Too Big To Ignore

It's a familiar drama in the schoolyard and in business too: One day a kid comes along with some cool new toy — instantly supplanting the previously reigning cool kid and winning schoolyard prestige. The registered investment advisory (RIA) industry's glorious growth over the past few years is like that kid with the cool new toy; the rest of the financial-services industry can only be thinking one thing — I want one of those. Today there are roughly 16,000 independent RIA firms with 42,000 advisors managing $1.8 trillion in client assets in the U.S., according to Moss Adams. (The number includes dually registered advisors, so-called because they have Series 7 licenses in addition to their investment-advisor rep status.)

Yes, that sum is dwarfed by client assets held at the big, national firms: Merrill Lynch, Morgan Stanley, Smith Barney, Wachovia (now with A.G. Edwards), UBS and Edward Jones employ about 73,000 advisors who control nearly $7 trillion in assets. Still, the RIA sector has made a big impact in a short period of time: Between 2001 and 2006 assets grew by 66 percent, and the number of firms grew by 33 percent. And the institutional firms that serve RIAs — primarily Charles Schwab, Fidelity, TD Ameritrade and Pershing — are reaping the benefits. The firms continue to capture RIA assets and attract disgruntled employee broker/dealer reps. In order to keep the gravy train rolling, those firms are investing millions to improve their existing RIA support offerings. In short, the RIA market is gradually emerging as a real rival to traditional brokerages.

Consider the success of Charles Schwab and its Schwab Institutional unit, a platform of asset managers and custodial services for RIAs. In the all-important asset-acquisition game, Schwab has been literally embarrassing the likes of Merrill Lynch and the other wirehouses. From September 2006 through September 2007, Schwab Institutional netted $129 billion in net new client assets, just short of Merrill Lynch, Smith Barney, Morgan Stanley and UBS combined during the same time period.

One wonders how much longer Merrill Lynch and the other wirehouses will sit on the sidelines, quietly watching Schwab exploit a fast-growing sector of the financial-advice industry.

Probably not much longer. In fact, Merrill is already building its own RIA strategy. Unbeknownst to many, Merrill has an RIA support platform called Money Management Services. According to Merrill, MMS serves almost exclusively large investment managers, most of which the firm has trading relationships with. The question is whether Merrill executives will really get behind a retail RIA initiative, and if so, when? Perhaps soon. In late August, Merrill's Bob McCann, president of Global Wealth Management, expressed interest in building an independent RIA unit like Schwab Institutional to Sanford Bernstein analyst Brad Hintz. They were talking about the brokerage business in general, and Merrill's Wealth Management Group. Hintz loves the idea. “Merrill is capable of doing everything that Schwab currently does,” he says. But then it is Merrill, and many people who spoke to Registered Rep. about the issue said it's not easy to imagine Mother Merrill supporting an independent model for advisors.

Other experts are not surprised: “Merrill understands the RIA market as well as anybody,” says Dennis Gallant, founder of GDC Consulting. “Merrill knows as much as Schwab, as much as Fido. I used to visit Merrill a lot, and I was always impressed by their expertise.”

Enter Stage Left

Merrill declined to comment specifically about its plans, but Dan Sontag, head of the Americas Client Relationship Group within Merrill's Global Wealth Management unit, did say that the firm plans to expand and leverage MMS — which has approximately 190 clients and $31 billion in assets — to compete for the business of independent RIAs. “Right now, it's a relatively small business,” said Sontag.

Some dismiss any Merrill initiative for RIA relationships as doomed. (“Hey, why affiliate with a firm we just ran away from?” is how some RIAs could view Merrill's offering.) But Schwab and others might want to take notice. Sontag said the firm is considering a “white label” for the unit, tailored from Merrill's own platform and offered in an unobtrusive way. No matter how the offering is rolled out, Sontag made it very clear that Merrill Lynch thinks it can not only compete in the RIA space, but dominate it. “We have the best platform for financial advisors in the industry. If you take some percentage of that — say 60 percent — and offer it into the RIA space, I think it can become better than what Schwab and Fidelity offer,” he says. “But it's a work in progress; we're not there yet.”

Certainly if there's an incentive to ramp it up, it is this: Its most sophisticated advisors are constantly a target of Schwab and other RIA firms. “Why not step it up, and go after the traditional custodians who have been going after us?” is how Gallant guessed Merrill executives might reason.

Besides, it is a profitable space. Moss Adams consultant Philip Palaveev says, “There isn't a single investment firm that isn't looking at the RIA industry — the profit margins are tremendous, the assets are sticky. There's little to dislike.”

The profit potential of the RIA business has already attracted private-equity investors who have fueled a wave of consolidation. More than 60 deals were done in 2007, conducted by a handful of private equity-backed firms like Boston Private, with 15 RIAs and $37 billion in assets; National Financial Partners, with 180 firms (not all RIAs), and an undisclosed number of assets; and Focus Financial Partners, which in only two years has grown from four RIAs and $3.5 billion in assets to 14 RIAs with $25 billion in assets.

Expectations for continued growth are high. The median assets of an independent RIA were $95 million in fiscal 2006, surely not big enough to intimidate most wirehouse reps. But consider that the median has more than tripled since 2001, when it was $28.5 million, according to Moss Adams. Stoking the competition: A massive amount of liquid assets is up for grabs — $5 trillion to be exact — that the Federal Reserve Survey of Consumer Finance predicts will be passed on to heirs or others by the baby boomers over the next five years. And baby boomers seem to get the RIA story: objective advice combined with a high level of personal attention, transparent fees and fiduciary duty. According to a Rydex Advisor Benchmarking survey released last summer, 41 percent of RIA assets come from $1 million-plus accounts, up from 39 percent the year before; and 15 percent come from $5 million-plus accounts, up from 9 percent the previous year.

Beat Chuck

In this market, Schwab Institutional is the team to beat. Schwab Institutional has roughly 5,500 affiliated RIAs with $581 billion in assets, about a 25-percent market share. The next closest competitor, Fidelity's Institutional Wealth Services, which has also outpaced most of the wirehouses in client-asset growth, has 3,500 affiliated RIAs with $333 billion in assets. From there the gap is wide: TD Ameritrade Institutional has 4,000-plus RIA firms, and a projected $90 billion in assets at year-end (after the integration of Fiserv, which the firm bought in May). Last of the behemoths is Pershing, already a kingpin in the clearing business, but a newcomer to the independent RIA business: It has 480 RIAs and $73 billion.

Each of them continues to improve its suite of offerings for the RIA population, focusing on such things as improving workflow efficiencies and profitability with technology improvements, and business model-specific consulting. Schwab, which continues to be the primary choice for most of the larger RIAs ($1 billion in assets and up) has a new trust-services offering to help its RIAs go after the tens of billions of dollars in trust assets squirreled away at banks (See chart on p. 28, upper left). Schwab is also targeting family and multi-family offices for its RIA network, entities which traditionally custody client assets at banks, says Schwab Institutional CEO Charles Goldman. In addition, it is expanding its alternative-investments platform and loan program ($100,000 to $500,000 loans) to attract the coveted wirehouse advisors who decide to leave the firm and start an RIA.

Not to be outdone, the other firms have been busy as well. Fidelity Institutional Wealth Services has rolled out an entirely new platform called WealthCentral that features EISI NaviPlan's financial-planning software, Advent's portfolio-management software, and a version of Oracle's CRM technology that Oracle customized for financial advisors. The applications and data will all be hosted on the Internet, removing the cost and time of managing and upgrading the software. “We're trying to solve what our advisors say is the biggest problem for independent RIAs: managing technology,” said Scott Dellorfano, executive vice president of the group. “Many of them said their workflow inefficiencies were immense.”

Tom Bradley, president of TD Ameritrade Institutional, says his organization is focused on integrating Fiserv as well as improving its platform: It has benefited from $100 million of investment spending across the entire firm, which added 15 people in RIA sales and others in support roles. Pershing, which has 80-percent market share as a clearing firm, is the newest entrant in the RIA space, but has lots of potential, largely because of Mark Tibergien, whom it recently hired to lead Pershing Advisory Solutions. The former Moss Adams consultant and axe on the RIA business model, says he'll spend much of his first year “gathering data,” and studying the needs of his RIAs. The firm has already collaborated with Moss Adams on a study focusing on practice management released in November.

That said, if there were a service model for the independent RIA channel that Merrill should aspire to, Schwab Institutional would be it. For the past few years Schwab's network of RIAs — which includes 290 firms with more than $1 billion in assets and 580 with more than $500 million — have cleaned the clocks of the retail brokerage competition. And not just in assets: Profit margins — forever the focus of retail brokerage management as more products and services become commoditized — were 42 percent for the first three quarters of 2007, according to analyst reports, more than 10 percent better than those of Merrill's Global Wealth Management Group, a leader in brokerage profit margins.

The Big Change

It's a tough field of entrenched competitors for any new entrant, even for Merrill. Indeed, Merrill will have to get over itself first. It is the poster child for the employee broker/dealer model, and an RIA venture would seem to be an about-face. But then, according to Bernstein's Hintz, McCann is all for venturing into new territory. Hintz says McCann told him, “The more [business] channels the better.” And Merrill has indeed taken a non-traditional approach in recent years. Sontag, in talking about ‘white labeling’ an RIA offering, mentioned the merger of BlackRock and MLIM, Merrill's asset management unit. He said using the BlackRock name improved sales of Merrill mutual funds. Then there's the First Republic deal. “The First Republic purchase and arrangement is a different channel, really,” says Hintz of the exclusive San Francisco bank that Merrill bought in February. Merrill plans to expand First Republic's branch network, and distribute Merrill products through them, but not rename the boutique or replace top management.

Indeed, the Merrill name could be the biggest roadblock to a hypothetical “Merrill Institutional,” according to analysts and consultants.

“Merrill is essentially the anti-RIA,” says Palaveev, describing Merrill as an incredibly complex, centralized mega-firm with every business and product known to man. “RIA clients want to be the focus of the business. Would a Merrill Lynch RIA unit be the core business or just a side dish?” asks Palaveev. Merrill also represents what a lot of RIAs and independents were escaping from. But as Schwab and the other custodian firms ramp up efforts to recruit top advisors from Merrill and the other firms, for Merrill to have its own unit might help it retain advisors and even attract competitors' reps too. “I'm not saying it couldn't be done, it's just not a natural fit,” says Palaveev. “But there are Honda dealerships in Detroit — many years ago no one would have predicted that.”