Asset Custody

For almost all private investors, asset custody will form the base on which all else is built. A custodian—typically a very large bank—safeguards investment assets by holding them in a segregated account owned by the investor.¹ The fact that the account is segregated is important. By “segregated” I mean that the investor's assets are formally segregated from the assets of the bank that is serving as the custodian. In the unlikely event that the bank should go bankrupt,² the investor's assets will not be subject to the claims of the bank's creditors. Hence, although there might be some delay in retrieving the assets, and some cost and annoyance, the investor will in fact get his assets back.

This is not the case, it is important to note, with brokerage firms that are acting as a custodian. If the broker goes under, the investor's assets go with it. For this reason, all brokerage firms carry vast amounts of insurance, designed to protect investors against just this possibility. Unfortunately, one has to wonder whether the insurance firms themselves could survive the bankruptcy of a major brokerage house.

Surprising numbers of investors don't bother to have their assets held safely in a custody arrangement, but simply place the assets at the disposal of whoever is managing the money. In such a case they are placing themselves entirely at the mercy of the honesty of the money management firm and all its employees.

A few years ago a money manager named John Gardner Black set up his own “custodian,” pointing out to investors that if they used his custody operation there would be no charge, whereas if they kept their money in custody with banks, the banks would charge several basis points (a basis point is 1/100 of 1 percent). A good many of Black's clients took him up on the offer, whereupon Black proceeded to spend their money on himself and his lifestyle. Black is now in jail, but his clients' money is gone.

In essence, a custodian holds and reports on all the client's investment assets, including cash and securities. Money managers engaged by a family will be given a limited power of attorney to direct the investment of the funds assigned to that manager (the custodian will set up separate accounts for each manager), but those managers will not have access to the cash or securities in the account. In other words, if a rogue manager attempts to misappropriate assets entrusted to him, he will not be able to gain access to the client's assets because no one, other than the client and those the client designates, can withdraw assets from the bank's custody or transfer them to other accounts.

Note that certain types of accounts are inherently not subject to actual custody, and are reported by the custodian only as line-item entries. Typical examples include mutual funds (each mutual fund has its own custodian), hedge funds (which are custodied, in a very limited sense, by a prime broker—see Chapter 15), private equity funds (which are not custodied at all), and so on.

What Services Does a Custodian Offer?

A master custodian will typically provide all the following services:

• Provide for safekeeping of the client's investment assets domestically and internationally
• Maintain accurate and timely records of the client's investments
• Consolidate assets as necessary for reporting purposes
• Clear and settle trades made at the direction of the client's money managers
• Transfer assets as directed only by the client
• Pay bills for various services (e.g., money manager fees)
• Provide multicurrency reporting for international assets
• Prepare reports on a cash or accrual basis
• Report transactions on a trade or settlement date basis
• Maintain records and processing trades on a tax-lot basis
• Maintain tax characteristics (interest, dividends, cost basis, etc.)
• Maintain compliance monitoring systems to ensure that managers adhere to whatever investment guidelines the client has put in place
• Provide unitized accounting and interim valuations
• Prepare tax returns³
• Maintain accounting for family investment partnerships (note that only a few very high-end custodians offer this service)

Finally, most institutions that offer custodial services also offer many other financial services, including banking, trust services, asset management, and so on. In rare cases it may make financial sense to allow a custodian bank also to manage certain assets for us. When a custodian has a best-in-class product in a particular asset class and is willing to discount its management fee because of the custody relationship (or to discount its custody fee because of the management relationship), the family may be better off allowing the custodian to manage those assets. But a custodian's asset management products must always be evaluated entirely separately from its custodial skills.

Evaluating Custodians

It's easy to identify the few financial institutions that aspire to excellence in the custody business. This is because asset custody is an extremely capital-intensive business, requiring massive and ongoing investments in technology and personnel merely to stay even with the competition. At the same time, custody is largely a commodity business with low profit margins. This unhappy combination of massive investment and low profits means that, globally, there are only a relative handful of institutions that have chosen to compete in this business.

However, once the small group of best-in-class custodians has been identified, it is more difficult to select the most appropriate custodian for our particular needs. At bottom, the decision comes down to extensive day-by-day experience with the performance of individual custodians handling different kinds of clients and assets. In making recommendations to clients about appropriate custodian candidates, the better advisors proceed as follows:

• Based on the advisor's knowledge of the client's needs and the skill set of the various best-in-class custodial institutions, the list of attractive candidates should be winnowed down to two or three.
• Each finalist institution should be sent an RFP (request for proposal) seeking answers to a large number of questions about the institution's custodial abilities, overall institutional strength, how they will meet the client's needs as investors, and so on. Responses to those RFPs can then be consolidated into a custodian comparison matrix for easy comparison by the client and its advisor.
• The client or its financial advisor should review each candidate's SSAE 16, an annual form global custody banks are required to file.⁴
• The primary contacts for each institution should be individually interviewed, focusing on areas of particular importance to our account.
• Fee bids should be sought from the institutions most likely to be appropriate to our needs.

Custody Pricing

Though asset custody is one of the true bargains in the investment business, it's easy to misprice custody services. Custodian pricing can be maddeningly complex, especially for taxable investors. Typically, a custodian will charge an overall fee that is asset based. This is simple enough and can easily be compared across vendors.

Unfortunately, the asset-based fee is only the beginning. Depending on the custodian, additional fees will apply for each managed account, for each line-item entry (e.g., mutual funds or hedge funds), for each transaction that is posted (dividends and income, for example) and so on. International separate accounts are typically more expensive because of the army of subcustodians that is required and the problem of dealing with multiple currencies. Because no two custodians will submit exactly comparable bids across the board, it's easy to select a custodian that appears to offer the best price, only to find out that we are being nickeled-and-dimed to death with other fees. Whenever possible, therefore, families should put in their RFP a reasonably exact picture of what the portfolio will look like. This won't make comparing custody bids easy, but it will help ensure that the family doesn't make a decision that turns out, inadvertently, to be penny-wise and pound-foolish.

Families will also want to be sure that they aren't paying for services they don't want or need. For example, most custodians will carry mutual funds as a line-item entry, updating the value of the fund and the number of shares held once a month. Another option is to have the custodian report the mutual fund in a way that allows the family to view the underlying shares. Finally, the family can hold the mutual fund completely outside the custody arrangement, receiving statements directly from the fund company and following pricing via the fund company's website.

The cost of the first option is typically something like $500/year—in many cases there is no cost at all. The cost of the last option is typically nothing (other than our time). The cost of the middle option is typically whatever basis point fee we negotiated. (For a ten million dollar account in the Vanguard Index 500 Fund, we might be paying 5 basis points for custody in addition to the 12 basis points we are paying for the Vanguard fund—a gigantic 42 percent increase in cost.) Few families will find a crucial need to drill down into the actual mutual fund holdings, and for those few who do, the best source is probably the Vanguard website.

Custody for Taxable Accounts

Until 10 or 15 years ago, custodians largely ignored the needs of taxable investors. Most large families tended to be captive clients of a local or national trust company anyway. But in recent years custodians have realized that taxable custody is by far the most rapidly growing part of the business, and they have made up for lost time by dramatically improving the quality of their services for taxable investors. Today, almost any bank that would be a serious candidate to custody a large institutional account will also be a serious candidate to custody a large taxable account.

Services provided to taxable investors will include those offered to nontaxable accounts, but will also include careful tending to tax issues, especially tracking the tax cost basis of securities across all the family's accounts. Without this familywide cost basis tracking, it will be extremely difficult to tax-manage the portfolio. For example, one manager may be sitting on nothing but unrealized gains, while another may be sitting on nothing but unrealized losses. If the first manager realizes its gains and the second doesn't realize its losses, the family will be stuck with a high—and completely unnecessary—tax bill.

In addition, most, though not all, custodians can provide accounting services for family investment partnerships (see the following discussion).

Securities Lending

In an effort to reduce or even eliminate the costs of custody, some families engage in securities lending transactions. A well-structured securities lending operation can not only offset the costs of custody, but can even be a small profit center. Unfortunately, securities lending is a dicey business, and only the largest and most sophisticated families should even consider engaging in it.

Securities lending exists to meet the needs of investors who wish to sell securities short—typically, hedge fund managers, but also including other investors. In a short-sale transaction, the manager borrows a security from another investor and sells it. Because the manager doesn't own the security it has sold, it will have to replace that security eventually, by buying it back in the open market. The manager hopes the price of the security will decline, in which case the security can be repurchased at a lower price, locking in a profit. But even if the price of the security rises, the manager will have to purchase it and return it to the investor who has lent it in the first place.

Because custodian banks hold millions of securities, they are obvious sources for brokers who want to locate securities their clients can sell short. Custodians will therefore establish securities lending businesses and may ask custody clients to make their securities available for lending. The technicalities of this business are too intricate to go into in depth, but in essence the borrower of a security pays for the privilege by paying an interest rate somewhat above the Treasury bill rate. Thus, for the lender of the securities, the transaction appears to be ideal: The lender is receiving interest for doing essentially nothing.⁵ The realities, however, are more complex and troublesome.

In the first place, there are so many potential lenders of the most heavily traded securities (U.S. large-cap stocks)⁶ that profit margins on the lending of such securities have disappeared. Most of the action therefore involves foreign securities and smaller securities, many of which are difficult to short. For most families, these sectors won't be large enough for the additional income to be meaningful.

A worse problem is counterparty risk—the risk that the security we have lent won't be returned, perhaps because the borrower or broker has gone bankrupt. Though such events are rare, they are not unheard-of, and one default can wipe out years and years of securities lending profits.

The reality is, therefore, that most families should avoid securities lending. It's a difficult business to understand, and the risks aren't, for the most part, worth the candle.

Brokers as Custodians

Unlike banks, brokers don't typically impose a separate charge for holding securities in custody. This is true both for traditional full-service brokers like Merrill Lynch and for discount houses like Charles Schwab. Instead, brokerage firms that hold our securities require that all or most trades take place through their own brokerage operations. As a result, it is important for us to compare the hidden cost of this directed trading against the fully transparent cost of bank custody. For smaller accounts and those invested mainly in mutual funds, broker custody may be less expensive. For larger accounts invested in separate account products, however, bank custody is likely to be more cost effective.

In addition, as noted above, brokerage firms don't hold our assets in accounts that are segregated from the brokers' own assets. In the event of a bankruptcy, creditors of the brokerage house can seize our assets right along with the broker's own funds.