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  • Writer's pictureRyan M. Vogel, CFP®

How Financial Advisor Custodians Work


Key Takeaways

  • If your investment advisor has custody of your funds or investments, they must protect these assets by using a qualified financial advisor custodian.

  • The SEC’s Customer Protection Rule safeguards customer assets at brokerage firms by preventing firms from using customer assets to finance their own proprietary businesses.

  • Having investments at multiple custodians won’t make you better diversified. It’s about how you strategically allocate your assets.

Managing risk is extremely important to us and it’s one of the main benefits we provide to clients. In light of the recent collapse of Silicon Valley Bank, I thought it would be a good idea to review how we safeguard our clients’ money. This article provides a behind-the-scenes look at some of the details and what it means to be diversified.

Why Financial Advisors Use Custodians

The U.S. Securities and Exchange Commission (SEC) requires investment advisors registered with the SEC to abide by the “custody rule.” This rule states that if an investment advisor has custody of their clients’ funds or investments, they must protect these assets by using a qualified financial advisor custodian. This procedure helps minimize the risk of loss, theft, or misuse of funds by the investment advisor.


A custodian is a financial institution that looks after a client’s funds or investments. Financial advisor custodians can hold the assets either electronically or in a physical form. Typically, since custodians are responsible for the security of these assets, they are often large, reputable firms (think Schwab, Vanguard, Fidelity, etc.).


Is my money safe? The first thing to remember is that your investments—like stocks, bonds, mutual funds, exchange-traded funds, or money market funds—are yours. The SEC’s Customer Protection Rule safeguards customer assets at brokerage firms by preventing firms from using customer assets to finance their proprietary businesses.

As many of you know, our firm uses Schwab Institutional as our custodian. At Schwab, our clients’ investments are segregated from other company assets and are held at third-party depository institutions and custodians such as the Depository Trust Company (DTC) and Bank of New York. There are reporting and auditing requirements in place by government regulators to help ensure that all broker-dealers comply with this rule. In the very unlikely event that Schwab became insolvent, these segregated securities are not available to general creditors and are protected against creditors' claims. So, if Schwab goes under, your account isn’t held there. It’s held through a trust and a broker-dealer. So, you would still have access to your money.


Schwab is a member of the Securities Investor Protection Corporation (SIPC), which provides protection for securities and cash in client brokerage accounts, including those held by clients of investment advisors with Schwab Institutional. SIPC protects against the loss of cash and securities—such as stocks and bonds—held by a customer at a SIPC-member brokerage firm. The limit of SIPC protection is $500,000, which includes a $250,000 limit for cash. In addition to SIPC, Schwab clients receive an extra level of coverage through "excess SIPC" insurance protection for securities and cash. This helps ensure that claims will be covered in the event of a brokerage firm failure and funds covered by SIPC protections are exhausted.

How Custodial Services (Like Schwab Institutional) Work

Let’s say you have investments at Schwab. Your assets technically aren’t held at Schwab. They’re held through a broker-dealer such as DTC or Bank of NY Mellon, for instance. Schwab provides reporting in the form of statements, tax forms, transaction confirmations, etc. and provides a platform and liquid market for trading stocks, bonds, mutual funds, ETFs, etc.

Then you have wealth managers like Novi who work directly with clients to develop their plans. We take care of buying and selling investments for our clients based on our agreed upon plan. It’s really three parties working together: the custodian (Schwab), the broker-dealer (DTC/BNY Mellon) and the wealth manager (Novi). I like to think of it as a financial supermarket. Your food supermarket rents a building to hold all the food (similar to the broker-dealer), the supermarket makes groceries available (like Schwab, which provides access to buying and selling investments) and a wealth manager (Novi) helps you pick which groceries (investments) to buy.

Structure Determines Performance

Investment performance is completely dependent upon your investment selection; not on where the money is held. So, if you had $500,000 in an S&P 500 index at Schwab and $500,000 in an S&P 500 index at Fidelity, you are not any safer or more diversified. What really matters from a diversification standpoint is how strategically your assets are allocated. How much are you in stocks vs. bonds? And within your stock allocation, are your stocks large or small cap? Are you more in value or growth? These are the questions that determine performance and how well you are truly diversified.


If you look under the hood of all your investments and you have a lot of large-growth stocks in one brokerage account and a lot of large-growth stocks in another brokerage account, you’ve got the same overconcentration of large stock in your portfolio; you don’t have meaningful diversification and you’re leaving yourself vulnerable if large stocks take a hit as we saw in 2022.


Bottom line: when it comes to your investments, your money is safe even if you have it all at a single custodian such as Schwab, Fidelity, Vanguard, etc. What really matters is how your money is invested. Novi picks those investments for our clients very carefully and with strict adherence to our clients’ financial plans.


Conclusion

If you or someone close to you has questions about the safety of their money or your overall investment plan, please don’t hesitate to reach out. We are happy to help.

 

RYAN M. VOGEL, CFP® is the CHIEF PLANNING OFFICER, PARTNER at Novi Wealth

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