Enjoy the current installment of “weekend reading for financial planners” – this week’s issue starts off with a review of the latest Mark Hurley research suggesting that the overwhelming majority of advisory firms still have no economic value and are struggling for profitability. There’s also a good review from Bob Veres of the rising range of online startup firms that are threatening advisors in various ways, a look at the recent SEC announcement that many RIA firms are failing to follow the Rule 206(4)-2 Custody Rules for client assets (in many cases, because the firms don’t even realize what they’re doing triggers the custody rule!), and a summary of recent research finding advisor use of social media – and consumer use of social media looking for advisors – continues to rise, with LinkedIn as the most active platform.
From there, we look at a few recent articles that have been critical of the SEC’s request for information to do a cost-benefit analysis regarding a uniform fiduciary standard, finding that the way the SEC is asking the questions may already be shaping the outcome in a manner that either undermines the intended purpose of the rule, or in the view of the Institute for the Fiduciary Standard outright narrows the potential scope of fiduciary to the point where it no longer provides effective consumer protection. There’s also an interesting alternative proposal from Don Trone that a better way to bring principles-based fiduciary to broker-dealers is to craft a series of “fiduciary safe harbor” guidelines that would allow broker-dealers to comfortably apply a fiduciary standard and know how to oversee it, without creating a maze of burdensome rules.
In addition, there’s an article from Steve Utkus of the Vanguard Center for Retirement Research that criticizes the recent and controversial PBS Frontline special “The Retirement Gamble” (despite the special’s favorable positioning of Vanguard and low-cost indexing), and a look from John Mauldin about how the progression to a “cashless society” (where we all do business using credit cards, debit cards, and smartphones) may be further away than we think, due to the rise in cash-based economic activity due to the incentives created by regulation, taxation, and social programs.
We wrap up with three very interesting articles: the first is a review of the recent “Technology Tools for Today’s High-Margin Practice” book by Bruckenstein and Drucker; the second looks at a behavioral bias called “motivated reasoning” – where we are more analytical and critical of things that would challenge our existing views and beliefs – that can be a challenge for both clients and advisors themselves; and the last looks at how the shift to 401(k) and other defined contribution trends is analogous to a broader societal shift towards a greater demand on self-motivation and self-reliance, which allows some to flourish but is creating significant challenges for many others, as a world with more choices and fewer limits also has fewer guarantees and safety nets… and perhaps more opportunities for advisors to help people navigate effectively. Enjoy the reading!
(Editor’s Note: Want to see what I’m reading through the week that didn’t make the cut? Due to popular request, I’ve started a Tumblr page to highlight a longer list of articles that I scan each week that might be of interest. You can follow the Tumblr page here.)
Weekend reading for May 4th/5th:
Mark Hurley: 5 Forces Changing The Economics Of Wealth Managers – This week Mark Hurley of Fiduciary Network published his latest study on the financial advisory industry (following on his 1999 and 2005 studies), entitled “Brave New World of Wealth Management” and this article from AdvisorOne provides a good summary of the key highlights. The latest research includes a significant mea culpa from Hurley, who acknowledges that his prior research takeaway suggesting mega industry consolidation was flawed, but notes that he still sees more concentration coming, and that ultimately there are still only about 200 high-value “evolving business” firms out of 19,400 in the industry, more than 18,000 firms that are “books of business” with little real economic value, and about 1,000 “tweener” firms that have some economic value but have not yet reached the top tier. Overall, Hurley suggests that the industry will be shaped in the coming years by 5 major forces: fewer wealthy clients available (the number of millionaires still has not rebounded above the peak prior to the financial crisis); demographic shifts as clients get older (leading them to be more conservative and risk averse, and becoming net spenders instead of savers); low returns, especially on low-risk assets (which limits advisors’ ability to manage those assets effectively and to charge normal fees for them); rising costs of doing business (climbing at 5%-7%/year); and the rising age of the founders of wealth management firms (with an average age approaching 60). Given these headwinds, Hurley believes that the “evolving business” firms will navigate successfully, albeit with slower growth rates and while struggling to control costs and maintain margins; on the other hand, the cost squeeze may be more brutal to the “books of business” firms who will just find their profits squeezed, and the “tweener” firms will have to either do nothing and become books of business, invest significantly into the business to get over the hump, or sell to another firm. Notably, Hurley suggests that there is actually “plenty of capital available” to those who want to buy and sell firms; the real issue is that capital moves based on cash flow, and most businesses simply don’t have the profitable cash flows to merit much capital.
The Most Underappreciated Threat To The Advisory Business – On Advisor Perspectives, industry commentator Bob Veres takes a look at the rising threat of online tools commoditizing the investment services of advisors, with business plans that are currently focused mostly on the direct-to-consumer market but explicitly envision themselves threatening to disrupt traditional advisory models as well. A prominent example in this space is Wealthfront, which scores a risk-tolerance measure and then invests the money into one of 10 model portfolios made up of low-cost index ETFs, with an algorithm to effectively asset-locate the investments amongst the available types of accounts – all for a cost of 25bps per year (and Wealthfront absorbs the trading costs), and free for accounts below $10,000. Another competitor is Betterment, which also charges 15-35bps to manage ETF portfolios, and also offers opportunistic rebalancing (as does Wealthfront), and other overlapping competitors include Goalgami, Bank Simple, FutureAdvisor, EverBank Wealth Management (a subsidiary of the EverBank online banking platform), Personal Capital, LearnVest, NestWise, and Covestor. Despite the explosion of providers, though, Veres notes that so far, online asset management providers are clearly still searching for their optimal business model, and most remain tiny start-up companies for now. Nonetheless, the threat is present, especially for those advisors who are just doing a basic plan and figuring out a static asset allocation, and advisors who rely on being differentiated by being a real person to talk to – and not a computer – may be increasingly threatened by services like Skype, Facetime, and GoToMeeting which allow for digital face-to-face interactions. Even if the online providers aren’t a direct competitive threat – and in fact, many of them are pursuing younger clients who would be “too small” for traditional advisors anyway – Veres notes that they’re also raising some tough questions about a traditional advisor’s fee structure and value proposition; in fact, the article concludes that the most successful may be the “cyborg” advisors who figure out how to combine the advisor human and the best technology has to offer.
Epidemic Of Custody Violations Among RIAs And How To Cure Them – This article highlights the recent release of SEC Risk Alert and Investor Bulletin 2013-33, related to the Investment Adviser Act of 1940 Rule 206(4)-2, better known as the Custody Rule. The issue at hand is that RIAs has significant additional compliance, audit, and oversight obligations if they have custody of client money, and recent examinations from the SEC are finding that advisors are not properly following the rules, either by failing to supervise and follow the rules properly, or often because they didn’t even realize they had custody in the first place. Common custody triggers – that advisors often didn’t realize – include situations where a member of the firm holds a power of attorney for a client or is a trustee for a client’s trust, where the advisor provides bill-paying services and has authority to withdraw funds, where RIAs have a client username and password to an online account that creates an ability to withdraw funds, being in physical possession of client assets (including stock certificates), receiving client checks and not promptly returning or sending them out, advisors having check-signing and/or check-writing authority on a client account. Notably, having custody of client assets is not illegal, but it does require the firm undergo annual surprise accounting examinations, and comply with additional rules. The bottom line: RIAs should either adopt policies and procedures to avoid custody altogether to escape the scope of the additional compliance burdens, or engage in custody-related activities with a deliberate plan and robust policies and procedures to protect client assets.
LinkedIn Courts Advisors As Social Media Use Grows – This article highlights the trend towards social media adoption by advisors, particularly LinkedIn, where 62% of advisors surveyed indicated they were getting new clients on the platform, and overall 63% of mass affluent consumers state they take action after using social media to learn more about financial products and services (and an estimated 90% of people with investable assets of $100,000 to $1M are social media users). Social media “super user” advisor Cathy Curtis notes that the social media activity has an amplified effect as well, helping to drive clients not only through those channels directly, but pushing her to the top of local Google search results due to all her online activity. In addition, the research suggests that social media can be a channel for financial advisors and institutions to share content that builds trust and credibility, especially given overall distrust of the industry in general and advertising in particular. And due to a combination of its professionalism and the target audience, LinkedIn seems to be the platform of first choice, with more adoption of LinkedIn by financial services than Facebook, Google+, and Twitter combined. The bottom line, though, is that consumers are increasingly seeking a wider and richer range of information to find and evaluate prospective advisors, and social media platforms like LinkedIn are increasingly becoming central to that process.
Has The SEC Unfairly Rigged Its Fiduciary Questionnaire? – This article from Fiduciary News highlights a recent keynote session from the fi360 annual conference on fiduciary, which questioned the objectivity and validity of the SEC’s recent information request for its cost-benefit survey on a potential uniform fiduciary standard. For instance, Ron Rhoades – who chairs the Committee for the Fiduciary Standard – noted that his group is struggling with how to even answer some of the questions to support a fiduciary standard, because of how they were written. Blaine Aiken of fi360 noted that the organization also intends to respond to the request, but “not in a way the SEC expects” and suggested that the SEC asking for comments before issuing at least a proposed rule is a disservice, and that the questionnaire-first approach may unfairly bias the process because the questions already direct the results towards certain preconceived – and not always appropriate – assumptions. At the most basic level, Aiken notes that “The SEC is asking how to accommodate the industry by compromising on two centuries of common law rules. This question is backwards. It should be ‘how do we accommodate the investor?’” Or more simply, Skip Schweiss of TD Ameritrade notes “Fundamentally, this shouldn’t be about costs, it should be about the philosophy of putting the client first.” Nonetheless, the SEC’s survey is out, and there will likely be a lot of visible responses in the coming months as the summer submission deadline approaches.
SEC Chairman Mary Jo White’s First Investor Protection Test: Will She Opt for FINO Over the Authentic Fiduciary Standard? – The Institute for the Fiduciary Standard has also weighed in on the SEC’s request for information for the cost-benefit survey, and also is unhappy with the approach, suggesting that if rules are implemented along the lines of what’s implied in the information request, the result will be a “Fiduciary In Name Only” (FINO) standard without real fiduciary duties. The problem is that while Dodd-Frank requires a uniform fiduciary standard that is “no less stringer” than the Investment Adviser Act of 1940, the direction of the SEC appears to be a very narrow application of that fiduciary standard, with significant exclusions. For instance, only a limited amount of written or oral communication would actually be deemed “fiduciary advice”, and that there may be a ‘facts and circumstances’ based test just to determine whether communications are fiduciary, creating significant uncertainty for investors (and the SEC implies it wouldn’t even require a broker to explain the difference between fiduciary and nonfiduciary language). Similarly, the SEC release suggests that fiduciary duty could be waived through contract provisions, marketing materials, or disclosures (and without first determining informed consent). The Institute also notes that the SEC’s direction suggests it believes disclosure is the optimum action for addressing conflicts (despite the history of fiduciary showing that some conflicts cannot be managed by disclosure alone), and that it appears to be minimizing the significant of certain conflicts, and that it is even redefining loyalty from “do the right thing” to just “disclose doing the wrong thing.” The bottom line: even though Dodd-Frank requires adoption of a uniform fiduciary standard no less stringent than the ’40 Act, the direction of the SEC suggests that it may be redefining the rules in a manner that would appear to meet this standard by the letter of the law, but not its spirit and intent.
An Alternative For The SEC: Fiduciary Safe Harbor Rules – This article by Don Trone also discusses the recent SEC request for information on the costs and benefits of a uniform fiduciary standard, and suggests that the questions being asked by the SEC may indicate its more likely to promulgate harmonized rules for brokers and investment advisers, not a uniform fiduciary standard at all; the key difference is that a fiduciary standard is based on principles, yet the SEC’s release only uses the word “principles” three times, while the word “rules” is used 81 times. In addition, Trone questions whether the type of quantitative data and empirical evidence the SEC requests will yield meaningful insights anyway, because you simply can’t comparatively measure such asymmetrical scenarios where one is based on rules and the other on principles (similarly, we can measure the cost of war, but not the price of peace; we can measure the cost of unethical and illegal activities, but not the prosperity lost due to unethical behavior). Given this challenge, Trone suggests an alternative: given the push towards fiduciary, the SEC should try to identify what steps can be taken to assist broker-dealers in reaching a comfort level with a principles-based fiduciary standard (as Trone believes most broker-dealers are not opposed to the standard itself, but simply concerned that they won’t know how to manage and oversee their advisors effectively). Accordingly, Trone proposes a safe harbor model – a series of minimum fiduciary requirements that, if followed, would protect the broker-dealer from liability. The safe harbor rules would include: the first must define minimum experience/licensing/training qualifications for advisors to serve in a fiduciary capacity; the advisor must accept and acknolwedge fiduciary status in writing; the advisor must agree to only utilize investment products, databases, software, and technology approved by the firm; the advisor must maintain records to demonstrate procedural prudent (i.e., details of the advisor’s decision-making process); and the activities of the advisor must be monitored by the firm. Trone believes that with these safe harbor fiduciary guidelines, broker-dealers could effectively apply a fiduciary duty for their advisors, maintain their supervision and oversight responsibilities, and reasonably limit their own liability in the process.
The 401(k) Debate – This article from Steve Utkus of the Vanguard Center for Retirement Research takes issue with the recent PBS Frontline special “The Retirement Gamble” that has been generating a lot of industry buzz over the past week for its expose-style look at the 401(k) industry. Although Vanguard and John Bogle were prominently featured in the piece, which highlighted a lot of 401(k) hidden costs and fees and the value of low-cost indexing as an alternative, Utkus is actually quite critical of the documentary. He starts by pointing out that two of the main tenets of the program – that most Americans aren’t prepared for retirement, and that the old Defined Benefit system left workers better prepared for retirement – are questionable, as many of the “unprepared” are either within striking distance or actually still have a good amount of time, and the defined benefit system only ever covered about 4-in-10 workers at its peak and was highly unfavorable to those who changed jobs often out of desire or necessity. Utkus also notes that the growth of 401(k) plans – or defined contribution plans more generally – is a global phenomenon (not some US-specific phenomenon that Wall Street is ‘inflicting’ upon Americans), that the real problem is our culture of spending and not saving in the US (which the documentary largely ignored), that automation of defined contribution plans is eliminating many of the challenges and complexities that Frontline criticized, that the program excessive focused on the losses in market downturns but not the long-term growth that results from the eventual recoveries, and that there’s already downward fee pressure on 401(k) plans (which in truth have average fees of about half the 2% amount that Frontline quoted). Ultimately, while Utkus notes that he still sees the push towards lower fees and indexing as a positive, his fundamental point is that the retirement outlook is not as bleak, and the 401(k) industry is not as sinister, as “The Retirement Gamble” dramatized.
The Cashless Society – In his weekly missive, John Mauldin takes an interesting look at the rise of the “cashless society” – the idea that soon we’ll all eschew cash and instead just complete transactions using credit cards, or even our smartphones as a functional wallet. Despite the progression of technology, though, Mauldin suggests that the cashless future may be a lot further away than we think – due to the growth of the so-called “underground economy” of businesses and workers that operate on a strictly cash basis. In fact, recent research suggests that we may have been significantly underestimating how much cash is circulating within the US borders, and that the US currency holdings are now as high as $750 billion within the country, which amounts to $3,000 per capita! So what is all this cash being used for? To conduct a large amount of unreported business on a cash basis, which is estimated to be as much as $2 trillion of economic activity, and may result in as much as $400 billion of lost tax revenue. Although the US is still a long way from Greece, “where tax evasion is a national sport and the shadow economy accounts for 27% of GDP” Mauldin points out that the incentives for a growing cash-based society are on the rise. For instance, the design of many welfare, unemployment, and other social support programs, can be very inhospitable to part-time or low-wage workers (not to mention small businesses that must comply with tax and other regulatory burdens), indirectly encouraging them to work on a cash basis while still collecting other benefits rather than reporting their $10/hour income and losing their benefits. The point here isn’t to blast those that need welfare, or to suggest that everyone receiving welfare benefits is underreporting their income, but simply to note that in today’s environment, there are still strong incentives for a cash-based society to stick around a lot longer than we might have realized.
Book Review: Technology Tools For Today’s High-Margin Practice – From the Journal of Financial Planning, this article provides a nice review of the recently released “Technology Tools for Today’s High-Margin Practice” by advisor technology gurus Joel Bruckenstein and David Drucker (and nearly a dozen supporting chapter authors). The review notes that technology for advisors is now increasingly challenging in two regards: first, the continual evolution of core software (financial planning, portfolio management, CRM, etc.) necessary to run a practice that needs to be upgraded; and second, the rapid adoption of new technology (eg., social media, file sharing, mobile devices) where the adjustments are more rapid and the outcome and implications are less clear. The book attempts to cover both areas, although the reviewer notes that some chapters are written by niche experts in certain areas who aren’t necessarily advisors themselves, and that sometimes the content could have benefited from more advisor-specific context; similarly, a lot of the chapters provide a good overview of key concepts and areas, but not necessarily the granular review of specific providers that would aid an advisor in making a final decision about what company to work with (although obviously such specific reviews would also limit the shelf life of the book). Notwithstanding some of these caveats, though, the reviewers ultimate conclusion is that “for advisers interested in staying ahead of the technology curve, Drucker and Bruckenstein’s book should be regarded as required reading.”
Motivated Reasoning – This article from Bob Seawright’s “Above The Market” blog highlights an important behavioral finance bias that investors – and advisors – often overlook: motivated reasoning. Many are familiar with its complement – confirmation bias – where we tend to seek out, notice, and accept information that fits within our existing views and beliefs; in a similar manner, motivated reasoning represents our tendency to scrutinize ideas more critically when we disagree with them. The classic study on this dates back to when the U.S. Surgeon General issues a report in 1964 linking smoking and cancer; in the aftermath, researchers found that nonsmokers generally agreed with the Surgeon General’s warning, but smokers questioned the results, often with dubious points like “many smokers live a long time” (as though an anecdote disproves the overall data) or “lots of things are hazardous” (which doesn’t change the point about the risks of smoking). In a similar study, people observing a trivia game winner were more likely to attribute the performance to skill if the person was on their team, but questioned the root of the individual’s success and attributed it more to luck if the person was on the opposite team. This has some significant implications to be cognizant of in the world of investing and advising, where many of us have certain views and perspectives and may unwittingly engage in confirmation bias and motivated reasoning to affirm our current beliefs without due diligence and shoot down ideas that disagree with our views without giving them a fair chance. So to say the least, it’s important to recognize that we may not be as rational as we like to think we are – and recognize that if we insist on questioning that conclusion, or something else that agrees with our current world view, it might be because we’re irrationally engaging in motivated reasoning in the process!
It’s A 401(k) World – In the New York Times, Tom Friedman takes a look at how the world is shifting in a manner that people must be increasingly self-reliant and self-motivated – a world of defined contribution plans like 401(k)s and not defined benefit pensions. But the shift transcends beyond just the actual trends of the retirement industry. With an explosion of connectivity, there is now a incredible platform that empowers people to access “learning, retrain, engage in commerce, seek or advertise a job, invent, invest and crowd source” in an online environment, but with one important caveat: the individual’s opportunity to take advantage of all of this rests on the individual. While this is a great positive for those who are highly self motivated, it’s a real challenge for everyone else, as the protections that were often available in the past are also disappearing; while there are fewer limits, there are also fewer guarantees. Friedman suggests that this ultimately means we need to do a better job inspiring individuals to learn, challenge themselves, and be more self-reliant, especially because the explosion of Big Data means, more than ever, that not only will the rewards increasingly go to those with individual success but we have the means to measure precisely who is contributing and who is not to ensure that outcome. This also means that we need better programs to help workers gain the competencies and specialized skills they may require to find those paths to success (although as a related column by Felix Salmon notes, the issue may be less of workers struggling with finding the right training and more about the fact that wages as a share of GDP have been falling for decades and that it’s tough to get ahead when the pie is shrinking). On the other hand, if Friedman is right, a 401(k) world is also likely quite bullish for financial advisors to add value in helping to navigate such challenges!
I hope you enjoy the reading! Let me know what you think, and if there are any articles you think I should highlight in a future column! And click here to sign up for a delivery of all blog posts from Nerd’s Eye View – including Weekend Reading – directly to your email!