Brooke’s Note: Considering that Schwab serves 7,000 RIA firms with about $700 billion of assets — all with different needs — it is remarkable how infrequently tension between the firm and its clientele rises to the surface. A big exception was three years ago when Schwab informed advisors that it was discontinuing custody of alternative assets as the 2008 fallout affected the regulatory atmosphere. It was some of Schwab’s biggest and most loyal clients who screamed the loudest. Schwab accommodated them but mostly stuck to its guns. Still, Schwab seems to have taken the pressure being exerted against it and redirected it toward the SEC in order to get some relief. This article shows the fruits of the seeds planted when RIAs spoke out.

Charles Schwab & Co. has won an important round in its efforts to give RIAs more access to hedge funds with less hassle by convincing the SEC to accept a protocol. See: After a wait, Schwab has a program for alternative assets.

The San Francisco-based broker got the Securities and Exchange Commission to issue a no-action letter that says, in essence, that it will not take enforcement action relating to the use of the Depository Trust & Clearing Corp. standard known as the Alternative Investment Products service. The protocol lays out the means by which a custodian can define the value of the investment and confirm that it exists. See: Schwab leads effort to create industrywide solution for alternative assets.

Because of this, RIAs will be able to go to issuers of hedge funds (and funds of hedge funds, REITs and limited partnerships) that they wish to invest in and encourage them to meet the protocol standards and get on the custodial platform that advisors use.

48 hours

The mechanical process that took weeks before can now be reduced to 48 hours or less, according to Schwab. By automating this process, Alternative Investment Products can reduce errors, lower costs, and reduce the time it takes to process account information, which benefits advisors, investors, issuers, and custodians such as Schwab. It will also allow Schwab and other custodians to include alternative-investment holdings on regular client statements.

Matthew Brown: I think it's one piece of the overall puzzle.
Matthew Brown: I think it’s one
piece of the overall puzzle.

Among other things that took a long time before this ruling was the need to get third-party pricing.

“It was painful for us,” says Bernie Clark, executive vice president and head of Schwab Advisor Services. “We didn’t want to be in this business [of being the middle man] forever.” Schwab RIAs manage about $5 billion of alternative assets.

Schwab will gain significant advantages now that it has received the SEC’s blessing on this standardizing of practices, according to Matthew Brown, co-founder and chief executive of CAIS, a New York-based alternative-assets platform used by RIAs including HighTower Advisors LLC and Focus Financial Partners, LLC. CAIS has already adopted the DTCC’s AIP protocol. See: Step-by-step on finding a platform for alternative investments.

“There’s less risk of misinformation and that lack of misinformation is better for advisors,” Brown says. “[Also], with a larger selection of investments, they will be able to build better portfolios.”

Expect a spike

Clark says that the AIP paves the way for hedge funds to be used much more like mutual funds and for Schwab to form a virtual supermarket of them on its platform. Currently, Schwab has only about 100 alternative asset providers on its platform; potentially there could be thousands in the future. “That number I expect to spike,” Clark says.

But he added in a release that Schwab will need help in ballooning its portfolio of hedge fund choices. “Success requires participation by alternative-investment issuers. We have been working to drive issuer adoption of AIP, and we’ll be stepping up those efforts in the coming weeks and months.”

Bernie Clark: It was painful for us.
Bernie Clark: It was painful for
us.

Ann Bergin, managing director and general manager, DTCC Wealth Management Services, says she believe that this SEC no-action letter may be a watershed event for hedge fund distribution.

“It takes a long, long time for initiatives to catch on and get critical mass. But most of that is time that has passed. We’re onboarding clients rapidly. We’ll see a rush to the front door in coming days and weeks.”

Bergin says the mutual fund market’s progress is instructive. It reached the same point of standardization in 1986 but didn’t gain critical mass of distribution in retirement accounts and so on until about 1996.

Though AIP adoption eliminates a hurdle, Brown cautions that the ruling is no silver bullet for the challenges of handling alternative investments and that much work remains for RIAs that wish to use them in portfolios.

“I think it’s one piece of the overall puzzle but it’s more mechanical than anything else. Advisors will still be charged with doing thorough due diligence.”

Mike Fields, chief operating officer of HatterasFunds, says that standardizing effect of the SEC letter on the DTCC protocols is helpful for his firm because it brings the focus away from annoying paperwork relating to applying to invest. Hedge fund investors need to be accredited.

“It becomes more about the investments,” he says. Hatteras Funds is available on Schwab’s AI platform and advises about $2.1 billion of assets in funds of hedge funds, alternative mutual funds and funds of private investment funds.

Pershing and Fidelity are also both positive about the DTCC protocol.

“We agree [that a DTCC standard is the way to go], which is the reason we were part of it from the start,” says Mark Tibergien, chief executive of Pershing Advisor Solutions LLC. See: Pershing is working to create a better alternative assets experience.

Mark Tibergien: We were part of it from the start.
Mark Tibergien: We were part of
it from the start.

Fidelity made this comment though its spokesman, Steve Austin: “We also have been working closely with the DTCC to establish the Alternative Investment Product to support many alternative investments for advisors. We are pleased to hear about the SEC no-action letter as this will streamline the custody process.”

Establishing value

Schwab began the process of getting the SEC to recognize the DTCC’s protocol two and a half years ago. “We’re the largest custodian and largest player in alternative investments. We knew we had to start organizing the industry,” Clark says.

The alternatives issue exploded for Schwab three years ago after it told RIAs that it would no longer keep such assets under custody for them. Schwab’s decision reflected the regulatory environment after the 2008 meltdowns on Wall Street.

Since then it has announced various stopgap measures, but some advisors moved assets to Pershing and Fidelity.

Clark took the reins of Schwab’s RIA business two years ago after the full-time leadership position was essentially eliminated. The disadvantage of having the role vacant was made clearer when RIAs began complaining about the ban on alternative assets and Schwab had nobody to deal with the issue full time. The RIA business was being overseen by Jim McCool, but it was only part of his job.

After working on this issue for two years, Clark is relieved to be able to have arrived at a better place with help from the DTCC but allows that there are still assets that Schwab will not keep under custody, including promissory notes, non-registered real estate investment trusts and private equity. It’s too difficult to establish their value and to show that the asset is there, he says.

Yet Brown says the advancement for Schwab and other custodians is important.

“I think it’s a big move for the industry.”