Enjoy the current installment of “weekend reading for financial planners” – this week’s edition kicks off with a call for better regulation of financial planning as a distinct calling unto itself, recognizing that in Massachusetts it’s harder to get a license to be a cosmetologist than it is to become a financial planner! There’s also an article discussing the recent rumored-to-be-on-a-fast-track NASAA regulatory proposal (now in comment period) that may require state-registered RIAs to adopt more substantive business continuity and succession plans for the protection of their clients.
From there, we have a few interesting new studies and articles on the so-called “robo-advisor” trend, including a Gallup poll that finds investors still prefer dedicated human advisors to financial website solutions by a 2:1 margin (and more affluent individuals favor the human solutions even more), a Spectrem Group study that finds for consumers who do plan to work in an online environment that the robo-advisors may actually be slightly preferable to human advisors engaged virtually (though there may be enough interest for both to succeed), and an interesting discussion from Mark Hurley about how ultimately the technology-will-replace-advisors threat isn’t really any more dangerous today than it was in 1999 (when similar comments were made) and that ultimately much of the technology that backs today’s robo-advisors will likely end out being used by the rest of the financial services industry (rather than continue to compete with it).
We also have several investment articles this week, including: a look at how some advisors are starting to adopt small allocations of Bitcoin into client portfolios; how Bitcoin does not really function (yet?) as a true currency but as a non-liquid investment asset may still improve risk-adjusted returns for portfolios (at least based on the historical track record for the virtual currency, which may or may not persist in the future); a fascinating look from Howard Marks of Oaktree at how true risk is more about the possibility of permanent loss of capital than about volatility, but that the truer measure of risk is also surprisingly difficult to quantify and apply effectively; and a discussion from Jason Zweig of the Wall Street Journal at the behavioral finance phenomenon of “shared attention” and the fact that who you choose to listen to and follow and get your information from can have a surprisingly powerful effect (good or bad) on your (investment) results.
We wrap up with three interesting articles: the first looks at how the only real way to stay competitive in today’s environment is to be a continual learner, or else face stagnation and boredom that can undermine yourself and your company; the second discusses the five essential skills that planners must learn (as distinguished from the technical knowledge we must have to be competent) if we truly want clients to implement our financial advice (hint: it’s all about the key skills that create true rapport and trust); and the last is a piece by industry commentator Bob Veres that takes an interesting look at the current regulatory environment and suggests that the real problem is not that we need to apply a new fiduciary standard to brokers but simply that the SEC has allowed the brokerage industry to drift too far from where it once was and should just do a better job enforcing the rules that were originally written which require a clear(er) separation of brokerage firms and investment/financial advice in the first place. Enjoy the reading!
Weekend reading for September 13th/14th:
Why Financial Planners Should Be More Like Hairdressers (Stuart Armstrong, Money) – In Massachusetts, where financial planner Stuart Armstrong is based, becoming a cosmetologist requires a license, which in turn requires two years of supervised work experience and passing a practical exam; however, there’s no such licensure requirement for one to hold out as a financial planning professional, despite the gravity of the financial situations about which financial planners deliver their advice. Accordingly, Armstrong notes how he and others are advocating in both Washington, and the Massachusetts state house, for recognition of holistic financial planning as a profession unto itself, including the ‘importance’ of proper licensure to ensure minimum standards for consumers, distinct from the current environment where financial planners are overseen by a number of regulatory bodies, which simply oversee the insurance and investment products that planners implement (or the narrow scope of investment advice) and not the delivery of comprehensive financial planning advice itself. Notably, Armstrong also points out that while the CFP marks could arguably be such a benchmark, confusion remains for consumers as long as an advisor can hold out as a CFP professional but then not actually provide comprehensive financial planning (and just implement the sale of a product instead). The bottom line: many consumers trust their financial advisors, but perhaps it’s time to have clearer licensure of financial planning as such so clients can better understand who should be trustworthy as an advisor and not solely a salesperson in the first place.
Regulators Propose Rule Requiring Succession Plans (Pete McGratty, Pinnacle Advisor Solutions blog) – Over the summer, the North American Securities Administrators Association (NASAA) opened a public comment period for a new rule that would require investment advisors to have a business continuity and succession plan in place for the protection of clients if something happens to the advisor. The rule is targeted at state-registered RIAs under $100M of AUM (subject to NASAA rules), and the regulators appear particularly concerned about the potential disruptions that can occur for clients when they work with advisors who are sole practitioners (and/or who rely on one or two key personnel). The regulators are concerned not only about concerns of record keeping and disaster recovery, but the simple challenge such as clients being unaware their solo advisor has had a health event, is unavailable, and is not longer actually monitoring their investment portfolios (and the concern that failure to ensure appropriate continuity could be a breach of the advisor’s fiduciary duty). Some compliance consultants believe the rule could be on the fast track and be finalized as soon as the end of the year, and the public comment period runs from August 1st until September 30th (it is still open now). (Michael’s Note: I will be moderating a webinar with Pinnacle Advisor Solutions discussing the rule proposal, what may come to pass, and what advisors should be aware, with compliance consultant Chris Winn of AdvisorAssist and Wisconsin Division of Securities Administrator Patricia Struck on Tuesday, September 23rd at 4PM EST (registration here)).
U.S. Investors Opt for Human Over Online Financial Advice (Lydia Saad, Gallup Polling) – A recent Gallup poll found that notwithstanding the rise of technology in the world of investing, investors (not exclusive to high net worth, as the survey covered a nationally representative sample of U.S. investors with just $10,000 or more in investment or retirement accounts) are still more likely to have a dedicated financial advisor than to use a financial website for obtaining advice on investing or planning for retirement; overall, the results found that investors are most likely to use a dedicated advisor (44%), then an advisory firm call center (35%), then a friend or family member (29%), and lastly an online financial planning or investing website (20%), suggesting that the trust/credibility gap with websites may be even more severe than the trust gap with financial advisors in general. (Notably, the study was not specifically about “robo-advisors” but could be any form of financially-related advice website.) When digging into the numbers further, Gallup found that retirees and “high-value investors” (those with at least $100,000 or more in invested assets) were even more likely (at 53%) to use a dedicated financial advisor. With respect to the use of financial websites, the results showed that retirees in particular were by far the least likely to use financial websites (at only 11%), and that women were also significantly less likely to use financial websites than men (at 14% vs 25%, respectively), while younger generations indicated significantly more comfort using such tools. Notably, though, while the survey examined primary sources of advisor, only 40% actually use just one source of advice, while another 40% rely on two or more, and only 20% of investors don’t use any of the resources indicated.
The New World of Virtual Advisors (Kent McDill, Millionaire Corner) – A recent survey by the Spectrem Group surveyed the preferences of affluent investors for non-human investment services (e.g., “robo-advisors”) versus a human-but-physically-distant option (e.g., meeting an advisor virtually through the use of technology). The survey found that given the choice, investors appear to prefer the robotic advisor service over the advisor who can only be reached through technology; amongst younger investors in particular, they were overall more supportive of both options, but still showed a preference for the robo-advisor versus the human-but-online-only advisor. Notably, overall 60% of the investors still said they prefer personalized service and 50% said they want to meet their advisor in person (suggesting their may be limitations to how “personalized” electronic communication currently feels), and as a blocking point to both robo- and virtual advisors, 36% of investors still state they don’t trust sharing personal information online and that face-to-face in-room communication is the only way for their true needs to be understood. In 2015, Spectrem will be doing a more in-depth study on “Perceptions of Robo and Technology Advisors” to explore whether consumers are/will be willing to move away from “traditional” in-person advisor services to more technology-based solutions.
Fear Not The Robo-Advisor (Mark Hurley, Financial Advisor magazine) – Mark Hurley highlights the interesting parallel between the recent rise of the “robo-advisor” and fears by some that they will render the traditional wealth manager extinct, and the similar frenzy that occurred 15 years ago when technology and the internet were going to “change everything” in the late 1990s as the dot-coms would put everyone (including financial services) out of business. The end result, at least in the financial services context? Instead of putting companies out of business, the industry now leverages technology better and is five times the size it was 15 years ago, and Hurley suggests the today’s robo-advisors-will-replace-traditional-advisors narrative is just as ridiculous as it was in the 1990s. As Hurley views it, the key distinction is that clients don’t simply go to wealth managers for advice, they go to get their problems solved, and they often don’t even know exactly how to define their problems or what issues to try to solve when they first show up in an advisor’s office; instead, part of the process is simply to help clients get an understanding of their situation, and frame what their problems actually are, so that they can then get help solving them… and that exploratory process, where the financial advisor is not just the advice-giver and product-implementer but the “financial physician” diagnostician as well, is a key value that technology alone cannot deliver. That doesn’t mean that some of today’s low-cost asset allocation robo-advisor services are useless, but simply that they’re limited in scope, and are a night-and-day difference from the holistic financial advice that (good) wealth managers provide. Hurley also points out that even the largest robo-advisors need to be as much as 16x their current size just to even be profitable, and far larger still to ever actually generate the kind of return-on-investment that their venture capital investors are expecting, and that while many robo-advisors may be hoping for the kind of growth that Financial Engines experienced, that company is still trading at 67X earnings (suggesting it too still has a lot of growth left to achieve to actually fulfill its own valuation) and that it only got as large as it did by pivoting away from the B-to-C approach that today’s robo-advisors are utilizing. The bottom line: robo-advisors are not a threat, but do deserve to be studied, as the technology tools they are creating may be here for the long term, even if the particular companies shift and change.
How Bitcoin Is Penetrating RIA Portfolios By Looking Riskier To Ignore Than Embrace (Sanders Wommach, RIABiz) – While many advisors have been understandably wary of Bitcoin (the virtual currency that operates without a centralized administrator and little regulation), and both FINRA and the CFPB have sent out reports warning consumers about Bitcoin’s highly speculative and volatile value, there is a growing acknowledgement of the potential for Bitcoin to ultimately be very disruptive to the current payment processing systems of the financial services industry. The key distinction is the ease by which Bitcoin can be used as a quick currency for transactions, allowing it to be used as payment for a cost of just 0.05%-0.10%, in a world where credit and debit cards typically charge 2% or more, and to be converted immediately into cash for the merchant while credit and debit card transactions can take a few days for the transaction to settle. This potential has led to a number of venture-capital-funded Bitcoin startups that already have implied valuations over $100M, and Bitcoin itself as a currency has vaulted from a value of about $0.05 in 2009 to over $1,000 in 2013, settling back down to a range of $400-$650 over the past year (and currently trading around $525 as of the time of the article, now down to about $470). Overall, the greatest risk to Bitcoin still appears to be regulatory, and the potential it’s either widely adopted or completely shut down (which means an investment may be a wild success or a catastrophic failure with little room in between), though Bitcoin advocates note that US regulators, the Treasury, the Fed, and the SEC have been supportive (though some other countries’ regulators less so). For some, security of the virtual currency is still a concern, after a high-profile theft from Tokyo-based MtGox last year, though supporters argue that security has improved dramatically after the lessons of MtGox’s theft incident. So how can advisors invest in the currency? The Bitcoin Investment Trust (BIT) launched last fall, and currently has net assets of about $60M, with a $25,000 minimum and a 0.5% front-end fee and an “annual administrative and safekeeping fee” of 2%, and its creator is trying to get it onto major RIA custodian platforms; in addition, a Bitcoin ETF that will trade under the ticket COIN is anticipated to be available soon as well. The primary investment thesis for the currency itself is built around the fact that its supply is limited (there is no central bank to “mint” bitcoins, and the way the currency naturally operates allows for only very slow and steady growth through “mining“), while if Bitcoin is adopted widely the demand may be tremendous, and simply supply/demand constraints would be anticipated to force the Bitcoin price significantly higher.
The Value of Bitcoin in Enhancing the Efficiency of an Investor’s Portfolio (Chen Wu & Vivek Pandey, Journal of Financial Planning) – This article provides a good explanation of Bitcoin, what it is, how it’s unique, and how it can potentially fit into a client’s portfolio. The essence of Bitcoin is that it’s a digital/virtual currency, with the caveat that unlike virtually any other digital currency, it isn’t controlled by a single organization that also serves as the clearinghouse for all of its transactions, nor is its value pegged to any other (real world) currency; yet despite these caveats, Bitcoin can increasingly be used as a currency for real-life purchases of goods and services. Unlike traditional currencies that can be printed/minted, the unique aspect of Bitcoin is that there are a limited number in circulation (currently about 12.4 million), and they can only be created under a prescribed algorithm that adds more coins at a slower and slower rate until there are a maximum of 21 million created (especially appealing to those who fear how a central bank might trigger deflation and debase a currency); given a Bitcoin exchange rate earlier this year of about $600, the current volume of circulation would peg the total value of the currency at about $7.2 billion. Bitcoins are purchased through a Bitcoin exchange, where investors can create an account, and then transfer money from a ‘traditional’ financial account (e.g., a bank or Paypal account) to purchase bitcoins for a fee (which is currently 0.0006 bitcoin per sale). From the tax perspective, the IRS issued IRS Notice 2014-21 earlier this year, which clarified that bitcoins are considered property, may be subject to capital gains rates if used as a capital asset in a portfolio, and are still income to a merchant when received in exchange for goods or services. From the security perspective, the unregulated nature of Bitcoin has allowed it to be used for some criminal activities, and there is limited recourse for investors if the currency is stolen (it’s estimated that as much as 4% of the currency is “lost” due to the fact that the owners no longer have their private security key, e.g. due to a hard drive failure, and have no other way to recover their bitcoins). As an investment, the authors look at how a portfolio including bitcoins (based on historical prices in recent years) would have fared, and found that it generally has not simply behaved like a currency (the volatility makes it a poor store of value, merchants still price in dollars and not bitcoins directly, and it is still limited as a medium of exchange) and has been more like a very illiquid financial asset, though the astronomical rise in bitcoin prices (averaging 1% per day from July 2010 to December 2013) has made it a “good” investment, at least up until now.
Risk Revisited (Howard Marks, Advisor Perspectives) – The traditional definition of risk in the academic literature is “volatility”, which Marks suggests is the case because volatility is something that can be quantified and therefore can also be used in calculations and models (it is “machinable” in Marks’ words). Yet Marks questions the validity of volatility as a proxy for risk, for the simple reason that ultimately investors demand higher returns to compensate for risk, yet no one ever says “the prospective return isn’t high enough to warrant bearing all that volatility” – the true risk most fear is the possibility of permanent loss of capital, which is distinct from volatility in that a volatile downward fluctuation can be temporary, while a permanent loss is a (volatile) downward decline from which there won’t be a rebound, either because the investor sold at a loss (due to personal, emotional, financial, or other issues), or simply because the investment itself cannot recover for fundamental reasons. Yet the challenge of recognizing that true risk is the potential for permanent loss is that it cannot be quantified effectively – at least not ahead of time, and arguably not after the fact either, since you’ll never know what the risk of loss was for an investment that happened to rise from $10 to $20 but ‘could have’ gone the other way (and it’s unclear whether the great return from $10 to $20 was because it was a great safe investment, or actually was a reward for risk that simply never materialized); in other words, after the fact you’ll know whether you made or lost money, but you still won’t really know how risky the investment was. So given how ultimately unknowable the future is, and how unquantifiable the risks are (either before or after the fact), what’s to be done? Marks suggests the following: just because we don’t know future outcomes doesn’t prevent us from making some reasonable estimates of a range of probable outcomes and managing accordingly; to properly account for such risks, it’s crucial to think in terms of diverse outcomes (“risk means more things can happen than will happen” and as many as possible should be considered up front); recognize and be comfortable with the fact that even though a range of outcomes could happen, ultimately only one will (and just because the improbable outcome occurs doesn’t mean it was wrong to invest as though it wouldn’t). The article wraps up by looking at an interesting array of other ways to define and frame risk, from event risk to headline risk to career risk as well as fundamental and valuation risks and even “upside risk” (and the “danger” the portfolio will not be exposed enough to an upside surprise).
Can Peers Burn Holes In Your Portfolio? (Jason Zweig, Wall Street Journal) – Recent research into psychology and behavioral finance has been exploring the concept of “shared attention”, the idea that when you pay attention to something at the same time that others do, you will remember it better and be more inclined to act on it. Knowing that other people are focusing on the same thing you are (whether a movie, a sunrise, a stock price, or a financial feed on Twitter) also intensifies emotional reactions (both positive and negative). And notably, it takes remarkably little to feel this “peer” effect of being in the presence of others witnessing the same event; in one study, even just having a virtual avatar paired with another person who also had the same virtual avatar was enough to trigger the effect. This research effect explains a lot of interesting investing phenomena, from one study that found people who live near each other increase their ownership of stocks around the same time, to 401(k) investors who put more money into stocks when their co-workers have recently earned high returns, to fund managers who are more likely to invest in a company when other stock-pickers in the same city are also buying it (the common effect in them all: the investors were likely talking about the stocks with their peers, created a shared attention effect). Zweig’s interesting conclusion given all this research: if we’re going to focus more on investments when there’s shared attention, we should try to choose information sources that are calm and methodical and therefore will at least be more likely to focus our shared attention in a constructive manner. In other words, the choice of who you hang out with (in-person or virtually) to talk about investments and who you follow for investment information could be having a material effect on your investment decisions and results.
The Best Leaders Are Insatiable Learners (Bill Taylor, Harvard Business Review) – Almost 25 years ago, John Gardner – a public intellectual and civic reformer (along with being a celebrated Stanford professor, architect of the Great Society under Lyndon Johnson, and founder of Common Cause and Independent Sector) – delivered a speech at a meeting of consulting firm McKinsey & Company about the concept of “Personal Renewal“. The idea was that leaders who wish to make a difference and stay effective must commit themselves to continuous learning and growing; as Gardner put it, “we have to face the fact that most men and women out there in the world of work are more stale than they know, more bored than they would care to admit” leading them to remain trapped in fixed attitude and habits. The solution to this boredom is not simply ambition to keep climbing higher, but a natural curiosity and desire to “be interested” in things; as the proverb goes, “it’s what you learn, after you know it all, that counts.” In today’s increasingly competitive environment, where the pressure is on to out-hustle, out-muscle, and out-maneuver the competition, the real key is to out-think the competition, and developing a unique point of view about the future to get there before anyone else does is not just about “bold thinking” but requires an insatiable desire to always be learning. When we’re young, every day is full of “firsts” – new experiences that lead us to learn – but as we get older, the frequency of firsts becomes fewer and fewer, so good leadership requires additional effort to seek out those firsts, spend time with people we don’t know and those who are not like us (unlike our typical reliance to associate with peers, those we already know, and those we already agree with), and push forward the learning effort. As Taylor sums it up: “Are you learning as fast as the world is changing?”
The 5 Essential Skills of an Exceptional Financial Planner (Lisa Kirchenbauer, Journal of Financial Planning) – While there’s a wide range of technical knowledge that advisors must know to be competent and proficient, this article focuses on the ‘big 5’ skills that financial planners must learn and practice to be able to deliver that advice effectively and have a successful client relationship where clients actually implement the advice. The essential skills are: 1) demonstrate Authenticity (if you can’t express your real, genuine, and true self, clients will likely be able to tell and the lack of integrity will undermine their trust, so self-awareness is crucial; are you living your own financial life plan and following the kind of advice you’re providing to your clients?); 2) be a Deep Listener (in a world where most planners are trained to give advice and be the expert, it’s remarkably difficult to stop talking and just listen, but ultimately if we cannot really hear what clients are saying, and identify the subtle issues between the words, it will be difficult to develop the real trust necessary to help them move forward; in your next client meeting, take a moment to focus on how much you are really paying attention to clients yourself and not drifting off throughout the meeting); 3) Empathy (the ability to understand the way another person is feeling; if client’s don’t feel like you truly understand them and care, they won’t trust the advice that’s provided and will resist); 4) Non-Judgment (being judged makes us all feel misunderstood, defensive, and unwilling to share, yet as a planner have you really practiced not being judging when clients confess problems like overspending, bad investments, or irresponsible use of debt?); and 5) Curiosity (asking questions can engage clients and draw out information as you express your curiosity, but be cautious not to use “why did you do that…” types of questions that may imply you’re being judgmental in the process of being curious!).
Failed Experiment at the SEC (Bob Veres, Financial Planning magazine) – In digging through recent blogs about the regulatory history of advisors after the Great Depression, which included the creation of the SEC and the passage of the Investment Advisers Act of 1940, Veres notes that in the historical record, it’s quite clear that the original intent was to separate brokers who sold securities from investment advisors who provided advice. The investment advisers would be subject to the fiduciary duty, and the brokers would not, with the caveat that to avoid fiduciary duty the brokers must clearly do business at arm’s length in a clear position of sales and “not disguised as a confidant and protector” instead. Today’s environment has wandered a long way from these roots nearly 75 years ago, where brokerage firms now advertise how they help guide clients to reach their financial goals, and brokers outright call themselves “financial advisors” on their business cards. Yet despite how far the brokerage industry has moved towards being advisors, Veres notes that the SEC has failed to require them to become RIAs as the rules originally intended. Veres suggests that the divergence really began in 1995 with the Tully Commission, driven by then-SEC chairman Arthur Levitt to evaluate the changing brokerage industry, ultimately providing recommendations like an end to commission structures that favored in-house over nonproprietary products, a prohibition on sales contests, and a separation between registered representatives and “the sale of inventory” from the brokerage firm’s accounts, shifting instead to being compensated based on clients assets where the brokers would be trained in “financial planning tools.” The assumption was that as brokerage firms evolved in this direction, they would eventually go ahead and become RIAs because they’d be so close to doing it already, yet Veres points out that the scandals of the past 19 years since the Tully commission suggest this hasn’t played out as expected, and instead now the brokerage industry is fighting to make the SEC’s “lenient” advice-driven-but-non-RIA delivery model a permanent non-fiduciary fixture. Given how this has played out, though, Veres suggests that instead of pushing for the brokerage industry to adopt a fiduciary standard, the better course of action might be to revisit the SEC’s deviation from its clear initial mandate and policy, and simply reinforce the original rules as written, requiring brokerage firms to choose whether they really wish to be advisors (and register as such) or go back to being true arms’-length brokers. And notably, such a course of action doesn’t require an Act of Congress, but simply the SEC enforcing what it was created to do in the first place, using the precedents from the 1940 Act itself and subsequent court rulings over the decades to substantiate the path.
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!
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.