Vanguard Topping Fidelity Shows Shift to Independent Advisers


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By Christopher Condon, Bloomberg,

David O’Brien, a 46-year-old financial adviser in the Richmond, Virginia, suburb of Midlothian, has made Vanguard Group Inc. the world’s largest mutual-fund manager. Just not by himself.

O’Brien visits clients at their homes and, at kitchen tables and on front porches, counsels them on how best to invest their savings. Almost half of the $17 million he oversees has landed in mutual funds and exchange-traded funds sold by Valley Forge, Pennsylvania-based Vanguard, the company that pioneered low-cost index investing for individuals in the mid-1970s.

While O’Brien is a drop in Vanguard’s $1.6 trillion bucket of assets, he is part of a surge in fee-only consultants who have changed the way Americans invest. Assets overseen by registered investment advisers such as O’Brien more than tripled in the decade ended Dec. 31, 2009, to $1.7 trillion, according to researcher Cerulli Associates. The trend forced mutual-fund firms and broker-dealers to change how they sell funds and helped propel the ETF, an index-fund offshoot that trades like a stock, into the fastest-growing investment product.

“The single biggest driver of ETF sales through financial intermediaries has been the huge shift to fee-based advice,” said Anthony Rochte, a senior managing director at Boston-based State Street Corp.’s money-management unit, the world’s second- largest provider of ETFs, after New York’s BlackRock Inc. “The fee-only adviser has an incentive to keep overall costs low and that makes ETFs much more competitive.”

Challenging Brokers

The RIAs emerged to challenge stockbrokers in the first half of the 1990s, when mutual-fund assets almost tripled and individual investors sought out affordable and reliable guidance as the number of choices grew.

The advisers, who must register with the U.S. Securities and Exchange Commission or state regulators, carry the legal duty to put clients’ interests first. Brokers need only promise to sell products that are “suitable” for customers, according to SEC rules. All RIAs, except those dually registered as a broker-dealer, are barred from taking sales commissions or other payments from the fund companies whose products they pick for investors. Most charge a fixed annual percentage of the client’s money, typically 1 percent to 2 percent, so their incomes rise and fall with the fortunes of their customers.

“I have no incentive to sell someone’s product,” O’Brien said in a telephone interview. “From a consumer-protection standpoint, that’s a sea change.”

‘Niche Piece’

The advisers are the fastest-growing competitor to the four largest broker-dealers, or wire houses — Morgan Stanley Smith Barney LLC, Bank of America Corp.’s Merrill Lynch, Wells Fargo & Co. and UBS Financial Services Inc. Assets overseen by the brokers declined 17 percent to $4.75 trillion in the two years through 2009, according to Aite Group LLC in Boston.

“More than five years ago, RIAs were a niche piece at best,” said Scott Smith, associate director at Boston-based Cerulli.

Advisers range from thousands of small firms, such as O’Brien’s, to GenSpring Family Offices LLC, based in Palm Beach Gardens, Florida, with more than $20 billion under advisement.

“Clients never liked paying commissions, which come across as hidden fees,” Christopher Battifarano, senior investment partner at GenSpring, said in an interview. “The change to the fee-only model doesn’t guarantee you’re going to get better investment performance, but we do sit on the same side of the table as the client.”

Broker-dealers took notice in the early to mid-1990s as customers began leaving for fee-only advisers, Ben Phillips, a partner at consulting firm Casey, Quirk & Associates LLC in Darien, Connecticut, said in an interview. They encouraged their representatives to switch clients to a fee-based model.

Tech Bust

That push wasn’t aimed only at stemming customer defections, Phillips said. Companies wanted the steadier revenue associated with asset-based fees, instead of the peaks and troughs produced by sales commissions linked to market rallies and declines. The technology-stock bust of 2000-2002 helped firms convert brokers in growing numbers to the fee-based model when commissions plunged.

Companies also were responding to the growth in online trading offered by discount brokers such as Charles Schwab Corp., Christine Pollak, a spokeswoman for New York-based Morgan Stanley, said in an e-mail.

The firm holds $470 billion, or 28 percent of customer money, in fee-based accounts, compared with 18 percent in 2001. Of the $14.1 billion its brokers gathered in new individual investor assets last year, 89 percent went to fee-based accounts.

“Fee-only advisers are no threat to our business because we can and do offer more options than they do,” Pollak said.

‘Grossly Overstated’

Competition from RIAs is “grossly overstated,” Matt Card, a spokesman for Charlotte, North Carolina-based Bank of America, said in an interview. “We continue to read about it but we’re not seeing it in our business.”

Rachelle Rowe, a spokeswoman for Wells Fargo, said the San Francisco-based firm “has long encouraged advisers to adopt” fee-based client relationships. She declined to comment on how strong a competitor the company viewed fee-only advisers to be.

Karina Byrne, a spokeswoman for New York-based UBS Financial Services, didn’t respond to a request for comment.

Fund managers including Capital Group Cos., owner of the American Funds, and Fidelity Investments reacted to the shift by lowering and waiving commissions or creating share classes without the charges. American Funds, which has never allowed the public to make direct purchases, now levies a full upfront commission on less than 5 percent of sales, said Chuck Freadhoff, a spokesman for the Los Angeles-based company.

‘Open Architecture’

“There has been a very significant move to open architecture,” said Robert Pozen, chairman emeritus at Boston’s Massachusetts Financial Services Co. and a Bloomberg contributing editor.

With brokers less reliant on commissions, performance and cost became more important in determining what funds were sold. That created opportunities for firms with good track records that had refused to charge commissions and relied on direct sales to individual investors. No-load fund families such as Vanguard and Baltimore’s T. Rowe Price Inc. were well-positioned for the shift.

“We had no opportunity to play in 70 percent of the retail market in the U.S.,” Edward Bernard, vice chairman at T. Rowe Price, said in an interview. “All of a sudden we were totally compatible, not just in pricing but with our proposition of providing consistent performance.”

Passing Fidelity

Vanguard’s mutual-fund assets rose to $1.45 trillion at the end of 2010 from $564 billion in 2000. The firm passed Fidelity last year to become the biggest mutual-fund manager.

Dimensional Fund Advisors LP in Austin, Texas, increased its individual investor assets almost 11-fold in the past decade while selling through RIAs. That vaulted the firm to 10th- largest among mutual fund and ETF families at the end of 2010 with $127 billion, according to Financial Research Corp. in Boston. The company didn’t appear in FRC’s top 25 in 2000.

The growth of fee-based advice has benefited ETFs because they tend to be low-priced, tax-efficient and easily traded. RIAs allocate an average of 16 percent of their clients’ assets to ETFs, more than double the proportion among other advisers, according to Cerulli.

“You can get into the index areas that you want and create an efficient portfolio,” said Kent Addis of Addis & Hill Inc., an RIA in Wayne, Pennsylvania, a Philadelphia suburb. All of his firm’s $30 million in assets under advisement is in ETFs, almost half with Vanguard. Addis uses funds that invest in major stock and bond indexes, as well as U.S. Treasuries, high-yield debt, emerging-market equities and gold.

ETF Surge

ETF industry assets in the U.S. surged 15-fold to $992 billion in the decade ended Dec. 31, data from the Investment Company Institute in Washington show. Stock and bond mutual funds rose 76 percent to $9.01 trillion in the same span, according to the trade group. Vanguard, with more than $35 billion in ETF deposits in 2010, is the fastest-growing provider of the product.

The link between adviser compensation and ETF growth will be underscored over the next 5 to 10 years outside the U.S., said Scott Burns, director of ETF research at Chicago’s Morningstar Inc. Regulators in the U.K. have barred payments from fund and insurance companies to financial advisers for recommending their products starting in 2013. Australia passed a similar ban effective next year.

“We definitely see ETFs being embraced more because of this,” Deborah Fuhr, BlackRock’s global head of ETF research, said in an interview from London. “We’re already seeing firms launched to help financial advisers select ETFs.”

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