Schwab Does It Again

Can you name the Street's largest asset gatherer last year? Was it Merrill? Smith Barney? No, the title went to Charles Schwab. The pioneering discount broker, who was slammed by the tech wreck and suffered through protracted management struggles in the past two years, is beating the wirehouses at their own game. It's scooping up high-net-worth clients. And, in part, it's doing so with the help of former wirehouse reps.

Charles Schwab Institutional, the group that handles the accounts of registered investment advisors (RIAs) who compete with wirehouse reps for retail customers, doubled the rate at which it acquired assets in 2004. The unit brought in $30 billion, while Merrill and Citigroup's Smith Barney each brought in $24 billion. Including assets from individual investors, institutions and new clients at the U.S. Trust subsidiary, Charles Schwab & Co. has added $97 billion in assets over the past two years — equal to what UBS, Merrill and Smith Barney amassed, combined, according to company reports and Smith Barney analysts.

Two years ago, few would have predicted Schwab would be in this position. The once-core business of handling self-directed individual investors had collapsed after the dot-com bubble popped and trading volume evaporated. Even as the markets recovered in 2003, Schwab continued to lose ground to deep discounters like E*Trade. Meanwhile, its ambitious play for wealthy clients with the 2000 purchase of U.S. Trust had not panned out. The man behind that deal, David Pottruck, was forced out and, in 2004, Charles (Chuck) Schwab, stepped back in to run things.

Meet the New Boss

At 67, Schwab is reinventing the company that he founded 30 years ago, which, at one time, had been a one-trick pony: a discount brokerage. Now, Schwab says, cheap trades won't carry the company. The new name of the game is asset gathering. “Trading has been commoditized,” Schwab told me in an interview in January. “The future is really about competing for client relationships.” Schwab's focus, like that of its competitors, is on households with assets of $500,000 and up in liquid assets.

As he implements this new strategy, Schwab is also streamlining the organization and cutting costs. Over the past 18 months, Schwab has shed 2,400 employees and trimmed more than $600 million in fixed costs. He reduced the full branch network to 228, down from 339 at the end of 2003. And he retreated from his foray into investment banking. In August 2004, he sold Soundview Technology to UBS for $265 million, just eight months after the company had shelled out $322 million for the high-tech underwriter. At the same time, the company is reaffirming its commitment to U.S. Trust, even as Chuck Schwab acknowledges he underestimated the cultural mismatch between the two firms. (More than 300 U.S. Trust wealth advisors have jumped ship rather than submit to Schwab's focus on middle-income investors.)

Whatever U.S. Trusts' supposed problems, Schwab gained much of that $50 billion in new assets in 2003-2004 by attracting former wirehouse advisors who want a measure of independence. In the second quarter of 2005, Schwab recruited over 300 brokers who were converting their businesses to RIA practices. They brought in more than $11 billion in new client assets, according to Bob Oros, senior divisional sales manager for Schwab Institutional. “While we have always won business from RIAs and brokers turning independent, we really saw a pickup in that flow last year,” he continues. Many of these advisors had already converted to fee-based models, Oros says, which makes it easier for them to set up shop as independents and custody with Schwab.

The company is aggressively wooing advisors who already have sizeable books, “wealth managers,” wirehouse RIAs and bank trust officers. “A broker with $25 million to $50 million is on the small side,” says Oros. “The majority have upwards of $100 million in assets and north of that.”

Schwab depends most heavily on recruiting small or medium-sized RIAs. “The majority of our $1 billion-plus clients started with $20 million 10 to 20 years ago,” says Grist.

Still, Schwab says it is having particularly good success recruiting so-called RIAs in transition. These are advisors who still retain their Series 7 licenses and have a mixed book (part transaction, part fee-based). But, says Barnaby Grist, Schwab's managing director of Business Consulting, these veterans find that association with a wirehouse, especially in terms of personal satisfaction, limits their upside. At a wirehouse, even top brokers are stuck in a grid where half of their production goes to the firm. And, even with open architecture, firms limit what a broker can sell. “I've heard brokers complain, ‘I found this great approach or product, but can't offer it to my client because I'm being hamstrung by the wirehouse,’” says Grist. Of course, wirehouse management responds that its brokers don't have to worry about overhead and technology, since they provide it. Also, most broker/dealers do in fact have open architecture with a wide array of financial products.

That's Where the Money Is

Schwab already has over 30 percent market share of all RIA client assets that are not affiliated with b/ds — so incremental progress won't be easy. Yet while it has a relationship with about half of RIAs in the $1 billion-plus segment, its wallet share of assets is closer to 6 percent. That's a metric it hopes to double in three years.

How? One-way is to tap into the fast-growing separately managed account (SMA) business. Schwab currently has about $17 billion in SMAs (up 35 percent from a year ago) and is rapidly expanding the products offered to both the RIAs and to its internal private client group. Of the 5,300 FAs that affiliate with Schwab, only a small percentage currently uses SMAs for their clients. As affluent investors demand this product, Schwab intends to promote and expand its SMA offerings. Industrywide, SMAs now represent about $550 billion and are growing at about 20 percent a year, according to Boston-based Cerulli Associates. Schwab's SMA-generated assets will likely only increase.

As the basics have changed, so have essential elements of Schwab's business model. For example, Schwab became successful serving investors of average means. Today, Schwab makes no apologies in conceding that it can no longer serve average investors at a profit. Instead, like its competitors, it is pursuing high-net-worth investors.

The strategy is working. Over $700 billion of Schwab's client assets are with millionaire households, and $300 billion is in households with $100,000 to $1 million in assets, according to Smith Barney analysts.

To gather and hold assets of well-heeled clients, Schwab is also looking beyond the RIA channel and launching new programs that provide advice to clients who still want to control their investing. Well-off clients (with more than $500,000 to invest) who don't come through the RIA channel can now opt for the Schwab Private Client plan. It includes a quarterly face-to-face consultation with a Schwab advisor. Annual fees start at 75 basis points and decrease as asset levels increase; the minimum quarterly fee is $1,000. Of the total $28 billion in Schwab Private Client assets, over 90 percent of the new assets came from existing clients. That means that Schwab Private Client customers are satisfied, and FAs are winning more of their clients' assets.

Another offering for smaller investors provides a telephone consultation with an advisor, who prepares a custom asset-allocation plan. The average client has about $270,000 in assets at Schwab. The company says it has brought in about $6 billion in assets in less than a year. More than 400 new households are signing up every week, according to Smith Barney. Overall, Schwab estimates these new offerings attracted at least $22 billion in new net assets last year. The average client served by these offerings parks in excess of $2 million at Schwab.

Although the company down-plays the contribution of its Schwab Bank platform to asset accumulation, the company expects to leverage the “sweep” to the bank, which is now $4.6 billion and growing. Schwab Bank will not only add an incremental $100 million to the top line in 2005, but will contribute $6 billion to $8 billion to its current deposit base in 2005. Much of this is supplemented by other initiatives, such as consumer lending. The bank's main champion: Chuck Schwab.

If you go to Schwab's Web site, you can apply for a mortgage or home equity loan. These links represent the nub of Schwab's biggest challenge. How does the company extend the Schwab brand to include banking services without diluting it in the minds of brokerage clients?

With Chuck Schwab back as CEO, the Schwab franchise moves into a new era. The industry in which it participates has fewer players, is more commoditized, and is relentlessly focused on the wealthy. On this playing field, a new energized Schwab & Co. has emerged as an asset-gathering machine to be reckoned with.

NEW MONEY

Net new client assets, in billions, at Schwab and its competitors.

INDEPENDENT MINDED

Client assets of fee-only registered investment advisors unaffiliated with a broker/dealer have reached an estimated $900 billion. Schwab has over 30% market share.