publicity,” says Jeff Keil, managing principal of Keil Fiduciary Strategies, a mutual fund consultancy in Littleton, Colo. “They've been able to capitalize on being out of the spotlight, quietly gathering assets, similar to what you've seen with Dodge & Cox.”

Not Just Passive

That stealth success has a lot to do with how Schwab approached the asset-management business. In its early years, of course, it focused on discount brokerage. From there, it branched out into fund distribution with its pioneering OneSource supermarket. It was not until 1991 that it tiptoed into the asset-management business with money market funds, mainly as a service to clients.

“Their model was to be an asset holder, rather than an asset manager,” says Don Cassidy, senior research analyst at Lipper. In other words, Schwab has become an asset manager by default rather than by design. “Their mutual fund arm was always considered secondary to distribution,” Keil says. “They didn't want to compete with themselves.”

On the other hand, Schwab's tech-savvy, low-cost culture gave it advantages in passive money management — money market and index funds. Its OneSource platform was very popular because it offered so many different funds in one place. But that meant Schwab's own passive funds gathered assets, too. During the 1990s, Schwab Funds were predominantly money market or index, with a few actively managed bond funds in the mix (even now, 75 percent of assets are in 24 money funds).

The company has been getting more creative. In 1999, it launched Schwab YieldPlus, now the largest ultra-short bond fund with $6.6 billion in assets. In 2000, Schwab unveiled a new lineup of sector funds, which have also performed well. “Within the last five years, there was a concerted effort to start to grow the active base,” says Evelyn Dilsaver, CEO of Schwab Funds.

In 2004, in response to the Wall Street research scandals that had socked rivals like Merrill Lynch and Smith Barney (and would eventually tarnish Schwab itself), Schwab launched Schwab Equity Ratings, a quantitative system of stockpicking that eliminated potential conflicts. The system, run by Chicago Analytics, a research firm Schwab bought in May 2000, grades a universe of 3,000 stocks using fundamental and technical analysis. So far so good: Schwab's model portfolio ranks first place in the five-year category in Barron's annual competition — that's on top of two consecutive wins in the three-year category. In 2005, Schwab's stockpicking took first place overall in Barron's competition for the second straight year.

No wonder Schwab announced plans last October to distribute its funds outside its OneSource platform. Citing increasing demand for its funds from third-party advisors, who were previously prohibited from getting access without custody, CSIM has since aggressively pursued selling agreements across the different distribution channels.

New leadership was a key part of that initiative. Dilsaver, an accountant by training, was promoted to head Schwab Funds in July 2004, having toiled within Schwab since 1991 both as SVP of Schwab's asset-management products and CFO of U.S. Trust. Since taking the helm, Dilsaver has wrought better performance and expanded its lineup. Net assets in bond and equity funds grew 51 percent, and 13 new funds were launched. Advisors also recognized that its products were gaining momentum. Among Schwab's nine actively managed equity funds, five have four-star Morningstar ratings (the rest haven't been rated yet) and have been popping up on advisors' due-diligence screens for their three-year track record and minimal risk.

Paul Krsek, managing member of K&A Asset Management, a registered investment advisory in Napa, Calif., who manages about $85 million through Fidelity, has $6 million invested in Schwab Hedged Equity and uses it in every account. The fund takes traditional long positions in stocks Schwab expects to outperform the market and short positions in stocks expected to underperform the market to reduce volatility. “They're continuing to diversify to meet the market,” Krsek says. And so far, he likes what he sees. “Hedged Equity outperforms its peers and its expenses are competitive.”

Since branching out beyond OneSource, the Schwab fund complex has taken in $150 million in net new cash — $130 million since Jan. 1, 2006. “We've seen some good traction,” says Bill Thomas, Schwab's head of proprietary distribution. Schwab has 25 selling agreements, mostly in the RIA space through advisor-platform rivals like Fidelity, LPL, TD Ameritrade and Pershing.

Since the beginning of 2005, assets in Schwab's actively managed funds rose from $12 billion to nearly $19 billion. Advisor-sold assets in the Excelsior funds, funds managed by Schwab's U.S. Trust subsidiary, rose 53 percent. Meanwhile, the Laudus Funds, its 11 subadvised funds, saw assets jump 74 percent. The nine funds based on Schwab Equity Ratings saw assets sold through advisors increase by more than 342 percent last year, to $415 million.

Getting This Party Started

Schwab still has higher aspirations and, according to Thomas, is currently in discussions with the major wirehouses in New York, including Smith Barney and Morgan Stanley, as well as banks like Fifth Third and Wells Fargo. It is also nearing a deal with regional broker/dealer A.G. Edwards. Since last October, the new distribution strategy has netted an estimated 2,500 to 3,000 new advisors, Thomas says, beyond its existing network of 5,000 affiliated advisors.

“Because the active equity side of the house was getting such great performance, we kept getting a lot of calls from clients, prospects who wanted to buy the fund but not necessarily be a client of Schwab,” says Dilsaver.

However, the company is very clear about not using its funds as a lever to get more brokers and advisors into the tent — or to induce them to favor its funds once they're on board, Thomas says. To do otherwise would be to jeopardize the OneSource business, which last year sold $135 billion, up 8 percent year-over-year, in funds from all sorts of suppliers. “Schwab is forced to tread very lightly in this area of its own actively managed funds,” Lipper's Cassidy says. “They have several thousand funds by other brands that are paying some number of basis points, so they have to be careful about competing strongly with their own suppliers.”

“We've never steered our clients into anything,” says Jeff Mortimer, chief investment officer and portfolio manager of Schwab's subadvised funds. “As long as the investment is the best for the client, we're comfortable not recommending our own funds.”

Where Schwab's fund efforts don't measure up, according to Morningstar, is on the cost side. Its index funds, with fees of 42 basis points on average, are downright costly compared to Vanguard's 17 basis points. On the active side, Vanguard averages 26 basis points, whereas Schwab charges 90 basis points. “We never said we wanted to be the lowest cost provider,” Dilsaver says. “But we have a core [index] offering at 10 basis points, so we feel we compete very well.” And Schwab's active funds are still below the industry average, partially because its funds don't carry front-end loads or 12b-1 fees.

While pleased with the performance story so far, some advisors express concern over its inexperience on the active side and its short track record. “They've yet to be tested by down markets,” Krsek says. “Right now, they're a black-box shop.”

Next on Schwab's money-management agenda is a plan to broaden its offerings, probably through affiliation rather than acquisition, Dilsaver says. “Many of the acquisition candidates really want to cash out, and that's not really what we want to do,” she says, “We're looking to those who want to continue to manage money and not get out of it. When you buy an investment-management firm, you're buying the performance and the portfolio manager who creates that, and if they want to cash out, what did you just buy?”

Instead look for Schwab to continue to seek partnership opportunities, particularly in institutional and international spaces. “They will continue to evolve but they'll do it slowly and continue to find niches,” says Burton Greenwald, a mutual fund consultant in Philadelphia. Its big “adoption” deal with AXA Rosenberg in November 2003 enabled it to capture $1.4 billion in assets and fill some of that void without interfering or risk losing AXA stockpickers. (AXA Rosenberg will continue to manage the portfolio day-to-day as subadvisor, but Schwab is named the investment advisor and will handle the business side of the fund.) “We're still looking frankly for other adoption candidates, but the ideal candidate would be somebody who has a big institutional business,” Dilsaver says. “Or a big separate account-management type of business that does mutual funds on the side.”

Given their one-of-a-kind business model and significant lag time in bringing active products to market, Schwab will continue to play second fiddle to the industry behemoths. “I don't think they'll ever resemble a Fidelity or a Vanguard,” Keil says. But with more and more brokers going independent these days and open architecture on the rise, Schwab may very well bridge the gap sooner than you think.

On the Rise

Schwab funds are soaking up investor dollars.
(Assets and Estimated Net Flows. Long-term Funds Only. $ in Millions.)
Complex Name Assets March 2006 Assets Dec. 2005 Assets Sept. 2005 Assets Jun 2005 Assets March 05 Assets Dec. 04
Charles Schwab 5,354 4,174 3,322 2,611 1,888 1,242
Laudus Rosenberg Funds 4,207 3,505 3,086 2,604 2,496 2,205
Net Flows Q1 2006 Net Flows Q4 2005 Net Flows Q3 2005 Net Flows Q2 2005 Net Flows Q1 2005
Charles Schwab 953 699 581 651 646
Laudus Rosenberg Funds 289 385 295 90 298
Source: Financial Research Corporation

Heating Up

Schwab's top 5 actively managed equity funds, based on trailing three-year returns as of May 16, 2006.
Fund 3-Year Return % Rank 3-Year Category Return 3-Year Index Return
Schwab Health Care 23.34% 2% 10.95% 6.55%
Schwab Financial Services 20.10 13 15.93 16.87
Schwab Technology 16.20 29 14.34 9.29
Schwab Core Equity 16.12 13 12.97 12.99
Schwab Hedged Equity 15.93 6 7.08 N/A
Source: Morningstar
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