Enjoy the current installment of "weekend reading for financial planners" - this week's edition kicks off with some notable industry news, including a proposal from the SEC to institute "swing pricing" for mutual funds in times of market stress, to a new series of cybersecurity exams as regulators continue to eye new rules for advisors to protect client data, to the latest series of studies on advisor adoption of social media finding that advisors, finally, are starting to see real business results from their persistent social media efforts.
From there, we have several articles about the ongoing debate of whether advisors should be switching to retainer fees from the currently popular AUM business model, which collectively raise the question of whether the AUM model is too conflicted and it's time to move on, or whether the reality is that advisors are simply succumbing to competitive pressures as the AUM model is no longer the differentiator it once was and too few advisors have really crafted a specialization or niche around which they can demonstrate a unique value proposition for clients.
We also have a couple of technical planning articles this week, including: a reminder of the issues to consider given the likelihood that many mutual funds will be making big capital gains distributions in December for the first time in years; a discussion of the recent proposal from one Fed governor that the Fed may use negative interest rates as a policy tool to stimulate the economy, and how the strategy would work; and a look at how one advisor aims to create alpha for clients not just by trying to pick the best investment managers but considering ways that combinations of investment managers can be more valuable than any one individually.
We wrap up with three interesting articles: the first is a new study from the Center for Retirement Research suggesting that our shift from Defined Benefit to Defined Contribution plans in recent decades may not have been nearly as damaging to retirement savers as previously believed, once accounting for the fact that savers into DC plans actually get the direct benefit of the market returns that grow the account balance over time; the second is another notable study, finding that when it comes to retirement savings, showing people how much their peers are saving can actually backfire, making them feel so far behind that they're actually discouraged and less likely to save; and the last is a fascinating discussion of how success as an advisor can create more problems than it solves as the burdens of the business increase, and how the best solution is to keep raising your fees, to the point that if you're not turning away at least 1/3rd of your new clients and 1/5th of your existing clients every year, you may not be charging enough.
And be certain to check out Bill Winterberg's "Bits & Bytes" video on the latest in advisor tech news at the end, including a fresh push on cybersecurity from the SEC (including a $75k fine against an RIA for not creating a cybersecurity policy), how advisors should handle a "ransomware" demand if their own computers are hacked, and the launch of a new financial planning software provider RightCapital.
Enjoy the reading!
Weekend reading for September 26th/27th:
SEC Wants to Stem Liquidity Risk of Open-End Funds, ETFs (Melanie Waddell, ThinkAdvisor) - Earlier this week, the SEC issued a proposed new rule for public comment that would require open-ended investment companies (i.e., mutual funds) to establish a liquidity risk management program, as a part of the growing recognition of the systemic importance/significant of the fund industry (with almost $19 trillion in assets held by over 43% of all US households). The biggest change under the proposed rule is that mutual funds would be allowed to institute "swing pricing" under certain circumstances, where the fund's NAV could be adjusted in times of high trading activity, effectively allowing the fund to slightly depress its NAV during times of high redemptions to avoid having the dilutive effects of rapid selling be borne only by the remaining shareholders who didn't sell. More broadly, the rules would also require mutual funds to adopt a "liquidity risk management program" that provides more detail about the liquidity of the fund's assets, to establish a three-day liquid asset minimum, and funds are urged (though not required) to limit the amount of illiquid assets owned in the fund to no more than 15%. The proposal is currently out for a 90-day comment period, after which the SEC will make a final decision about whether to make changes and/or adopt the proposed rule.
SEC to Start Second Round of Cyber Exams, Issues Risk Alert (Melanie Waddell, ThinkAdvisor) - Also this week, the SEC's Office of Compliance Inspections and Examinations (OCIE) issued a new Risk Alert about cybersecurity for financial advisors, its second in as many years (which culminated in new Cybersecurity guidance for advisors earlier this year), noting that the SEC will soon begin a second round of cyber-related exams seeking to assess how advisory firms are implementation procedures and controls to protect client data. Particular areas that the SEC aims to focus on include: Governance and Risk Assessment (are firms periodically evaluating their cybersecurity risks); Access Rights and Controls (how does the firm limit who has access to information, including employees with remote access); Data Loss Prevention (do firms monitor how data is transmitted and verify the authenticity of client requests); Vendor Management (are advisors doing due diligence on the cybersecurity policies of their vendors?); Training (do advisory firms train employees on how to spot cybersecurity issues?); and Incident Response (does the advisory firm have a plan about what it would do if client data is breached?). Notably, commentators point out that the focus of the SEC's upcoming cyber-exams is not to play "gotcha games" but to identify concerns and best practices (which may eventually be codified into new rules/requirements for advisors regarding cybersecurity); on the other hand, though, in perhaps an effort to make an example, the SEC did fine one St. Louis-based RIA $75,000 earlier this week for failing to have any cybersecurity policies and procedures in place.
More Advisers Are Gaining New Clients Through Social Media (Alessandra Malito, Investment News) - Several new surveys have come forth in recent weeks finding that advisor adoption of social media is gaining momentum, and many really are finding success in getting clients. According to an American Century study on Social Media Adoption, 43% of the 300 advisor surveyed reporting that their social media efforts produced a return on investment, and 17% reported that they have acquired business of at least $1M partly because of social media; another 27% stated that they acquired a new client or gained more business from an existing client thanks to social media. And a Putnam Investments Social Advisor Study found 79% of more than 800 advisors surveyed have acquired clients through social media (up from just 66% last year). The Putnam study noted that advisors are using Twitter to find newsworthy content, and then cross-sharing it on other platforms like LinkedIn and Facebook, as a means to stay top-of-mind with clients and prospects (with 40% of advisors using four or more social media for business), although the American Century study found that Facebook is still the most used of advisor social media platforms (at 75%, with LinkedIn at 70% and Twitter only 37%). Notably, while social media compliance remains a concern, as tools and rules get better and clearer, compliance fears are on the decline, down to only 32% of respondents.
Flat Fees vs. AUM Recap: The Good, the Bad and the Really? (Bob Clark, Investment Advisor) - In this article, Clark dissects all the various arguments in favor of advisors adopting flat/retainer fees over the AUM business model, finding that some critiques are more valid than others. For instance, while flat retainer fees do reduce some conflicts of interest (no disincentive against clients who want to pay down their mortgage), it can create other conflicts (no positive incentive to make clients wealthier and more successful since the fee is the same!). Similarly, while critics suggest AUM fees send the wrong portfolio-centric message, the reality is that even on a flat-fee basis, if the advisor concentrates their value on the portfolio alone, the client will still focus there; ultimately, if advisors want clients to be less portfolio-centric, it's not about changing the compensation structure, but really ensuring that the advisor provides financial planning value outside the portfolio in the first place! Other criticisms that Clark evaluates include: AUM fees are unfair to wealthier clients who are more profitable (perhaps true, but if as a business the advisory firm chooses to use higher-net-worth clients who are happy to pay to subsidize lower income clients, isn't that the business' choice?); AUM fees rely on markets instead of advisors for performance (perhaps but if clients bail out of the markets both the advisor and client loses, so there's clearly still some alignment of interests!?); AUM fees take a big hit whenever markets decline (ok but financial services firms have managed this for 100+ years, and the reality is that when markets decline even a retainer-fee client can do the math and realize their flat fee is now a dangerously high percentage of the portfolio!); and flat fees enable advisors to work with clients who have small portfolios (which Clark agrees with as making good business sense for serving a wider range of clients).
AUM Or Flat Fees? Start And End With Your Clients' Needs (Angie Herbers, ThinkAdvisor) - The advisory industry has been abuzz lately with discussions of switching from AUM fees to flat fees, for both the reduced conflicts of interest, better alignment of fees to planning services, more predictable advisory firm revenues, and better alignment of advisor-client interests. Yet Herbers suggests that while the first three are probably true to varying degrees, the fourth - that flat fee retainers better align the interests of clients and the advisory firm as a business - is not. The fundamental issue is that ultimately, Herbers says an advisory firm should look to and listen to its clients and their needs first, and then come up with an appropriate compensation structure (and for clients who have assets, there's nothing wrong with an AUM fee!). Choosing a compensation structure first is at best misguided, and at worst is actually damaging to the advisory firm, putting the focus on differentiation through compensation and cost instead of differentiating through the actual value proposition that the firm delivers to the client! In fact, Herbers notes that while critics of AUM fees suggest that it devalues planning for clients, in reality the problem is more likely that advisory firms are so bad at explaining and demonstrating their financial planning value that clients have no choice by to focus more on the portfolio instead! The bottom line is that in the end, designing a compensation structure when working with clients should be a business decision and not a moral statement, and as a business decision be cautious that tinkering with your compensation structure isn't just a distraction from making more substantive and real improvements to your business instead!
Should Advisors Change How They Charge? (Sherry Christie, Investment Advisor) - While discussions about how advisors should best charge for their services have raged for years, without a doubt the rise of the "robo-advisor" platforms (or eRIA firms as labeled by Cerulli Associates) have cast a fresh light on the viability of the AUM fee in particular. Of course, the reality is that the AUM fee has actually been around (and competed with) for decades, and have survived other forces of commoditization (e.g., the rise of Vanguard and Schwab since the 1970s), but the growing number of advisors all adopting the AUM model at the same time - from brokers with wrap accounts to RIAs with AUM fees and now the eRIAs - is making advisors of all sorts more cognizant of the competitive pressures and the challenge of differentiating. Yet ultimately, if the real problem is that advisors are finding investment management increasingly commoditized - forcing them to compete on price alone - then the solution is not about compensation per se, but advisors finding a focus on where they truly provide value, and concentrating there; in other words, finding a niche or specialization around which the advisor can truly differentiate. Nonetheless, Christie notes that there are now a number of different advisory firm business models evolving, including: pure AUM, AUM plus fees for services (e.g., a core AUM fee plus a retainer for clients with additional planning complexity, and/or to bring them up to a minimum annual fee); ongoing retainers (whether a flat annual retainer, or a monthly retainer fee that better fits the cash flow affordability, especially for younger clients); straight hourly fees for services rendered (e.g., like advisors in the Garrett Planning Network); or commission-blended models (e.g., AUM fees, planning fees, 12(b)-1 fees, annuity trails, etc.). Notably, alternative compensation models are also increasingly transparent, a plus as the advisory industry goes increasingly fiduciary, but a path that can backfire if clients aren't used to writing checks for fees. Though ultimately, the real winners are those who can clearly demonstrate their value and deliver results to clients, which in the long term engenders the most trust from clients, regardless of the details of compensation models.
Dos and Don'ts for Mutual Fund Capital Gains Season (Christine Benz, Morningstar) - After a 6+ year rally, many mutual funds are showing some really big unrealized capital gains on their underlying holdings, and between fund managers shifting their allocations in light of market volatility, and outright fund redemptions in the face of market turmoil, some funds may have big capital gains events coming at the end of the year. So what should advisors watch out for when it comes to planning around these end-of-year taxable fund distributions? First and foremost, remember that it only matters if you hold the appreciated funds inside of a taxable/brokerage account in the first place (and in fact, buying mutual funds with embedded gains is a great reason to own the mutual in an IRA in the first place from an asset location perspective!). And remember as well that even if an investment has been tax-efficient (i.e., not distributing gains) in recent years, as the sheer volume of gains have grown, and now some funds face net redemptions, coming capital gains may be unavoidable this year. Fortunately, fund companies do generally provide guidance on their upcoming distributions, but the details may not come until November or early December. Of course, even for positions held in a taxable account with gains coming, it doesn't matter if your client is actually in the 10% or 15% ordinary income brackets (which means their capital gains will be eligible for 0% Federal tax rates!). On the other hand, it's still important not to "buy the gain" by investing into a mutual fund late in the year that is about to distribute a capital gain, which would effectively force new buyers to recognize a tax event caused by prior owners of the fund (though for current owners, it may still make sense to accept the distribution of some gains than sell the fund and realize an even bigger gain)! And remember, while capital gains distributions tend to come from mutual funds, especially actively managed funds, an index fund or an ETF is not immune and could see distributions too, especially for some smart beta "index" funds where the investments really can rotate and change with some frequency!
Thoughts On Negative Interest Rates (Jesse Livermore, Philosophical Economics) - The big surprise of last week's Fed announcement was not merely the decision to hold interest rates at zero, but the revelation that at least one Fed governor is now advocating the use of negative nominal interest rates as a policy tool. The basic approach is that the Fed would continue its "quantitative easing" program of buying assets from the private sector, driving new money into the economy where it would likely end up on deposit at banks as excess reserves, but once the financial system is saturated with excess reserves, the Fed would then require that banks holding those excess reserves pay interest on them (effectively like a tax), which in turn would cause the banks to either eat the associated expense against profits (not likely), pay negative interest rates on customer deposits (also not likely), or increase their lending to actually deploy the excess reserves into the economy (as the funds are loaned out, the excess reserves are reclassified as required reserves, which would not be subject to the negative interest rate policy). In essence, then, the policy becomes a strategy to drive greater lending into the real economy (increasing the velocity of money), and the Fed uses its tools to ensure that the system maintains the requisite liquidity to facilitate the process. Of course, as Livermore notes, banks still have to find desirable borrowers to lend to in order for the structure to have real economic benefits, and if the negative rate becomes "too" negative, banks likely will simply pass through the negative interest rate to consumers. So theoretically the key to the policy is to have a rate that is negative enough to encourage banks to lend given their large dollar volumes, but not so negative that borrowers are being paid to borrow money (which creates perverse incentives!) or so negative that the banks feel it's easier to just pass through negative interest rates to consumers instead (which risks creating a run on bank deposits if consumers realize their purchasing power is better preserved by stuffing the money in their mattresses instead of the banking system!).
How To Generate Alpha Without Selecting Superior Funds (Bob Veres, Advisor Perspectives) - While much has been written about trying to generate alpha by finding conditions where managers are more likely to outperform and developing techniques to identify above-average managers, Veres notes that ultimately there's a third way to outperform, which is to craft portfolios with superior combinations of funds. Veres interviews Gary Miller of Frontier Asset Management, who has crafted a process of analyzing the fund universe not based on Morningstar style boxes but by regressing their returns against a wide range of indices to see what they really own, and then vet their performance accordingly; this process effectively creates custom benchmarks for managers, allowing Miller to better understand whether the manager is adding value. In practice, this process tends to identify managers with higher active share that are generating favorable results, who are "eclectic" managers willing to go anywhere there are investment opportunities (the antithesis of closet indexers). Once the list of appealing prospective fund managers is winnowed down, though, the process doesn't end there. Because the caveat is that several "good" fund managers might be good at the same strategy, which means there's little diversification value of mixing them together; instead, the goal is to find managers who approach markets in different ways, creating better diversification in a variety of market conditions. This involves looking further at the track records of managers in various market conditions (Miller gives greater weighting to bear markets and downdrafts over bull markets, and weighs recent market performance more heavily than the distant past). Ultimately, the end point of this process is that Miller's portfolios have been able to beat their (blended custom) benchmarks by roughly 100bps in the long run (not huge but it certainly adds up and compounds over time!), and Miller has developed software tools to help him execute the strategy.
How Has Shift To Defined Contribution Plans Affected Saving? (Alicia Munnell & Jean-Pierre Aubry & Caroline Crawford, Center for Retirement Research) - While many have lamented that the shift from Defined Benefit (DB) pension plans to Defined Contribution (DC) savings plans like 401(k)s has led people to save less for retirement, this research brief finds that much of the hand-wringing about declining savings rates may actually be overstated. Using data from the BEA's National Income and Product Accounts, the researchers do find that the percentage of total salaries going to retirement saving did decline slightly from 1984 to the present; however, once adjusting for the fact that those who save into retirement accounts actually enjoy the benefit of returns/growth on those accounts, the results reveal that the shift to DC plans has not led to less total saving. Of course, the caveat to this outcome is that in a defined contribution world, the accumulators saving for retirement bear the risk of that growth not occurring (even though it has), and thus the psychological trade-offs of DC versus DB plans remain as relevant as ever. Still, the fundamental point remains: while we might obsess more over our retirement accounts because we see all the market volatility along the way, the latest research suggests that the shift from defined benefit to defined contribution plans has not damaged retirement savings nearly as much as commonly believed!
Don’t Compare Your Savings to That of Your Peers (James Choi, Wall Street Journal) - A popular approach in recent years to encourage retirement savings is to show savers how they're doing (or sometimes not doing!) compared to their peers; the idea is that the peer-to-peer accountability of realizing you're not keeping up with others in a similar situation may help nudge you to save more. Yet while this peer-comparison "social norms" approach has been effective in other domains (e.g., seeing that your neighbors use less electricity encourages you to be more energy-responsible too), a recent paper published by Choi and his peers in the Journal of Finance found that when it comes to retirement savings, the opposite seems to occur - those who weren't automatically enrolled in their 401(k) plan and saw how much more their peers were saving became discouraged and were even less likely to join the plan at all! It seems the difference is that while social norming around energy consumption may 'shame' us into being more responsible, comparing our savings to our peers is more of a social competition where if we feel too far behind we just don't want to try to compete at all. In other words, when you're really far behind everyone else, you may accept failure as a foregone conclusion and just go into denial and ignore the problem altogether. So the bottom line is that at a minimum, if we're going to encourage retirement savings by helping people compare to their peers, we need to be very careful about how we do it, and for low-income individuals (who appear most prone to the effect) it may be time to look at other strategies altogether.
Too Much, Too Soon? When Success Becomes A Curse (Jim Stackpool, Great Advice Greater Certainty) - For financial advisors, the biggest challenge of being successful is that success itself and gathering more clients makes it harder to sustain the success because there are so many demands to service all those clients! After a few years, that can result in more and more activity, more and more hours in the office, more and more staff and infrastructure to sustain the effort... and little or no increase in profits to go along with it, while work/life balance just tumbles down the hill and weekends/holidays go from being a fun break to an exhausted recovery period (or worse, a time to just catch up on work in the first place!). So what's the solution to this "Paradox of Success"? Stackpool suggests that ultimately, the problem comes down to one simple issue: you're not charging enough for your services. Even if what you charged was appropriate in the past, your greater experience, and the greater demands of your business, means that you need to raise your fees to clients. Of course, the risk in doing so is that you may lose some clients who don't want to pay the higher fees - yet the reality is that if you're growing your business, that's actually a good thing, because it frees up room to add more clients at your new higher price point! In fact, Stackpool suggests that if you don't lose 1/3rd of your new clients and 1/5th of your existing clients every year based on your pricing, your retention is too high and it means you're not charging enough! Of course, raising your fees over time also means you'll eventually limit who you can serve as well, but as Stackpool notes, you can't realistically be everything to everyone anyway.
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. You can see below his latest Bits & Bytes weekly video update on the latest tech news and developments, or read "FPPad Bits And Bytes" on his blog!