Gordy Wegwart and his partners at Verity Investments were just about ready to give up. As Wegwart tells it, five years ago they had converted their broker/dealer practice in Durham, N.C., to an investment advisory practice and were looking for a new clearing and custodian service. It wasn't a simple matter of going with a well-known national brand. Verity specializes in managing 403(b) retirement programs, and they were looking for a technology interface that would allow them to change the models for their clients' asset allocations without incurring substantial trading costs. For nine months they examined dozens of custodians, culled from searches of the Internet and trade magazines and from conversations with industry colleagues. None of the companies had a system that exactly matched Verity's needs.

“We found it was very difficult,” Wegwart says. “At one point we thought that it didn't exist. We were about to throw our hands up and say, ‘What do we do now?’”

But they finally found what they were looking for — not at a goliath custodial firm but at a company in Colorado with a relatively modest $2.5 billion in assets.

In the custody and clearing world, giants still dominate. A survey of 100 registered investment advisors released in February by Morgan Stanley Research showed that just four companies accounted for 64 percent of assets custodied on behalf of RIA clients: Charles Schwab, Fidelity, Pershing, and TD Ameritrade. Schwab, the largest, reported $590.4 billion in custodied assets for its Advisor Services division at the end of 2009. Scale is critical to this business, because the greater the number of clients a company has, the more efficiently it can operate its pricey technology platforms, and the biggest players continue to grab market share. In their shadow are far smaller firms that are just eking out a profit, and scrambling to expand against significant odds.

“I don't think the small players are winning,” says Tim Welsh, president and founder of California-based marketing researcher Nexus Strategy. “The 80-20 rule is alive and well in the industry, with 20 percent of the firms gathering 80 percent of the new assets. Small firms tend to stay small because they do not have any scale. Big firms can grow faster since they have infrastructure that can be leveraged with more clients and assets.” Also, custodial relationships tend to be “sticky.” Such tasks as paperwork, asset transfers, and the mastering of different software and computer systems can be daunting to advisors who might prefer to leave well enough alone.

Yet Welsh and other industry observers agree that opportunities exist for smaller firms in the clearing and custody channel that weren't available years ago. Technology has become the great leveler in the financial advisory business, they argue, and business people who are adept can offer solutions that are tailored to the needs of an individual advisor at prices that are competitive with the large custodians. The need for custom-made solutions is likely to grow as the RIA channel itself expands and moves into niche markets, they say.

“I think that the big guys are vulnerable,” says Steve Winks, principal at srconsultant.com, an FA consultancy in Richmond, Va. “Because of their size, they're somewhat insulated from some of the factors that are driving the market. They don't have to be responsive because they already are fairly dominant,” he says. But that leaves “the doors open for smaller custody firms that view disruptive innovation as the key to their winning market share.”

From Fledgling To Player

Some smaller custodians are setting themselves apart by providing extra high-touch client service. Patricia Heath, who has an RIA practice in Northfield, Ill., says she switched over to Shareholders Service Group about three years ago because she was impressed with the firm's commitment to quality. One thing she noticed when she stopped by the company's office to talk with management was a board on the wall that kept track of mistakes. The fact that they had a system in place to do so gave her a sense that attention would be paid to details, she says. It's not unusual for her to put in 20 calls a day to her custodian on such matters as account transfers and issuing checks to clients. Before SSG, she had her share of instances where clients' names were misspelled, mistakes that weren't her fault but still reflected poorly on her. “A broker/dealer can make or break your business if they are sloppy or don't get things done on time,” Heath says. “I've had clients for 20 years.”

Other small custodians compete by catering to the niche needs of smaller RIA firms. Wegwart sees his own experience as emblematic of that kind of market. “There's definitely evolution going on in the industry,” he says. “Our business was built very much outside the box.” Wegwart's Verity Investments custodies about $150 million in assets with Trust Company of America in Centennial, Colo., which provided the technology solution that Wegwart sought with such difficulty five years ago. A custodian that focuses on fee-based RIAs, Trust Company uses a technology platform that can roll up the multiple trades that portfolio rebalancing requires into a single trade, lowering trading costs to FAs and their clients, he says. Trust Company's model seems to be working: Since Verity signed up in 2005, Trust Company's assets have more than quadrupled to $9.1 billion. While it occupies the small end of the custodian size spectrum, continuing growth is very much on its agenda. Frank Maiorano, its new chief executive, said the company wants to reach $20 billion in assets within five years.

“You could say we're a niche player because I think that's just the thing people say about companies that are our size. But we work with wealth advisors. We work with breakaway brokers. We do a significant amount of business with TAMPs (turnkey asset management programs),” says Maiorano, who previously helped expand RIA business at Nuveen Investments and at Schwab before taking over at Trust Company in January. “Four years ago I would say we were a small fledgling custodian. Now we actually have presence and we have significance in the marketplace. We don't have to grow, but absolutely we want to grow.”

Indeed, for small custodians, growth should be deliberate and strategic. Peter Mangan, president and chief executive at Shareholders Service Group in San Diego, Calif., says he's not looking to expand the firm aggressively. Mangan helped found the company in 2002 and today it manages several billion dollars in assets and growth of 20 percent to 30 percent a year. That's not bad. “The pace of growth has been fairly steady over the past years. We don't do a lot of marketing. We're really not aiming at becoming a real fast grower and looking for a quick exit. We enjoy the business and would like to run it for a long, long time to come,” Mangan says. “You can do more marketing and sales and increase the rate of growth, but you better be able to service it because if you don't, you'll just end up losing your credibility and losing your reputation.”

With the collapse of major investment banks following the credit meltdown of 2008, and the Bernard Madoff scandal, credibility is one of the qualities that advisors continue to seek from custodians. They want to know that their client's money is safe. In this area, big firms with brand names may offer a certain comfort that smaller, lesser-known companies simply cannot. Perhaps that is at least in part why Schwab was rated the No. 1 custodian platform in a Morgan Stanley RIA survey released Feb. 1, getting 35 percent of advisor respondents' votes. Fidelity was second, with 18 percent of the vote. The survey showed that 24 percent felt reputation was the most important factor in choosing a custodian, although a greater number of respondents rated other criteria — including service, technology platforms, and cost — as most important. “It has definitely become a critical question for investors to ask. Where's my money, and how do I know it's safe?” Mangan says.

On the other hand, credibility may be measured less by the amount of assets managed by a custodian than by the experience of the managers who are running the company, Mangan adds, and this can work to a smaller custodian's advantage. “At the end of the day it's a confidence issue,” he says. “Do advisors have confidence in your ability to deliver what they need to run their business? Not everybody does. You can see cases where firms have set up advisor businesses and decided it wasn't worth it because they didn't get the assets. Why didn't they get the assets? It's because the advisors are running their own businesses and they're not going to put those assets into the hands of someone who doesn't know how to do what they're doing, or who the advisors don't trust will be there the next year and the year after.”

Sometimes an advisor will sign on with a smaller custodian simply because the advisor has difficulty setting up a relationship with a major player. Take Paul Acker, who started NetWorth Consulting in Washington state about 18 months ago and now manages around $5 million in assets. Acker says he decided to work with Shareholders Service Group after talks with a few of the larger ones, including TD Ameritrade, fell through. Acker said he was put off when the TD rep pressed him for a business plan and for AUM growth goals for the first year. He didn't think he could grow as rapidly as they wanted him to. TD Ameritrade doesn't require a prospective client to meet minimum asset levels, says Tom Nally, managing director of institutional sales, but it does expect advisors to demonstrate they want to run a growing business. “You don't want to devote resources to somebody who's not serious,” Nally says.

Shareholders Service Group's Mangan said his company has no minimum AUM levels for advisors, but it does expect its advisors to be registered, have a corporate structure, and have client agreements. Acker met those criteria, and was “thoughtful and coherent about his plans for growth,” he adds. Mangan doesn't worry too much about working with advisors who others may feel are too small to operate effectively. “The natural effect of running a business will weed out those that can't sustain us or themselves. We don't need to throw people out. The business environment takes care of that.”

Acker says he's happy with his custodian and believes the relationship will thrive in the days ahead. “They probably don't make money off me, but they know if my business grows, we'll use more of their services,” he says.