Monday’s news lead in finance is Charles Schwab buying TD Ameritrade for $26 billion in stock. Schwab is the primary custodian of our clients’ assets (holding approximately $400 million of the $525 million of assets we have under management).

Schwab holds roughly three times the assets of TD, and once combined they will hold $2 Trillion (with a “T”) in assets, more than double the next largest custodian (Fidelity). In this space whatever Schwab does matters.

Individual investors have reaped the benefits of technology and transparency for over 20 years now. Vigorous competition for client assets have driven down much of the friction in investing that used to sap returns but now goes into the pockets of investors. We’ve seen transaction costs in mutual funds go from a peak of $99 when I began in 1998 down to a maximum of $25 today. Many mutual funds trade without a fee at all (even though in the bad old days a fund that traded without a transaction fee often had bloated internal expenses).

Much of this benefit has come from large custodians like Schwab, Fidelity, TD Ameritrade and Vanguard. At its peak, Vanguard Group was receiving $1 billion per day in assets being deposited or transferred, mostly from banks and brokers that were much more expensive. Its assets are still growing by the $hundreds of millions every day.

We now have mutual funds like Fidelity ZERO Total Market that cost literally nothing to buy or to hold. There will be more to come. Other firms have removed all transaction fees for trading ETF’s (Exchange Traded Funds).

Does this mean that Schwab, Fidelity & the like have become charitable institutions, offering back the $billions of revenue and profits they have derived from serving investors? The answer is somewhere between “no” and “hell no.”

Wirehouses (think Morgan Stanley, BOA Merrill Lynch, etc) still hold $7 Trillion (yes, with a “T” again) of investable assets as of the end of 2018. The numbers here get a bit dizzying, but even if they lost $1 billion per day it would still take over 19 years for all their assets to leave. The custody business (which is used by firms like mine to hold client assets, since we are not a bank or a broker) now hold almost exactly the same amount of assets. The custody business is growing every day and it’s doing it by taking assets from the old guard.

While assets are nice, what custodians really want (like any business) is revenue. Where is this revenue going to come from? Look to the activities that custodians engage in and you’ll get a pretty good idea.

If you go to Form 10-k on page 24 of their most recent annual report, Schwab discloses that its primary revenue generator is something called “net interest revenue.” Here, I’ll save you a click:

“Net interest revenue is the difference between interest generated on interest-earning assets and interest paid on funding sources, the majority of which is derived from client cash balances awaiting investment, held by Schwab as part of clients’ overall relationship with the Company.”

Virtually all brokerage accounts hold a cash position. Most are in the form of a money market fund, but for our purposes understand that it’s just cash.  Schwab can turn around and lend that money to clients on margin at 7% while paying their customers less than 1% for their assets. Schwab has possession of the collateral used to secure these loans (and can liquidate it at their discretion if certain market contingencies occur). Even if demand for margin loans dropped Schwab could still buy 5-year treasury debt for a multiple of the cost of funds. When a bank is able to lend money at above-market rates without risk of loss, this is as close to a license to print money as exists in the world.

At Aegis we have a fiduciary obligation to our clients to secure the most advantageous custodial relationship for their assets. This is not based strictly on cost (although that is certainly a component) but also on the quality of service they receive for their investment dollar. A Hyundai costs less than a Mercedes for many reasons. Do our clients need (or want?) a Mercedes? Sometimes they do. In this regard Schwab does an excellent job for them at a reasonable cost. Some of the time we want to go with the low-cost provider, which is an ever-challenging quest.

Most people who are successful enough to accumulate substantial assets realize that there is no such thing as something-for-nothing. Those who do not will be parted from their assets soon enough.