Enjoy the current installment of "weekend reading for financial planners" – this week's edition kicks off with a look at the recent Focus Financial IPO, which did in fact go off as planned this week, at a lower price than the rumored peak, but far higher than first anticipated when the IPO was announced, with trading that began at $33/share and closed at $37.55 after the company's first day... which at a multiple of nearly 18X EBITDA, is both a tremendous validation of what markets in the aggregate still see as the promise of the independent RIA model, and will likely fuel a fresh wave of advisory firm roll-up aggregation and M&A.
Also in the news this week is a discussion of how CFP Board is beginning to gear up its compliance enforcement capabilities more than a year in advance of its new fiduciary Standards of Conduct that will take effect in October of 2019, and the questions that still linger after the FPA not only terminated its affiliation agreement with a challenged New York chapter but chose not to replace the chapter with a new independent nonprofit entity (as exists for its more-than-80 other chapters) and instead decided to roll the FPA of Metro New York into the national FPA organization, and raising questions about whether the approach may be a template for national attempting to centralize more of its chapter system in the coming years.
From there, we have several articles on investment themes, from a paper in the Financial Analysts Journal suggesting that Bill Sharpe's famous "Arithmetic of Active Management" (suggesting that the average active manager return will and must underperform the market in the aggregate, net of fees) may not be valid in practice due to the existence of IPOs and share repurchases along with additions and deletions from public market indices (which creates opportunities for active managers to still add net value at the margins), to a look from Research Affiliates at when and whether investment manager selection is really worth the effort (at least compared to simply trying to help clients better manage their own behavior), and a candid look from Morningstar at how its own new Morningstar Analyst Ratings have performed after their first 5 years (finding that Gold ratings do predict risk-adjusted outperformance, and Negative-rated funds underperform, but Silver, Bronze, and Neutral funds are ending up in a murky middle).
We also have a series of articles on client communication, including some good icebreaker questions on how to get clients or prospects to start talking about themselves, 10 "tactless" things that advisors often have to tell clients to help them face reality, and what to consider in the unfortunate situation you actually need to communicate to a client that it's time to end the relationship (i.e., to "fire" the client).
We wrap up with three interesting articles, all around the theme of how increased longevity, paired with increased connectivity, are changing the ways we work and the ways we take breaks from work: the first explores the rising interest, especially amongst Millennials, in taking sabbaticals (and even 1-2 year stints off from work) as an alternative to just working continuously for 40-50+ years (given increased longevity) and then taking the vacations all at the end; the second looks at how the conventional view is that you have flexibility to "goof off" and pursue your passions while you're young, but in reality, we often don't really know what we enjoy and want to pursue when we're young, and that perhaps a better formula is to just focus on working hard in the early years and aim to pursue your passions in your 40s and 50s instead (when your life is more stable and you better know what you actually would want to do); and the last makes an interesting case that, in a 24/7 ever-connected world, perhaps it's a good idea to deliberately live a "24/6" lifestyle, where we take one "digital sabbath" per week to completely unplug and focus on ourselves, our health, and our relationships... both because doing so seems to improve our happiness, and because the alternative has a greater risk of leading to burnout, anyway!
Enjoy the "light" reading!
RIA Milestone: Focus Stock Begins Public Trading (Charles Paikert, Financial Planning) - This Thursday, shares of RIA aggregator Focus Financial (ticker symbol: FOCS) officially began trading, and is viewed as the first real publicly traded stock representing the RIA model. The IPO had initially been priced in the low $20s, then was estimated to potentially come in as high as $35 to $39/share, before ultimately pricing at $33/share at the IPO open (and closing at $37.55 after its first trading day). The significance of the Focus IPO is not merely its stock price itself, valuing the firm at nearly $2B of company value and raising over $500M of capital, but that FOCS will become the bellwether indicator of public market perceptions around the strength and health of the RIA model (even though it is a minority ownership combination of many firms, and not a single centralized operating company). Thus far, the outlook is incredibly rosy - with Focus IPOing at nearly 17X EBITDA with an estimated (and whopping) 13.4% organic growth rate - and the potential to IPO at 17X or more when even large RIAs are only trading hands at 7X - 10X earnings will likely drive even more mergers and acquisition interest from private equity firms and large roll-up aggregators. For Focus itself, though, the question will simply be whether it can sustain its strong organic growth rates, especially at its size and once a number of its owners have the opportunity to cash in on the IPO event. Nonetheless, the sheer strength and success of the IPO - which came down from its high IPO price but was still far stronger than initial estimates - affirms that at least so far, the market sees strong continued growth for the RIA channel.
CFP Board Sharpens Compliance Focus Ahead Of New Ethics Standards (Kenneth Corbin, Financial Planning) - The new CFP Board fiduciary Standards of Conduct will take effect in a little over a year (October of 2019), but the CFP Board is already gearing up its capabilities to be ready to oversee and enforce the new standards, with a new opening for a "Compliance Counsel" position, which the organization indicates "won't likely be the last hire in the compliance department ahead of the new ethics and standards." Notably, the CFP Board is also aiming to become increasingly active between now and then in putting out education and guidance to CFP professionals about what is expected of them to comply with the new rules, including the formation of a new Standards Resource Commission that will be responsible for creating additional guidance and educational materials. Nonetheless, as the CFP Board focuses on its strategic "Four A's" of Awareness, Access to Planning, Authority of the CFP Board, and Accountability, the organization is indicating that it is serious about stepping up accountability for CFP professionals to actually follow the new rules, an area where CFP Board has been criticized in the past for lax reactive enforcement. Which will likely put substantial pressure on Vanguard veteran Jack Brod, recently elected as the CFP Board's incoming President-Elect of its Board of Directors, who will be taking on his full leadership year just as the CFP Board's new rules take effect and potential enforcement begins.
FPA Tries To Move On From Messy Divorce With New York Chapter (Greg Iacurci, Investment News) - The national Financial Planning Association cut ties to its FPA of New York chapter earlier this year, terminating the independent chapter's affiliation agreement after infighting amongst its board of directors about alleged improprieties regarding the use of consumer contact information from its public awareness events for lead generation amongst certain board members, and in the chapter's stead created a new "FPA of Metro New York" to provide ongoing services to local members. Notably, though, the new FPA of Metro New York was not established as an independent nonprofit entity with an affiliation agreement to the FPA, as exists with all of its other more-than-80 chapters; instead, the FPA of Metro New York is simply funded and staffed directly by FPA National, effectively being treated like its other "communities of interest" (e.g., NexGen). The FPA staff leadership suggests that this new structure was the "easiest path" to keeping member services intact rather than "go through the hoops and processes of creating another legal entity", although it's not entirely clear why an organization with a more-than-$10M operating budget would have difficulty spending a few thousand dollars of lawyer fees to quickly spin up another entity. For the time being, the FPA National organization is simply trying to fill out the Board of Directors of the new chapter community, and identify volunteers willing to serve. But in the meantime, substantial questions remain about whether the FPA is laying the groundwork to engineer a broader-scale shift to reduce the independence of its affiliated chapters, and whether the transition of the FPA of New York chapter is an intended model and template for other chapters to be assimilated in the future, while the organization itself has remained silent to its broad membership regarding the events of the New York chapter's reconstitution as a non-independent entity.
Sharpening The Arithmetic Of Active Management (Lasse Heje Pedersen, Financial Analysts Journal) - A famous article by Nobel Laureate William Sharpe on "The Arithmetic of Active Management" states that "before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar," such that after costs are considered in the aggregate, active management always and must be a losing value proposition (even if there are certain groups of active managers that systematically outperform, as they would only do so by systematically beating other "bad" active managers who underperform by an equivalent amount). However, Pedersen points out that this entire premise is still really only true in a world where the market portfolio itself is stable and never changes - which isn't reality, as companies issue and repurchase shares and the index market portfolio itself is reconstituted over time... which means even "passive" investors must regularly trade in the aggregate just to maintain a "market portfolio", and at least run the risk that they may "passively" trade at inferior prices to active managers. Of course, the caveat is that the impact of newly issued and repurchased shares, and the additions and subtractions from the index/market portfolio, can only create a positive active management opportunity if the changes are high-volume enough to allow an impact on the aggregate results. Yet Pedersen's research suggests that this is in fact the case, given that IPOs in the primary market tend to sell at a discount relative to what they trade for in the secondary market when passive index funds would first get access to them (giving active managers an opportunity to better select the most winning IPOs before their market capitalization is clearly established by the market itself). Similarly, active managers can also trade in front of "known" index changes before they are implemented by passive funds, and because the "market portfolio" itself is still somewhat debated (market of US stocks? international stocks? also US bonds? international bonds? gold? commodities?), different active managers may fare better or worse by better selecting which "market portfolio" to own. Accordingly, Pedersen suggests that a better way to recognize the distinction is that active managers play an important economic role - to help allocate resources efficiently in the economy, particularly as new companies/shares are issued or repurchased, which is an economic benefit to society (even if net performance after fees is reduced?) - while the economic role of passive investing is more about simply creating low-cost access to markets for the mass of investors in the first place. Which means passive investing isn't "bad", but active managers aren't necessarily doomed (or only subtracting value from the economy) either.
Is Manager Selection Worth The Effort? (John West & Trevor Schueseler, Research Affiliates) - For advisors who provide some kind of investment management solution for clients, providing asset allocation advice is generally more scalable and less time-consuming than engaging in manager selection, which, even if it creates value for clients, still must be weighed against the additional staffing and other costs that it entails for the firm to conduct the appropriate manager research and due diligence. The challenge is compounded by the fact that the most readily available data on investment managers is their past performance, yet not only does past performance fail to indicate future performance, but there is a growing base of evidence suggesting that mutual fund outperformance tends to mean-revert (such that, once controlling for expenses, it may be a better bet to buy the worst-decile managers than the top-decile ones!). Accordingly, to the extent that manager selection is feasible at all, West and Schueseler suggest the key is not "return-chasing" but focusing on the factors are predictive on a forward-looking basis: the soft "Ps" of philosophy, process, and people. And given the time-consuming nature of conducting such detailed forward-looking due diligence in the face of a clientele that has a known strong tendency to chase performance (the so-called retail investor "behavior gap"), the question arises as to whether it's better to pursue such manager selection in pursuit of positive alpha, or simply to focus on helping clients themselves eliminate their "negative alpha" of the behavior gap itself. Especially since the reality is that client behavioral biases themselves will likely pressure advisors to fire bottom-quartile or bottom-decile funds and replace them with recent top performers along the way, which itself is the antithesis of good manager selection in the first place.
How Well Has The Morningstar Analyst Rating Performed? (Jeffrey Ptak, Morningstar) - The Morningstar Star Ratings based on past performance have long been criticized, including by Morningstar itself, as having only limited predictive value at best regarding future performance (and mostly driven by the impact of fees and persistent underperformance). Accordingly, back in 2011, Morningstar launched "Analyst Ratings", which were explicitly intended to be a forward-looking assessment of a fund's likely ability to outperform its peers or benchmark over a market cycle, with "medal" ratings of Gold, Silver, Bronze, Neutral, and Negative. And after more than 5 years of track record performance, Morningstar has dug in to evaluate how effective its November 2011 Analyst Ratings actually were at predicting subsequent outperformance. The good news is that the post-mortem reveals Analyst Ratings were generally predictive - most significantly amongst equity and asset allocation funds, where Gold (and sometimes Silver) rated funds generally did outperform, and in the case of equities the "Negative" funds underperformed as well. However, there was relatively little persistent return differential between Bronze and Neutral funds, and the relative outperformance (or predicted underperformance) varied significantly by time horizon and asset class (and geographic region). On the plus side for Morningstar, the results were not solely explained by differences in cost or risk (i.e., Morningstar appears to be effectively identifying unique predictive factors). Morningstar is still aiming to make adjustments to further improve its Analyst Rating performance, especially by more carefully considering absolute vs risk adjusted performance (as Morningstar Analyst ratings were better able to predict risk-adjusted performance, but some investors just care about the final return), and trying to identify how better to separate out the ratings and results of the Silver, Bronze, and Neutral funds that usually did not result in statistically significantly different performance results (as Gold and Negative funds did) despite their varied ratings.
The Two Questions That Immediately Engage Prospects (Dan Solin, Advisor Perspectives) - As the neuroscience research shows, human beings like talking about themselves. So much so, in fact, that we often feel better about the person we're talking to (as though we're being heard and understood) when we get the opportunity to talk about ourselves. Accordingly, Solin suggests that one of the best ways to bond with clients is to get them talking about themselves... and a good way to do so is to ask them questions, particularly ones that are likely to evoke a personal response. Two questions that Solin suggests are especially effective are "What's your favorite city and why?" and "Are you an introvert or an extrovert?" The reason why both questions work so well is that they invite moments of self-reflection, followed by a very personal level of sharing (and often reminiscing on personal situations where we were at our best, which makes us happy). The key point, though, is that what engages people is not what their actual favorite city is, or whether they are actually an introvert or extrovert - which you could also answer by simply showing them a PowerPoint presentation discussing the 10 most popular cities around the world, or the differences and population statistics of introverts and extroverts. In other words, it's not about educating clients on these issues, but engaging the clients (or prospects) in a way that lets them share their own experiences and literally talk about themselves. Which is true when it comes to their portfolios and investing, too.
10 Tactless Things I Tell Clients (Allan Roth, Financial Planning) - Sometimes, it's difficult to face reality, but arguably one of the greatest value propositions of a financial advisor is to provide an outside perspective and help clients confront hard truths. Accordingly, Roth shares his list of 10 "tactless" things he tells clients to help them face important realities, including: "I'm charging you $450 an hour to tell you I don't know the future" (to emphasize that so often the value of an advisor is not to help clients predict the investment future, but to help them not overconfidently mis-predict it themselves); "Investing should oscillate between boring and painful" (because markets will inevitably go up and down, and most of the time it's boring to just participate and go along, even if that's best); "Is your goal to die the richest person in the graveyard?" (and if not, what are you doing to enjoy the money you've accumulated?); "You are borrowing money at a higher rate than you are lending it out" (don't keep a substantial cash balance or hold low-yield short-term bonds while you maintain a higher-rate mortgage!); "Your cash may be your riskiest asset" (given the long-term impact of inflation and taxes); "It's often best to 'keep it simple, stupid'" (despite our natural tendency and desire to complicate things - especially portfolios); "Get real" (it's important to thing in real inflation-adjusted terms, not in nominal dollars); and "I'm not right for you" (because sometimes the reality is that the client really isn't a good fit, and it's best to move on before the relationship deteriorates further).
How To Fire A Client (Jake Redger, Advisor Perspectives) - For most advisors, one of our greatest struggles is getting new clients... which makes it especially important to retain and hold onto the clients you have (and not lose any), and makes the idea of "firing" a client especially painful. And while some clients can be difficult to work with, the reality is that the clients most difficult to work with are often the ones who need our help the most (and arguably we have a professional obligation to serve all clients in need, and not just the "easy" ones). Nonetheless, Redger notes that sometimes, it really is necessary to terminate a client relationship, whether it's because the client makes unreasonable demands and wants everything for nothing, isn't paying your fees, or worse, is not listening to you, showing a basic lack of respect, or is just flat out being unresponsive in the advisor-client relationship even when there are needed tasks to be done. And the good news is that for at least most independent advisors, you can choose who to work with - and who not to work with - which means sometimes, the best course of action is simply to "fire" the client. So what's the best way to go about the process if it's necessary to do so? Redger suggests first considering the state of the markets and client results - as the reality is if there's been recent underperformance (and especially if there's been a recent market decline), clients may be looking for someone to blame, which makes it especially important to properly note and detail all communication to reduce the risk of being sued by a bitter client (or even delay firing the client until the relationship is less stressed). From there, consider the potential impact of terminating the client - both from the personal perspective (do you have an overlapping personal relationship with the client outside the firm?), professional (do you do joint work on this client with other centers of influence?), and financial (how profitable is the client, or not, in the first place?). And of course, be certain to review the situation with your compliance and/or legal departments (if applicable). When the time comes for the termination itself, Redger simply suggests setting up a face-to-face meeting, where the goal is to: 1) explain the situation; 2) deliver the rationale for the decision; 3) remain professional; and 4) refer the client out to where he/she can be better served (whether another advisor in your firm, an outside advisor, or a robo-advisor). And don't forget to document every detail, in case questions ever arise again in the future!
Why It's Time To Quit Your Job And Travel The World (Ben Steverman, Bloomberg) - With medical advances and increasing longevity come longer lives, and a longer period of healthy lifespan also means a longer time for both retirement itself, and the career that precedes it. Yet at some point, the idea of working straight through for as much as 50 years, before finally enjoying "retirement" in your 70s, 80s, and 90s, may no longer be appealing. Or stated more simply, instead of waiting 50+ years to begin to enjoy a 25-year retirement, what if workers started to intersperse years of mid-career "breaks" along the way, and enjoy some of the fruits of their labor sooner rather than later? This idea is one of the central tenets of the recent book "The 100-Year Life: Living and Working in an Age of Longevity" by Lynda Gratton, who advocates "tak[ing] some of the retirement at the end of your life and distribut[ing] it to the middle of your life" instead. Of course, the idea of taking a "sabbatical" as a midcareer recharge is not new (and is still common in academia), and for many workers it's simply not economically feasible to take such a break. Nonetheless, for those with above-average incomes who live within their means, and especially those in professional services careers that may have more flexibility, it's surprisingly feasible to take 1-2 year breaks, and in fact Wealthfront recently launched an enhancement to its Path planning software tool specifically to help clients model and plan for such breaks. The key shift, though, is not merely the idea of taking a break from work, but that "retirement" itself may no longer be the ultimate goal, especially for Millennials increasingly likely to see 100+ year lifetimes, and Wealthfront finds amongst its own Millennial-centric client base that "take time off to travel" ranks higher as a priority than anything except "financial independence" (the ability to do so indefinitely!). Perhaps the greatest risk for many workers, even in high-income professions, is simply whether or the extent to which a year-long (or more) break could derail their future career progression... yet given that a 50+ year career could actually mean 2, 3, or even 4+ different careers over a working lifetime anyway, arguably a mid-career break may actually be a natural fit leading up to a transition.
How About Later? (Jonathan Clements, Humble Dollar) - When the goal is to retire in "just" 20-30 years, there's little room for error in the effort to cram away and save as much as possible. However, for those who might work for 40+ years, there is more flexibility, including the possibility of doing some of the "goofing off" and pursuing our fun passions sooner, rather than waiting for it all to happen in retirement. Traditionally, the view has been that we "goof off" when we're young, and then buckle down and get serious by our 30s and 40s... but Clements suggests that instead, it might actually be a better approach to try to grind harder in our 20s, and then take some breaks to "goof off" later. After all, when we're in our 20s, we often don't really know what we want from life anyway - pursuing careers only to find we dislike our chosen profession, or spending money on "all manner of things" only to regret many of our purchases later, and suggesting that perhaps just focusing on working and saving during those years, and starting to spend later when we better understand what we really enjoy, would be more productive. Similarly, Clements notes that in our 20s and 30s, "all" the work we do is new and can feel novel and exciting... while by our 40s and 50s, the "grind" feels very grindy (after a few decades of repetition), such that we're more likely to want to make a change and pursue our passions and the work we love (now that we finally know what it is we really enjoy doing)... which suggests, again, that the grinding period is better early on, and the more flexible "goofing off" period should come later. And of course, there's the simple math that saving and accumulating more early on just helps us compound more wealth over time. The fundamental point, though, is simply that while the conventional view is that it's best to goof off or pursue your passions when you're young, arguably your 20s and 30s is a better time to grind and work and save (while it's at least still a little bit novel and interesting), and leave the flexible time to pursue our passions until later, when we're more likely to be able to do so productively.
The Hard Break: The Case For A 24/6 Lifestyle (Brad Feld, Feld Thoughts) - In our increasingly digital work, it's hard to disconnect, which means many of us end out being "on" 24/7... at least on our technology devices, and often "on" for work as well. Accordingly, in a recent book entitled "The Hard Break: The Case for a 24/6 Lifestyle", author Aaron Edelheit makes the case for why we should try to get away from the ever-connected 24/7 lifestyle by deliberately creating a "24/6" lifestyle instead, where there is a hard break away from technology for 24 hours every week. Notably, Feld himself has long adopted a "digital sabbath" for 24 hours that runs from Friday night to Saturday night (and sometimes into Sunday morning), where he eschews phone calls, emails, text messages, and other digital channels (and while he does sometimes read books on his Kindle, he stays completely off the web). And notably, the issue is not merely one of taking breaks to have fun, but recognizing the reality of burnout, and that constantly "burning the midnight oil" and working all day, week, month, and year long is not healthy nor does it necessarily even lead to better business results. So if you're curious, take your own "hard break" for 24 hours... and perhaps use the time to read The Hard Break?
I hope you enjoyed the reading! Please leave a comment below to share your thoughts, or make a suggestion of any articles you think I should highlight in a future column!
In the meantime, if you're interested in more news and information regarding advisor technology, I'd highly recommend checking out Bill Winterberg's "FPPad" blog on technology for advisors as well.