Rolling Out Choices

By Bill Stoneman

To retain high-net-worth clients, banks need to offer a wider range of non-proprietary products.

When it comes to investment products, wealthy people are increasingly demanding a wide range of choices from multiple providers. And that poses a dilemma for banks that have traditionally offered proprietary products only. "The more you try to push your own product, the more your clients pull away," says Damian Kozlowski, chief operating officer of Citigroup Inc.'s private bank in New York City.

Some banks are indeed responding with more choices. For example, SunTrust Banks Inc. has promised affluent investors an "open architecture" in regard to product offerings. PNC Financial Services Group Inc. is offering hedge funds managed by a unit of Germany's Deutsche Bank, as well as by Global Asset Management, based in Ireland. "What's really important now in the high-net-worth market is offering a wide range of choices and understanding client needs," says Bryan Garlock, executive vice president for wealth management with Pittsburgh-based PNC.

But the prevailing practice is still for customer assets to be managed in-house by old-school investment officers who started in the business managing conservative co-mingled funds for their institutions' trust department. These units traditionally focused on preserving the value of assets and assisting in their transfer from one generation to another. Although the large banks generally do add a smattering of third-party investment products to the mix they offer wealthy clients, these offerings can't be characterized as a mass movement.

That's a problem for a large segment of today's wealthy clientele. These people no longer respond to the traditional approach because they have more ambitious investment goals and a more diverse range of financial planning needs. They increasingly expect to be offered an array of options that more accurately reflects the diversity of the current market, where hundreds of investment managers and mutual fund companies vie for their attention.

Though solid data is hard to come by and subject to interpretive dispute, banks clearly lost some share of this high-net-worth money management business over the past decade to both brokerage firms and independent investment managers. "Most affluent individuals view their brokers as the ones who are more sophisticated in investments," says J. Scott Slater, a director of Spectrem Group Inc., a Chicago-based consulting company.

Trying to retake this lost ground poses both operational and cultural challenges for banks. Keeping track of multiple investment managers will require many institutions to build more sophisticated electronic record-keeping systems. They must also resign themselves to giving up some of the fees that come from managing investor funds internally. Finally, there's the inertia factor: "Reversing 100 years of history is going to take some time," says Bob Vermont, a strategist in SunTrust's private client services unit in Atlanta.

But these challenges can be overcome if managers keep sight of the potential payoff, which is stronger, more lasting relationships with their most profitable clients.

Open Architecture?

While executives acknowledge customer demand for more options, the job of picking stocks and bonds for wealthy customers is still mostly handled internally.

The chief investment officer for wealth management at Wachovia Corp., for example, says the Charlotte-based bank has "moved from the old trust model, which was totally proprietary, to a more open architecture solution." Yet the executive, Steve Reynolds, also says his unit still "predominantly" uses internal management, in some cases drawing on the management expertise at the company's Evergreen family of mutual funds.

Reynolds justifies this practice by citing Wachovia/Evergreen's expertise in certain aspects of money management, such as bonds, which constitute 40% of most client portfolios. He also asserts that tailoring investments to an individual's needs virtually requires internal management.

That's because while banks might be comfortable including externally-managed funds in a client portfolio, most banks would not be comfortable delegating the entire oversight of "separately managed accounts" to an outsider. And only separately managed accounts, which contain a selection of investments for individual customers, offer investment managers the ability to build portfolios around particular asset-allocation or tax-planning objectives.

For example, an individual with a sizable holding of his own company's stock would be encouraged to diversify. Though rather inefficient at smaller sizes, separately managed accounts are as efficient as mutual funds with portfolios that are larger than about $1 million, experts say.

Like Wachovia, PNC Advisors handles the bulk of asset management chores for its wealthy customers in-house. Garlock says his staff has the expertise to pick large-cap stocks, usually the major share of a typical client's holdings.

Most of these clients are served through separately managed accounts. For smaller investment categories, such as international and small-cap stocks, PNC Advisors offers third-party mutual funds, as well as those operated by BlackRock Inc., the New York-based investment manager that is 70% owned by PNC. The rationale for this practice is that these funds are more efficient than in-house management for relatively small parts of a portfolio.

PNC Advisors is considering introducing third-party management of separately managed accounts, however, at least on a small scale, according to Garlock. If carried to fruition, this could cede even more control of the client's money than does the use of third-party mutual funds and hedge funds.

Best of Breed?

The relative slowness of the banking industry to respond to customer demand for non-proprietary products reflects some complex operational and philosophical issues. The first point to be made is that these products are not necessarily better than those managed internally. Considering the stunning market reversal of the past two-and-a-half years, many clients who put their money into aggressive growth stocks through a broker are no doubt wishing they had chosen a stodgy trust account at their local bank instead.

Alan Trench, a consultant to wealth management companies for IBM Business Consulting Services in New York, asserts that investment management is becoming a commodity, given the difficulty of proving that one manager is consistently better than another in the long run. For example, he contends, "the investment products that you get from Bank of America Corp. do not differ significantly from the investment products you get from J.P. Morgan Chase & Co."

Still, perceptions matter, and the ability to access non-proprietary products certainly reinforces customer perceptions that they are being offered a "best-of-breed" selection. One reason brokerages have made substantial inroads into the business of trust banks is their success in positioning themselves as purveyors of "objective" advice, in part by dropping the emphasis on selling their own funds and investment management.

Since customers prefer greater selection, it seems only smart to offer them that. Most bankers accept this logic, but continue to drag their feet nonetheless, according to Trench. "When I ask how many trust accounts have actually been moved into non-proprietary products, I get a fairly low response," he says.

Sheer inertia is one culprit. Banks with long-established trust departments have been organized to deal with wealth management issues in a certain way. It's never easy turning the battleship. Contributing to this inertia is the complexity of making business deals with multiple outside managers and building a system that connects a bank electronically to the record-keeping systems used by those managers.

Then there's the fear of losing the fees that come from managing funds internally. "A lot of executives are terrified of cannibalizing their own proprietary products," says Peter Atwater, chief executive officer of private client services at Chicago-based Bank One Corp.

Money managers, whether within banking companies or elsewhere, typically charge about 1% of assets annually, according to W. Christopher Maxwell, managing partner in Conestoga Capital Advisors in West Conshohocken, Pa. Banks might even be able to charge more, as much as 1.5% of assets, when they position themselves as managers of managers, who guide clients to the best fund managers and then monitor those managers to make sure they perform well and stick to their stated styles. Even in that role, however, banks likely would not net more than 0.5% or 0.6% of assets after paying the outside managers for their services.

So moving to non-proprietary products does exact a financial toll on the institution. Yet shunning this practice imposes a financial price as well, if customers defect in significant numbers. "Our view is there is no way to stop the cannibalization," Atwater says, adding that Bank One makes substantial use of outside managers but declining to quantify that statement.

Losing Trust

With their legacy of trust services to the nation's affluent families, banks already enjoy a strong competitive position in the wealth management business. And indeed, many of them are major players in this arena. For example, Citigroup's private bank manages $59 billion for high-net-worth clientele, according to Barron's, which placed Citi 14th in a December 2001 ranking of the top wealth managers in the U.S. by private banking assets under management. PNC Advisors, PNC Financial's wealth management unit, followed right behind Citi, with $58.7 billion.

Assets managed by banking organizations typically constitute a mixture of trust and non-trust accounts, since trusts are not always the appropriate vehicle for holding personal wealth. The non-trust business, known as "agency" accounts, grew handsomely in the '90s, driven by the economic and stock market boom. At the same time, however, banks began losing some of their trust assets.

The trust business traditionally included fiduciary, administrative, estate settlement and investment management services, all of which could be handled by bank trust departments. Then, in 1972, the adoption of the Employee Retirement Income Security Act made it easier to separate fiduciary responsibilities from investment management. Conestoga Capital's Maxwell says ERISA opened the door for family members, lawyers and other individuals to serve as trustees of trusts. Maxwell, a former Citicorp and KeyCorp executive, says these trustees increasingly turned from banks to a wider array of money managers, including brokerage firms and independent managers such as his own.

On top of that, the long bull market of the '80s and '90s tended to favor providers with more aggressive investing styles than was typical at banks. Boston-based Cerulli Associates estimates that the share of high-net-worth assets (defined as from $10 million to $25 million in investable assets) managed by private banking units in the U.S. fell from 79% to 26% over the past decade.

Researchers with VIP Forum, a Washington-based consultant to wealth management service providers, question whether banks ever had as large a share of the market as Cerulli says, but agree with the overall premise that wealthy people gravitated toward more aggressive investment managers during the last decade. "The bull market was a great time for the brokerages and fund companies," says practice manager William Whitt.

Though it doesn't provide historical data and it measures the market from a different perspective, VIP Forum casts banks in roughly the same position as Cerulli does. It estimates that brokerage and fund companies combined brought in 58% of wealth management revenues last year compared with 24% for banks. This business largely comprises asset management, but also deposit, loan and other financial services, for roughly the same category of affluent households analyzed by Cerulli.

Banks responded to the customer erosion by folding their old trust departments into newer wealth management or private banking units, and positioned these units to assist affluent people across the spectrum of their financial needs.

Additionally, banks acquired or started brokerage companies, which may serve some of the same clients, or at least people with the same financial characteristics, as those served by their private bank units.

Although these brokerage units fall under the private-bank label on some companies' organizational charts, they tend not to be well integrated into the institutions' overall wealth management strategy. For one thing, they typically don't depend heavily on the investment management expertise of their parent company's trust unit or fund family. They also tend to serve a slightly less upscale market and focus more narrowly on investing, as opposed to the full range of a client's financial planning needs.

Agency asset management accounts and trust accounts, by contrast, generally utilize the institution's in-house money management, and that's where the battle over proprietary products is being fought.

Despite the obstacles, it seems likely, over time, that banks will increasingly recast themselves as objective advisers to affluent individuals and families on a range of wealth management-related issues, since that's what customers want. The final payoff should be more assets to manage, even if only indirectly, and closer customer relationships. "The less you try to push your own products and instead talk about what clients should be doing," says Citigroup's Kozlowski, "the more they want to deepen the relationship."

Mr. Stoneman is a freelance writer based in Albany, N.Y.

Copyright © 2003 by Banking Strategies, published by BAI.

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