Jeff Gerson, a million-dollar producer at Smith Barney, remembers in the early 1990s, when the ability to act as a discretionary portfolio manager really took off. A trading system previously only available to outside fund managers became available to reps at the firm. Reporting standards were enhanced, conferences were held to instruct reps in working as portfolio managers, and, in general, the improved technology made managing portfolios—and thus serving clients—a lot easier.

Clients noticed.

“We had clients who had half their assets with us and half their assets elsewhere, but after enjoying the personal, one-on-one relationship with their own manager, they decided it would be the place they wanted to consolidate their assets,” says Gerson, who manages more than $1 billion with his two partners.

Of course, the life of a rep is increasingly revolving around activities that were once considered peripheral to stock picking—broad financial and estate planning. That is to say, management would like the rank-and-file broker to drop the stock and bond peddling for fee-based wealth management. “If you listen to the wirehouses, you’d think that was the only business,” says a Wachovia broker. “Unh, unh, unh. No way. Transactions are still huge. Lots of clients like it that way.”

About two-thirds of reps surveyed by Prince & Associates, a consulting firm, are still primarily commission-based. And as much as management might like to kill off the stock-jockeying transactional business, there is another animal emerging from the bush, part stock trader, part wealth manager: It’s the rep-as-portfolio-manager, the rep, epitomized by Gerson, who designs an investing plan for a client and then actually executes the plan, picking the individual stocks, bonds, funds and the like and wrapping it in a fee based on assets under management.

In fact, the rep-as-portfolio-manager model is taking off. In a one-year period, ended Sept. 30, 2003, assets in such programs jumped by 21 percent to $65 billion in assets, according to Cerulli Associates. That growth rate is less robust than the growth rates of other types of fee-based programs (see table page TK). But, unlike those separate accounts or wrap programs, firms are not flogging the rep-as-portfolio manager business, much less advertising it to the public.

Use Discretion with Discretion

It’s a wonder that discretionary money management by brokers is growing at all, since it makes Wall Street firms and some smaller broker/dealers very nervous. The associated liabilities—increased suitability and supervisory risks, and, therefore, greater chances of adverse arbitration—is too much for many firms to bear. As a result, they restrict it to a small, elite group of advisors. Some firms, including Edward Jones and A.G. Edwards, don’t allow the practice at all.

Others are only slightly more excited by the discretionary model. Morgan Stanley’s Custom Portfolio program has about 165 reps as discretionary portfolio managers, according to firm officials, and Merrill Lynch’s Personal Investment Advisory program has, the firm allows, “several hundred” out of 13,500 total reps. Wachovia has about 1,000 of its 12,000 reps acting as money managers in its Portfolio Investment Management program. Smith Barney, in stark contrast, says more than half the firm’s 12,500 advisors are qualified.

Wirehouse executives say they’re not as averse to discretionary portfolio management as the numbers would imply. In fact, several of the large firms, including Morgan Stanley, the program comes in handy when recruiting some big producers from the competition.

But make no mistake: It’s not your father’s discretionary account. “Historically, at wirehouse firms like ours, the word ‘discretion’ has had a negative connotation,” says Carl Swanson, director of the custom portfolio group at Morgan Stanley, who was brought over from Smith Barney in 2000 to run Morgan Stanley’s rep-as-portfolio-manager program. “But you’re almost doing it a disservice by calling it a discretionary program. In addition to all the services the broker is providing, this version of discretion has investment parameters that must be adhered to.”

What Swanson means is that Morgan Stanley keeps strong guidelines on what kind of reps can enter into discretionary portfolio management, which is why there are just 165 reps managing $1.7 billion in assets in its custom portfolio program, at the end of third quarter of 2003. The firm could have many more advisors running money, but Swanson says he’s turned down a few hundred applications in the last few years. “Could we have 500 or 1,000? Sure, if we just let anybody in,” says Swanson. “There are a lot of people interested who don’t qualify. Our philosophy is that it’s a much more elite program. My average broker has been in the business for over 18 years. It’s a varsity team.”

Varsity indeed: Morgan reps with less than five years of experience and less than $75 million in assets need not apply. And, of course, the CRD form must be clean. A qualifying rep then must submit an application describing his investment strategy. If approved by management, the rep moves on to an internal course in portfolio management that takes anywhere from 25 to 40 hours of study. That’s followed by a two-day business development workshop to instruct him in the legal and compliance ramifications of portfolio management. Oh, and that’s on top of getting a Series 65 or 66.

Most other large firms have similar qualifications and training prerequisites. And it shows: Wachovia has about $8 billion in assets in rep-as-portfolio-manager programs, or about 13 percent of fee-based assets. Merrill Lynch, in contrast, has about the same assets under management, representing only about 4 percent of its fee-based assets. Overall, these broker-as-portfolio-manager programs account for a mere 7.5 percent of the industry’s fee-based accounts, according to Cerulli Associates.

The major outlier is Smith Barney, which, as of the third quarter of 2003, had $21 billion in these programs—representing nearly one-third of the industry AUM. (Within the firm, it accounts for about 11 percent of fee-based business.) More than half of Smith Barney’s 12,500 brokers are qualified to use discretion as a portfolio manager, and about 1,000 reps consider it a primary part of their business, according to Paul Hatch, chief operating officer in Smith Barney’s consulting group.

Hatch says broker-discretionary portfolio management is never going represent even, say, 30 percent of the fee-based business at the firm, such business should continue to grow. “We’re one of the few that has actively been trying to encourage and grow this business, rather than just accommodating it,” Hatch says. The firm regards broker portfolio management as a “core competency.” The firm uses automated monitoring to send out blasts to reps when sector weightings reach proscribed limits.

Still, the dominant relationship in large broker/dealers remains the agency-client one. Some think reps interested in portfolio management are going to ultimately gravitate elsewhere, perhaps to independent broker/dealers.

“We’ve seen a lot of greater interest from wirehouse people,” says Mike DiGirolamo, senior vice president in the investment advisors division at Raymond James, who recruits reps to use their custodial services. The firm has between 60 and 70 advisors affiliated with Raymond James in this manner, and he expects growth of about 50 percent in 2004. “They’re frustrated with the bureaucracy, and the restrictions on how they can allocate client portfolios.”

Eating Your Words Why are brokerage houses loath to letting the lion’s share of brokers manage money on behalf of their clients? “On the surface it looks benign, but what a hornet’s nest it can open up,” says Bill Singer, attorney with Gusrae Kaplan & Bruno in New York and a columnist for this magazine.

The fundamental nature of the relationship between a broker and a client changes when discretion is involved. “A broker’s liability generally is very finely tuned to two events—the point of purchase of the stock and point of sale of a stock,” Singer says. “When you take on the obligation of discretion, you’ve opened that window. What the attorney for a plaintiff is going to allege is that you were servicing so many accounts that the rep couldn’t watch these accounts.”

It’s one reason why some executives object to it entirely. “Are they working with clients and trying to manage their investment needs or are they running money?” asks one brokerage exec. “I would say in this day and age it’s difficult to do both.”

If there is a prescription that makes firms less skittish, it’s an audit by an outside firm. Smith Barney says it’s considering becoming compliant with performance standards prescribed by the Association for Investment Management and Research—standards required by most institutional investors before they will even consider an asset manager. The firm does audit the results of all reps doing discretionary management. Producers with more than $100 million under management can qualify to have an AIMR-approved audit to use for marketing purposes.

AIMR has lengthy standards that require separate account and fund managers to conform to certain performance and reporting guidelines. But reps that run money can do this too; it’s the only way they can market their results. It’s a chief motivation for Tom Samuels, chief investment officer at Stavis/Margolis Advisory of Houston, for getting his group AIMR-compliant. “We’re very cognizant of having our results not just be for clients, but for growing the practice,” he says.

Samuels’ firm had to submit results of various portfolios that an advisor runs to an outside verifier. Those portfolios have to be clustered in style buckets—you can’t submit the portfolios of each individual client account. It requires having some portfolios that are similar, with some deviations for individual accounts. “Part of the compliance process is to see that you didn’t get there by random chance,” he says. “There has to be a certain homogeneous character of the portfolios.”

Anything You Can Do…

Smith Barney’s Gerson, who manages more than $1 billion with two partners, Chris Guarino and Greg Meisel, says his group isn’t out to be the top portfolio manager every year. They’re aiming for a measure of consistency that allows them to tell clients they’re adding value every year.

Guarino believes the revolving door of money managers at a particular fund company can harm continuity—whereas with a rep that acts with discretion, a client has continuity. Besides, that’s what got many reps into their careers: They simply love managing portfolios and watching the market. More important, asset managers have become a commodity, so there’s nothing to stop clients from jumping firms as long as they can stick with the same mutual funds. With this approach, clients are more tied to the rep.

“It’s resulted in a funnel of referrals,” says Gerson. “The [prospective] client realizes, ‘Hey, we can’t find Gerson, Guarino & Meisel in the Morningstar listings?’ As far as we’re concerned, that’s a new client right there.”

Reps who do act as money managers say they can run money and maintain close contact with their clients Ira Walker, Morgan Stanley’s largest producer and one of the top producing brokers in the nation, concentrates his portfolios in exchange-traded funds, and uses them to diversify client accounts. But he still finds time to keep in close contact with his clients. Indeed, it gives him, as he sees it, better service than packing clients off to a money manager. “The buck stops with me and I’m comfortable with that,” Walker says.

Christopher Willett, a Legg Mason vet of 20 years, says he would be lost without studying the market. He also believes portfolio management is the future—a more sophisticated style of service. But it also focuses. “With everything that’s happened, the key going forward for reps is going to be knowledge,” he says. “I feel it connects me still to the market—otherwise I’m really no different than a Century 21 salesman.”