Schwab Sharpens Focus, Gains Strength

Over the past several years, Charles Schwab Investment Management (CSIM) has strengthened its executive management, investment team, and risk management capabilities. These changes, coupled with the firm's disciplined focus on low-cost portfolio building blocks and strong execution under new leadership, are behind Morningstar's decision to upgrade Schwab's Parent Pillar rating to Positive from Neutral.

These positive changes emerged in response to a dark chapter in the firm's history when one of its ultrashort bond funds, Schwab YieldPlus, fell sharply during the financial crisis. Schwab paid a $119 million fine to the SEC to settle claims that it made misleading statements about the fund and its risks, including the maturity of its holdings, and paid $235 million to settle a class action lawsuit with investors in that fund. In response, the firm hired a new CEO, Marie Chandoha in 2010, who brought in new management and made significant changes to strengthen the organization.

Among these, the senior leadership team added risk management performance as a determinant of managers' variable compensation. That is an unusual step, as most firms expect their managers to effectively manage risk (mitigating unintended risks and keeping each fund in line with its mandate) as a core part of their jobs and not necessarily something that requires an explicit incentive. This approach encourages managers to be extra vigilant and notify senior management of potential risks before they become problems.

The firm has also expanded its investment team, adding 18 net new members from 2012 through 2016. Last year, it continued to strengthen the team's leadership ranks with the addition of Chris Bliss and John Greves as the new heads of passive equity and multiasset strategies, respectively. Bliss was previously the Head of Americas Institutional Index Equity Portfolio Management at BlackRock, while Greves previously served as a portfolio manager at Russell. With this team in place, the firm is well equipped to run the index and money market funds that account for the bulk of its assets. However, many members of the portfolio management team are new to the firm, and there has been moderate turnover in recent years. That said, key-person risk is minimal because the firm fosters a collaborative environment that eschews star managers.

Business Strategy Charles Schwab Investment Management supports the core brokerage business of its corporate parent. The firm positions both its brokerage and investment management businesses as low-cost solutions for individual investors. Consistent with that strategy, the firm often undercuts the competition on price, setting fees for many of its index products below similar offerings from Vanguard. And it makes its low fees available to all by only offering one share class of each fund with low investment minimums. With such aggressive pricing, Schwab's funds may be loss leaders to support the brokerage business. CSIM's strategic importance to Schwab frees it from having to be highly profitable as a stand-alone entity. Not surprisingly, most of CSIM's assets are from the firm's brokerage clients.

As an asset manager, Schwab is less ambitious than many of its peers. It currently only offers its funds for sale in the United States. And it primarily focuses on low-cost core strategies meant to serve as long-term holdings. This includes broad market-cap and fundamentally weighted index funds. This disciplined focus keeps the firm in its circle of competence and breeds confidence that it won't offer trendy products that lack long-term investment merit.

While the firm has strong index and money market businesses, its actively managed franchise is a smaller piece of its business that doesn't stand out. At the end of December 2016, the firm had about $302 billion in assets under management. Money market and index funds represented $163 billion and $112 billion of that figure, respectively, with the remainder in actively managed strategies and collective investment trusts. Most of the firm's actively managed funds carry low fees, but it does offer a handful of funds subadvised by Laudus that look a bit out of step with its low-cost philosophy. Those strategies were launched before Chandoha took the helm, and it is unlikely that the firm would launch similarly priced strategies going forward.

Schwab has come a long way since the YieldPlus fiasco. Chandoha and her team have considerably strengthened the firm's investment organization and risk management culture. Most importantly, the firm has stuck to its knitting and avoided the temptation to respond to client demand with trendy products. Most of its offerings are pretty vanilla, but the firm is well-equipped to manage them. And it has put investors first by charging low fees, which are available to all. The firm isn't perfect. Manager turnover on the investment team is a little higher than we would like to see, many members of the team haven't worked together long, and the Laudus funds' fees aren't consistent with the firm's overall philosophy. Despite those reservations, the firm's strong execution on its well-defined strategy support its Parent rating upgrade.