Is Custody Free? The New Generation of Custodial Options for Advisors
There’s a fallacy among advisors that selecting a platform partner is an either/or proposition: a TAMP or an open-architecture solution. There is a middle ground. Some describe it as a “full-service portfolio management platform.” The team at SEI calls it a TechstodianSM.
Steven A. Gardner is a managing director for RIA Sales with Independent Advisor Solutions by SEI. He heads up SEI’s sales efforts within the independent and hybrid registered investment advisory (RIA) market. As a part of these efforts, he is responsible for market validation and research for SEI’s RIA platform offering within the United States.
Erich A. Holland is a Senior Vice President and head of distribution and engagement with Independent Advisor Solutions by SEI. He is responsible for the distribution and go-to-market strategy, leading efforts focused on SEI’s continued growth and expansion in the independent advisor market.
I spoke with Steve and Erich on September 9, 2021. This interview was sponsored by SEI.
There are a range of choices an advisor can make when selecting a platform, from turnkey asset management platforms (TAMPs) to in-house systems that provide full open architecture. How do you view the choices along that spectrum?
Steve Gardner: This is great news for the advisor community because, prior to this, there were just two end points. There were the TAMPs, which SEI and many others have historically offered. There's been the open architecture platforms of the legacy custodians – Schwab, TD, Fidelity and Pershing. For many advisors, they were a square peg trying to fit into a round hole. They were trying to fit one of those solutions and they unfortunately did not fit well. That leads to this dissatisfaction that we are hearing in the market. The great news is that there is now a continuum that advisory firms can take advantage of that they didn't have previously. At SEI and other firms, there's much more flexibility on the turnkey side; it’s no longer cookie cutter. You have a lot more investment options.
The open architecture custodians are still in their space, but there are new entrants moving in that allow advisors to get the best of both worlds – the functionality and simplicity of the TAMPs and the open architecture of a custodian. SEI happens to be one of those. We use the term “Techstodian”—technology included in the custody solution, and that is resonating.
My role is to talk exclusively to RIAs and I'm doing that all day long. What we can offer these advisors the connection of a round peg with a round hole, which is a great way of doing business.
Erich Holland: I'm going to take no credit for this analogy because it's something that I heard directly from an advisor who we work with. There is this middle ground that a lot of advisors didn't realize existed before. Some describe it as a full service portfolio management platform. We call it a Techstodian, but it's different from what advisors have experienced before or what they may believe to exist. Drawing this analogy or comparison is useful to open up people's eyes to what it is.
Think about a comparison to that legacy either/or choice that consumers had to make when buying a dress suit. They see two choices.
I could walk into a major department store, or a warehouse store, where I have pre-constructed options that I pick up off the rack. Or I could go through the high-end, labor-intensive process to create a custom suit that's designed exclusively for me. It has every millimeter measured perfectly. Every fine detail is my own.
Option one is easy. It's cost-effective. I could walk in to one of those warehouse stores at noon today, walk out at 12:30, and show up dressed for a wedding at 5:00 PM. It's turnkey. It works, but the downside is that it's going to fit tight or maybe it might fit baggy, or it's not the exact color to match my wife's dress. It's not mine. It's not exclusive. It's not unique to me.
Option two is more labor intensive. I need to show up somewhere. I need to take dozens or hundreds of specific measurements. Then it's expertly tailored to meet my body specifically. I can pick any fabric, buttons, linings, or pockets that I want, but I'm going to pay an arm and a leg for it. It's very costly. And I better get a couple months head start on that process.
A lot of people don't realize option three exists and it lives in the middle. There is a mass-personalization option that gives you a made-for-you suit, which is a blend of options one and two. It lets you take your measurements at home or show up and do them with a professional. It's your choice.
It provides you all the critical infrastructure – all the common colors, fabrics and accessories to go with it, while still giving you enough choice for anyone's style preference. They do it all for the cost of the turnkey option, but with the flexibility and choice of the customization option. Then I get that suit in weeks, not months, and it lasts for decades. It's timelessly crafted in my own image. This model exists for suits. I literally have a few of them myself, and I just went through this process as recently as this month.
It exists for custody options too. It doesn't have to be that either/or conundrum anymore. If you're a giant mega advisor firm and you have the money to spend and the people to support the infrastructure of that custom suit – that custom business infrastructure – great. But the vast majority of advisors don't have that. And further, we're finding more and more advisors that do have that scale and infrastructure and they're learning that they don't need to have it. That's where we come in.
Given this range of choices, from the fully tailored custom suit to the one-size-fits-all, how is the custodial industry structured? A lot of people view custodians as commodities. Is it appropriate to view custodial services as a commodity?
Steve Gardner: There is not a lot of recognition that choice exists, and this is on all of us. At SEI, we are trying to correct that, to educate people about this middle ground, which gets you that mass customization that will fit the large majority of firms. Based on my “travels,” which are on “Zoom” these days, most advisory firms view custody as a commodity. They view it as low value. I've heard the term “a necessary evil.” These aren't compliments.
I hear the examples of this perception of low value more commonly than I’d like to admit: outrageous hold times, ridiculous amounts of NIGOs – not in good order paperwork, even when the paperwork is perfect, and fear about potential changes in asset requirements for RIAs to stay on board.
The message is that advisors have an almost adversarial relationship with custodians. The service levels are plunging in many cases. What would a rational RIA conclude? He'd conclude that he's dealing with a commodity that he or she needs to get the lowest price they possibly can. They have an expectation that they are going to be disappointed. You just don't hear very many compliments about the legacy firms. You hear of poor service. You hear about inflexibility. You hear about dated systems.
The history of the custodial world is informative. It started from a retail discount brokerage platform, built for direct, retail customers. It had a mutual fund marketplace and they just spun this around to work with advisors as another business. It was a brilliant marketing idea and making it available to RIAs was a way to increase their business.
If you're an enterprise advisor – a billion-plus or more – you've probably got a chief operating officer. You might also have a chief technology officer. It's Nirvana. I can do anything I want on this platform, including customizing it. As Erich said, it is like a bespoke custom suit. But it is not a custody platform built for the majority of advisory firms.
The average RIA is saying this: “I'm left with this platform clearly not built custom for my business, lousy service, I have to build and maintain my own technology stack. I don't have the people to do this. It's just not a good experience.” That's what we're seeing over and over again. Advisors should demand more.
The enterprise firms do have it made. They're likely not getting bad service, but many others are. To passively take this is not a smart business decision. Advisory firms need to demand more. If price is the only criteria, if you only want custody to be a commodity, then you are likely going to get lousy service. Typically, if you pay very little for something you're going to get very little back. However for the majority of the market, it's just a bad deal.
The Techstodian that we at SEI are talking about is resonating with advisors because it is not a commodity. It is a high-value custody plus technology offering.
Given your statement that advisors tend to view custodians as commodities, who gets hurt when that happens?
Everybody but the largest advisory firms can get hurt. The majority of advisory firms are the ones winding up with the NIGOs, the hold times, the bad service, the lack of tech integration, and very little help. They're left to themselves to figure things out. These are in most cases intentionally small business owners who run very healthy very profitable businesses. Most of them don't have the staff, like a chief technology officer to deal with this. For them, it's just a bad result.
Advisors need to recognize this challenge is ongoing it's not over, not one and done. We know about E*TRADE and Trust Company of America. We know about TD and Schwab. We have a bifurcated market consisting of the big legacy firms and a whole bunch of small niche firms that are owned either by the founders or by private capital, which by its nature signals the potential for is temporary ownership.
RIAs are looking for stability. They don't want what just happened—custodial upheaval—to happen again on their watch. It's very disruptive.
Transaction fees are at zero. There are some platforms that don't charge asset-based fees. How do custodians compete and how do they make money?
Erich Holland: Transaction fees might be at zero, at least on equities and ETFs. Mutual funds haven't quite gotten there yet, by and large, at least on the major proprietary platforms. But free or commission-free doesn't mean free.
How do transaction-centric custodians make money? They make money on mutual funds, which are still a heavy part of investment selections for independent advisors. It is through the transaction costs of the funds or the revenue shares of the underlying expense ratios of those firms or of those funds themselves. The custodians make money here and it can be big money. Michael Kitces wrote a blog on this topic in 2018.
The custodians make money through cash sweeps. They force elevated cash holdings that advisors have to keep on hand and then they pay investors zero or near zero while netting those custodians major money. It’s gets called net interest. The revenue collected by some of the major custodians in net interest far exceeds what they make on those commissions from trades. They also make money on securities lending. They lend investors’ assets out to a short seller and make money on payment for order flow.
All of these things add up. When they do, the facade is a full moon, it looks like a big zero. Zero costs, free custody. The reality is that the dark side of the moon can be just as big if not bigger.
Given that landscape, what should an advisor expect from a custodian?
Erich Holland: They should expect and demand more. That comes in two directions. They shouldn't be forced to deal with poor service. Custodial choice is a major part of an advisor's business stack. That choice should support them, not defy them. They certainly shouldn't have to compete with their custodians for resources within the much larger retail side of those businesses.
But, if custody services are just plumbing, unfortunately I'd expect little other than a 1-800-SERVICE experience.
On the other side of the equation, RIAs, as business owners, should demand innovation. They should demand progress. They should demand more tools. Steve talked about this concept of a Techstodian. Technology change has never been more progressive or rapid. The robo-advice concept of a decade or so ago has turned into techno advice that enables technology-assisted, but human-enabled financial advice, where custody and technology can work together and work for advisors, not against them.
Some custodians focus on providing services that are directed to the advisor, and others are focused more on the client. How does that factor into the services that a custodian provides?
Steve Gardner: What's the highest and best use of an advisory firm’s resources and time? We all face that issue. Custodians that try and service both, being retail-oriented and advisor-oriented, encounter a conflict. You should study their financials, which any good RIA should do, to understand their markets and their businesses. When firms drove transaction costs to zero nearly a half-decade ago, it started the sequence of events that ultimately spelled doom for custodians that derived substantial revenue from those transactions. Likewise, for most of the legacy custodians that have retail operations, guess where their highest margins are? They're on the retail side. Guess which side of the business is going to get the best resources?
So most of their innovation and resources are directed to the retail side, and have been for years. Is it any wonder that an advisory firm working with these custodians views them as a commodity provider? Or views them as not providing good service? Or views them in many cases as competition?
When you have that conflict, you've got challenges. When that conflict has the retail side making more money than the advisor side, it opens the possibility for trouble. If you're a mega RIA, this discussion doesn't apply. The mega RIAs are getting fine service. They're getting access to this technology. It's the large majority of firms - everybody else under a billion in assets under management - that may suffer from the dual-focus. Custodians that are focused on the advisor business have a huge advantage because their bread and butter is made by doing good work for RIAs.
RIAs should understand that it's great that their custodial partner makes money. It's a wonderful thing that they're getting a return on their investment. Why? Because they'll increase innovation, get ahead of the market, and offer better service. It’s great that they aren’t distracted and don't compete with the advisor. SEI doesn’t have that conflict. All our resources are focused on advisors and their clients. As a result, advisors can get more value and better service.
We've seen a lot of consolidation in the custodial industry. The most obvious was Schwab's acquisition of TD Ameritrade. We've seen Morgan Stanley acquire E*TRADE and many other deals. What does that consolidation mean for advisors?
Steve Gardner: It may mean less competition, lower levels of service, and the potential for less innovation. Some advisors have used multiple custodians to help them compete with each other to get a lower price. The fruit of all that is coming to bear.
It's not all dreary and awful. That’s not an accurate picture of our industry’s future. There are new entrants that have come in over the last few years - the next generation of custodial platforms. But many of these startups are under-capitalized. They don't offer broad services. They have no track record and are less dependable. No advisor I've talked to wants an unstable chassis and to have to worry about potentially changing custodians again and repaper their clients again. If your chassis is unstable, you are in deep trouble.
How should advisors approach this critical decision when they want to select a custodian? Steve, coming back to the question that you raised earlier, should they demand more from custodians? If so, what should they demand?
Steve Gardner: They absolutely should demand more. Anybody who reads this article and is afraid to demand more or worries that there'll be turned away, please call me and demand more. Look for custodians that want you. Look for people who say, “You are my niche.”
We at SEI get excited when we meet a startup advisor. We take firms that have zero assets because many of them will grow healthy businesses and provide great advice to clients. For example, I was visiting a firm in Plano, Texas years ago whose office was in the advisor's house. At the time, he had around $15 million in assets under management. He was with an Independent Broker Dealer not known for working with the top advisors of the time. He didn't know which way was up but was searching for advice and had a drive to be successful. He broke away from his broker dealer and went RIA shortly thereafter, and today he's got over five and a half billion in assets under management.
I wouldn't be doing this interview if I knew which firms were going to do that and which ones weren't. I'd be on a Caribbean island somewhere, probably my own island. But I can't do that because no one can predict what’s going to happen next year, never mind over an advisor’s career. Therefore, we love advisors of all sizes and treat them all like they have the potential to be great.
We want advisors that are serious businesspeople, whether they want a lifestyle practice or they want to build a five and a half billion-dollar enterprise. But our advice for all advisors is to demand more. Do your due diligence on the custodian. Find a partner who wants you and has the patience to grow with you at whatever pace you desire.
There are signals. Listen to the analyst calls, look at what the executives say, look underneath what the executives say, find out who are their “best” clients. Go beyond the legacy big three – Fidelity, Schwab and Pershing. Once you've done that due diligence, you've got a much better opportunity to find a great match that will pay off for you for years.
What are the key takeaways for advisors when it comes to the shifting landscape in the custodial industry?
Erich Holland: You heard this already, but advisors should demand more. The relationship with their custodian can be so much more than simply the exchange of basic functions. Advisors provide life-changing, life-altering advice for the futures of individuals and families. You should be supported as such, both through the human element of that service offering as well as through technology innovation.
Second is the fallacy of the either/or decision. Do I either want a turnkey option with limited flexibility or custom options with limited scale and efficiency?
That's no more. It's a fallacy. You can have both. You can have that made-to-measure custom offering to support your business and your clients without giving up any of the flexibility. You can get a partner that innovates on your behalf and doesn't share resources with a different channel. SEI is a firm built on connections. We connect custody with technology and make a Techstodian. We connect the dreams of your investors today to the outcomes of tomorrow. We strengthen that connection between advisors and the clients that they serve.
If you're going to make a major technology stack choice for your business, demand more and find the connection that works best for you.
Custody services provided by SEI Private Trust Company, a federally chartered limited purpose savings association and wholly owned subsidiary of SEI Investments Company.
Investing involves risk including possible loss of principal.