Charles Schwab's Big Chance

CHUCK SCHWAB WANTS to profit from Wall Street's misery.

Taking advantage of the turmoil and confusion at many remaining brokerage firms, not to mention the anger of their clients, his firm is cutting prices, reducing minimum investments, and rolling out new products aimed squarely at luring customers—for what he believes will be a radically different investment environment over the next few years. It's also putting more resources behind some of its proprietary mutual funds.

Schwab, chairman of the namesake financial-services firm he founded in 1971, expects a prolonged period of low returns, potentially higher inflation, more lucrative overseas markets, and substantial competition for funds from expanded government borrowing, he tells Barron's.

Charles Schwab the firm is aiming to turn this to its gain by offering solid products at good prices. In a striking example of its approach, Schwab (SCHW) in May cut the expense ratio of its Schwab S&P 500 Index (SWPIX) fund to 0.09%, less than cost-conscious Vanguard's hugely successful Vanguard 500 Index Fund (VFINX), which carries an expense ratio of 0.15%. At the same time, Schwab cut the minimum amount required to invest in the fund to just $100, compared with Vanguard's $3,000 minimum. It was "a call to action to get back into the market" for individual and institutional investors, says Randy Merk, Schwab's president of investment-management services. He adds: "We've seen a nice little pop. We've seen exactly what we're hoping to see. We've seen transfers from Vanguard and Fidelity based on price and minimum investment." (Spokesmen for Vanguard and Fidelity said their businesses are in good shape.)

As part of this push to draw in more clients, Schwab is also seeking Securities and Exchange Commission approval to roll out its own family of exchange-traded funds. The latest moves complement a strategy that already seems to be working. In 2008 -- when many money managers were struggling to keep funds in house -- Schwab, with its many money-market funds, took in $113 billion (through funds, brokerage accounts and pension and retirement products), or more than Citigroup, Morgan Stanley, Merrill Lynch, E*Trade and TD Ameritrade combined. It now warehouses a total of $1.1 trillion across all of its businesses, and is the country's 13th-largest fund complex, with $242 billion in assets. Founder Schwab, 71, and new Chief Executive Officer Walt Bettinger believe the firm's assets will grow at a rate of 8% to 10% per year, based on recent growth and the firm's positioning.

TODAY, SCHWAB IS COMPRISED of a brokerage unit (called "investor services") that accounted for 21% of revenue in 2008. Asset-management and administration, driven by Schwab's institutional-services unit, accounted for 46% of revenue. Then there's Schwab's bank, which holds excess cash from certain brokerage-client accounts and also provides mortgages and home-equity loans. Net interest revenue brought in another 32% of revenue last year.

In addition to its own mutual funds, Schwab has an extensive fund platform of outside funds. The Mutual Fund Marketplace, launched in 1984, has $311 billion in 14,533 available funds. OneSource, launched in 1992, offers funds without transaction fees. Layer on the advice -- the Schwab Center for Financial Research screens funds quarterly—and you can see why the platforms are so popular. At the center of the Schwab business are independent financial advisors, many of whom quit their jobs at wirehouses to hang up their own shingle. They're about 40% of Schwab's business and key consumers of Schwab funds -- particularly OneSource, its mutual-fund supermarket that has no transaction fees.

Of the $113 billion in net new assets for 2008, independent advisors accounted for more than half. Low-cost proprietary funds clearly play to that constituency. Says Peter Bourbeau, a portfolio manager at ClearBridge Advisors, a unit of Legg Mason: "There's a roughly $2 trillion opportunity in the advisor channel, and they have 25% of the market -- double the nearest competitor."

Schwab uses the a "high-touch" approach with this vital clientele. For example, it regularly holds splashy "Impact" conferences each year to bring advisors and fund companies together. They upped the hand-holding this year with the market downturn, producing 400 events for advisors, up by a third from 2008. One representative conference in California featured: quantitative fund-manager and investment theorist Rob Arnott, who talked about the viability of diversification; U.S. Global Funds chief Frank Holmes, who addressed global markets and the boom in commodities; and Santa Clara University (Calif.) financial-behaviorist Meir Statman, who talked about helping clients feel comfortable about getting back into the market. "It is very high-end," says Holmes.

Soon to come will be proprietary ETFs. Schwab, by its own estimate, already handles about 22% of all retail-ETF flows, and about 10% of all outstanding ETFs are held in custody at Schwab. Yet the ETF business has put some pressure on Schwab: If a client moves from an actively managed mutual fund on One Source to an ETF, the firm loses revenue on fees that fund companies pay to Schwab to be on its platforms. And if that same client dumps a Schwab fund for an ETF, Schwab loses the investment-management fee itself. Thus Schwab has sought permission to offer ETFs, as a response to the popularity of these cheap, tax-efficient, and hedging friendly products. Merk won't say much, but Schwab will offer an ETF that mirrors the Dow Jones U.S. Total Stock Market Index and 10 other ETFs. The funds will undoubtedly be low-cost, passive products at the outset (there are, after all, only two ETFs tracking the Standard & Poor's 500, versus 140 open-end mutual funds), although Schwab wants to offer actively managed funds too. Schwab already offers a popular, highly rated target-date fund that could be one of the first consumers. Says Schwab: "We are seeing ETFs as a major beginning for us."