Weekend Reading For Financial Planners (November 4-5)

DoL Takes Aim At 'Junk Fees' With New "Retirement Security Rule"

(Mark Schoeff | InvestmentNews)

The Department of Labor (DoL), in its role overseeing retirement plans governed by ERISA (e.g., employer-sponsored 401(k) and 403(b) plans), has gone through a multi-year process across 3 presidential administrations updating its "fiduciary rule" governing the provision of advice on these plans. The DoL fiduciary standard first formally proposed in 2016 under the Obama administration took a relatively stringent approach (where commission-based conflicts of interest had to be avoided altogether), but encountered numerous delays under the Trump administration and was ultimately vacated by the Fifth Circuit Court of Appeals in 2018 (under the somewhat awkward auspices that brokerage firms and insurance companies themselves maintained that their own brokers and insurance agents are merely salespeople and shouldn't be held to a fiduciary standard because they are not in a position of 'trust and confidence' with their customers), before in December 2020 being resurrected and adopted in a more permissive form (e.g., allowing broker-dealers to receive commission compensation for giving clients advice involving plans governed by ERISA, as long as the broker-dealer otherwise acts in the client's best interest when giving that advice).

And now, after many months of anticipation that the DoL was working on yet another updated version of its fiduciary rule, the DoL this week released a proposal, dubbed a "retirement security rule", designed to curb conflicts of interest around retirement savings recommendations. Among other measures, the proposal would amend the current 5-part test that determines fiduciary status for retirement accounts by defining as a fiduciary act a one-time recommendation to roll funds from a company retirement plan to an Individual Retirement Account (closing what historically was a loophole that the fiduciary obligation only applied to "ongoing" advice, such that one-time sales transactions avoided its scope). The proposal also would strengthen advice standards for independent insurance professionals, in particular, by applying itself to insurance products that are not securities (e.g., fixed index annuities), and would cover advice that is provided to plan sponsors regarding the menu of investment options to include in a company's retirement plan (e.g., regarding the recommendation of insurance or annuity products into a plan's lineup in the first place).  

Not unexpectedly, given the increased requirements the rule would impose on its members, industry lobbying groups representing broker-dealers as well as the insurance and annuities industries (which brought the successful legal challenges to the Obama-era fiduciary rule) have pushed back against the proposal, arguing that investors are protected by other regulations (e.g., the Securities and Exchange Commission's Regulation Best Interest [Reg BI]), that commissions are often an appropriate form of compensation, and that, ultimately, the rule could lead to fewer investors being able to access advice given that compliance costs associated with the new rule could be passed on to consumers. At the same time, the new rule was cheered by groups promoting stronger standards for financial advice such as CFP Board, the Public Investors Advocate Bar Association (PIABA), and the Consumer Federation of America.

The DoL's latest proposal will now go through a 60-day public comment period and the agency is expected to hold a public hearing about 45 days after the proposal's publication. Though, even if the rule is ultimately adopted (after what will assuredly be a contentious comment period), the rule, similar to its Obama-era predecessor, could face legal challenges from product manufacturers and distributors. Which could ultimately lead a court to decide whether this latest proposal is substantively different than the previous rules that were struck down and whether it would remain in force!

Indie Advisors Outnumber Wirehouse Advisors, But Continue To Lag In Assets

(Andrew Welsch | Barron's)

Historically, broker-dealers, and large wirehouses in particular, have led the way in terms of advisor headcount and Assets Under Management (AUM). Nonetheless, recent years have seen a shift toward the RIA model, both among advisors (as brokers break away to start their own independent firms and aspiring advisors seek positions that don't rely on an 'eat what you kill' approach) and consumers (who might be attracted to the differentiated service proposition they can experience working with an RIA that isn't manufacturing its own financial services products for sale). 

Recent findings from research and consulting firm Cerulli Associates confirm this trend, with the number of advisors working at RIAs growing at a Compound Annual Growth Rate (CAGR) of 5.2% over the last decade to 78,282 at the end of 2022, and the number of RIAs seeing 2.4% growth over the same period, reaching 18,558. Altogether, RIAs managed $7.1 trillion at the end of 2022. Notably, RIA headcount ticked higher than that of wirehouses in Cerulli's study, representing 15.3% of all advisors, compared to 15.1% for wirehouses (though the 25 largest broker-dealers by headcount, including the 4 major wirehouses, collectively still account for 65.3% of the total advisor population). 

Yet despite the growth in RIA headcount and the associated AUM (reaching a 15.7% market share), RIA AUM still trails that of the wirehouses, which have a 34.1% market share, as wirehouse advisors in practice still typically work with a significantly more affluent clientele than the typical RIA (such that wirehouses sustain double the AUM with a similar number of total advisors). Nonetheless, given growth trends, Cerulli said that it expects RIAs to control nearly 1/3 of industry AUM by 2027.

Altogether, Cerulli's research indicates that while RIAs continue to trail broker-dealers in terms of headcount and AUM, the RIA model still appears to be increasingly attracting advisors and client assets, as consumers vote with their feet (as shown in asset flows between channels) for a more advice-centric, rather than product-centric, approach to the advisor-client relationship. On the other hand, as broker-dealers' own use of fee-based models increases (as opposed to primarily relying on commissions from selling products), the question arises as to whether RIAs will continue to see such growth in the years to come, or whether broker-dealers will continuing trying to reinvent as large RIA platforms to retain those assets (and advisors) themselves?   

A Year Of Profitability Married With Caution

(InvestmentNews)

In years of strong market performance, financial advisory firms can see their Assets Under Management (AUM) grow whether or not they add client assets through organic growth (i.e., onboarding new clients or bringing on additional assets from current clients) or inorganic growth (i.e., gaining client assets through acquisitions). But 2022 was a very different year, with both equity and bond markets seeing sizeable declines, potentially putting a dent in client portfolios and overall AUM for many firms. Nevertheless, a recent benchmarking study shows that many RIAs were able to leverage organic growth to help blunt the impact of this weak market performance.

According to the 2023 InvestmentNews Advisor Benchmarking Study, firms saw their AUM fall by an average of 7.4% in 2022, as market performance led to an average 11.0% reduction in AUM among participating firms. Firms also lost an average of 2.2% in assets from clients who left the firm and 3.6% of assets to distributions (e.g., for retirement income). Organic growth in the form of current client contributions (adding an average of 3.7% to firms' AUM) referral activity (1.8% growth), mitigating some of the impact of these negative factors. In addition, Mergers and Acquisitions (M&A) activity created 1.9% growth on average, though only 9.5% of participants reported AUM inflows from M&A activity. 

Despite the reduction in AUM for many firms, overall profits remained strongly positive, as firms had an average operating profit margin of 26.0% for 2022 (a similar figure to the 2018-2020 period, but a decline from the 35.0% profit margin experienced in 2021, which saw strong market performance). Which suggests that while market performance can be a strong influence on firm AUM and profitability (particularly for firms that charge on an AUM basis), other sources of asset growth have allowed firms to remain profitable through a range of market environments! 

Private Equity Won't Diversify Your Portfolio

(Allison Schrager | Bloomberg Opinion)

The poor performance of both public equity and bond markets in 2022 left many investors looking for alternative investments that could act as a diversifier and potentially buoy their returns if a similar market environment appeared again. One potential asset class that could be considered is private equity – which can include investments in venture capital, real estate, and infrastructure – and has seen 4X asset growth over the past decade to $7.6 trillion.

Schrager argues, however, that the diversification value of private equity might not be what it seems, particularly for leveraged buyout funds (that collect money from investors, take on debt, then buy a significant stake in a private or public company), which accounted for 28% of total private equity AUM in 2022. For instance, the market Beta (i.e., the correlation between private equity and the public market) for leveraged buyout funds is between 1 and 1.3, suggesting little diversification value compared to just investing in publicly traded equities. And while private equity has provided higher returns than publicly traded stocks, this is often due to the leverage involved in many of these investments. In fact, one study suggested that investors who took on leverage and invested in publicly traded value stocks could achieve a similar risk/return profile to buyout funds (with more liquidity and lower fees). And notably, the recent rise in interest rates could increase costs (and potentially dampen returns) for funds that take on debt.

Ultimately, the key point is that investing in private equity does not necessarily provide the diversification benefits a client might be seeking, particularly in the case of those engaged in leveraged buyouts. Which suggests that financial advisors could add value by analyzing different private equity fund options to confirm that they actually will provide the diversification that could benefit certain clients!

High TIPS Yields Are A Retiree's Best Friend

(John Rekenthaler | Morningstar)

During the past decade of relatively low interest rates, it was challenging to find sources of yield for clients without taking on significant market risk (particularly for advisors looking to optimize their clients' safe withdrawal rates). But the rapid increase in government bond yields this year presents an opportunity for advisors and their clients to get higher yields on their fixed-income investments. At the same time, because the current elevated inflation level can eat away at nominal bond yields, Treasury Inflation-Protected Securities (TIPS), which include both a fixed real yield plus and adjustment of principle based on inflation rates, have emerged as a potentially attractive opportunity for advisors and their clients.

And given the recent increase in interest rates, the 2.38% real (i.e., inflation adjusted) payout on TIPS could make them even more attractive. In this environment, Rekenthaler suggests that creating a TIPS ladder (i.e., purchasing TIPS with various maturities to match income needs) could provide retirees with the income they need without having to take significant risks. Using data on historic TIPS yields, he calculated that today's yields could support a 4.6% real withdrawal rate over a 30-year retirement. And while this approach would liquidate the client's portfolio, the client could still incorporate equities into their asset allocation by committing less capital to the TIPS ladder. For example, a retiree seeking a 4% real withdrawal rate over the next 30 years with a $500,000 portfolio (i.e., $20,000 per year) currently could achieve that by investing $435,000 in TIPS, leaving them $65,000 to invest in stocks, which (if equity markets rose over time) could support the retiree if they outlived the TIPS ladder or be left to heirs.

In sum, today's elevated real yields on TIPS could make them an attractive addition to client portfolios, whether they are used as a part of a client's fixed-income allocation (to replace non-inflation-adjusted bonds) and/or in the form of a ladder to provide income throughout retirement. Which presents an opportunity for advisors to help clients decide whether and how TIPS might fit in to their asset allocation given their investment goals and risk tolerance!    

Is The Small Cap Premium Still Worth Investing Into?

(Nick Maggiulli | Of Dollars And Data)

Factor investing (i.e., screening stocks based on certain factors like size, value, momentum, or quality) has become increasingly popular as investors have searched for ways to optimize the risk and return of their portfolios. Research into one of these factors, size, has shown that small-cap stocks (i.e., those with a market capitalization of less than $2 billion) have offered investors a higher return compared to other stocks during the past century (with a real return of 8.4% compared to 7% for the overall U.S. stock market), making them a potentially attractive addition to a client's portfolio. 

Nevertheless, this outperformance has not been consistent and small-cap investing is not without its risks. For instance, while small-cap stocks outperformed the large-cap S&P 500 index in all but one decade between 1930 and 1970, large caps have had the upper hand in 3 of the past 4 decades (with the 2000s being the exception). Further, (perhaps as a tradeoff for the higher returns), small caps have experienced greater volatility than the broader market, with a standard deviation of annual returns of 32% compared to 21% for U.S. stocks overall (and for investors seeking non-correlated assets to counterbalance large cap exposure during downturns, small caps have actually decline more than large caps during broad market declines).

Further, some academic research suggests that the small cap premium might not be as robust as it seems and calls into question whether it will continue into the future. For example, New York University professor Aswath Damodaran has noted that the small cap premium disappears if the smallest stocks (i.e., those with market capitalizations below $5 million) are excluded or if returns for the month of January are excluded. In addition, there is less evidence of a small cap premium for stocks outside of the United States, suggesting it is not a global phenomenon.  

In the end, while small caps have offered investors higher returns than their large cap counterparts during the past century, this asset class comes with increased risk and uncertainty surrounding its value going forward. Which suggests that while some client portfolios might benefit from the addition of small caps, they are not necessarily a 'free lunch'!

Give Away Your Secrets – And Thrive

(Dan Solin | Advisor Perspectives)

Financial advisors spend a significant amount of time building up the expertise needed to be an effective and can rightly expect to receive compensation commensurate with their skill. And given that they are being paid in part for their knowledge, some advisors might be reluctant to 'give away' their expertise in the form of public-facing content such as blog posts or videos with the thinking that consumers who receive this content could then apply it themselves and not need to engage an advisor.

However, Solin suggests that "giving away expertise" can actually be an effective way to generate business for an advisor. For instance, content marketing can help an advisor establish themselves as a credible authority by demonstrating their expertise and knowledge. Further, this activity can help an advisor differentiate themselves and attract qualified prospects. For instance, an advisor who writes a blog about student loan payoff strategies for young doctors might show this ideal target client that they are the' right' advisor to meet their needs. And even if a reader or viewer does not decide to become a client themselves, building a brand and name recognition through content marketing could put the advisor's name top of mind when a friend asks for a recommendation for an advisor. Finally, 'giving away' valuable content can take advantage of the reciprocity rule, whereby when an individual feels as though they have received something of value, they are inclined to reciprocate in some way (e.g., by scheduling an introductory meeting or by referring a friend). 

Ultimately, the key point is that while advisors might be tempted to keep all of their knowledge for the benefit of their paying clients, in reality, offering useful content to the broader public can not only provide value to the broader public (as many advisors are service-minded) but also be a valuable marketing tool as well! 

Stop Giving Away Pre-Sale Value

(Ari Galper | Advisor Perspectives)

Given the time and financial commitment involved, becoming a client of a financial advisor is a major decision for a prospect. Which might lead an advisor to try to demonstrate as much value as possible – perhaps by creating a draft plan that not only diagnoses potential issues in the prospect's current financial situation, but also offers potential solutions – to convince the prospect to become a client.

But Galper suggests that this kind of approach might have the opposite effect, as this tactic could keep the prospect in "option-gathering" mode (and perhaps take the advisor's recommended course of action to another advisor they are considering to get their opinion) as opposed to "problem-solving" mode (i.e., deciding to work with the advisor then to solve the problems the advisor has identified). He suggests that because a prospect is unlikely to have the same technical knowledge as the advisor, they will have a hard time judging the advisor's proposed recommendations until they actually become a client.

Instead, Galper suggests that prospects are more likely to want to work with an advisor with whom they have built a relationship of trust. He recommends that advisors take an approach similar to that of a doctor, engaging the client in a deep, diagnostic conversation (like a doctor might ask a patient about their symptoms). By engaging in active listening and demonstrating their understanding of the prospect's planning issues, the advisor can start to build trust and position themselves as an expert. And by providing clarity around the prospect's problem (without offering potential solutions), the advisor can shift the prospect from an option-gathering state (perhaps considering other advisors or a 'DIY' approach) to a problem-solving state (making the decision now to work with the advisor to get their problems solved). 

Altogether, Galper argues for a "trust-based" sales process rather than one focused on delivering value. Which, if effective, not only could save advisors time (by not having to produce formal recommendations or deliverables for prospects), but also improve their conversion rate of prospects into clients!

I'm The World's Worst Salesperson And Proud Of It

(Allan Roth | Advisor Perspectives)

When one imagines an ideal salesperson, they might think of someone who is able to connect and build trust quickly with a prospective client or customer and then make the sale on the spot rather than having the prospect take time to "think it over". Roth, however, is not a fan of the 'classic' sales techniques and instead has taken a more deliberate approach to engage prospects and grow his business. 

First, rather than meet immediately with a prospect and try to have them sign on as a client, Roth requires those who reach out to complete a "Confidential Personal Profile". By doing so, he ensures that prospects visit his website and learn about his philosophy and approach (giving prospects who do not agree with it the opportunity to opt-out, saving both them and Roth time), allows him to better understand the prospect's financial situation and planning concerns, and demonstrates that the prospect is serious about a potential planning engagement. After the prospect has filled out the profile, he meets with them for a free 20-minute meeting, during which he provides a diagnosis of the client's portfolio and finances (e.g., noting whether they are over-concentrated in a certain sector or could benefit from better asset location) without providing specific recommendations and listens to the prospect's response to his thoughts. After providing the prospect with an estimate of his costs (Roth operates on an hourly planning model), he requires them to take at least one day before formally moving forward with the engagement (even if they are eager to become a client at the end of the meeting!) to ensure they are committed to the planning process rather than making a spur-of-the-moment decision. 

While Roth's process might differ from many traditional sales techniques for advisors looking to grow their client base, he has found that this approach has led to better prospect conversations and a strong flow of business (as he has maintained a client waitlist for more than a dozen years). Which suggests that just as advisors can build their business and planning process based on their preferences, they can do the same when it comes to converting prospects into clients as well!    

Can AI Replace Your Financial Advisor?

(Shlomo Benartzi | The Wall Street Journal)

Financial advisors have faced a range of potential technological threats over the years, from online brokerages that allowed consumers to buy and sell stocks on their own (rather than through a broker) to the introduction of robo-advisors, which provide automated asset allocation at a lower price point than many advisors. But while these technologies have shifted the work of advisors (e.g., the move toward more comprehensive financial planning from 'just' investment management), human advisors have not been displaced by their 'tech' counterparts.

In the past year, the emergence of a range of Artificial Intelligence (AI) applications, including the large language model ChatGPT, have led to suggestions that these tools could replace professionals in a variety of fields, including financial advice. With this in mind, Benartzi surveyed relevant research to determine how AI tools tend to perform in areas where advisors are able to demonstrate value. For instance, advisors can support clients by helping them keep a long-term perspective when it comes to their investment portfolio (as research has shown that clients who focus on short-run performance often make sub-optimal investment choices). But it turns out that ChatGPT has many of the same tendencies and biases as consumers (and, even worse, is overconfident in these decisions), suggesting that it would need 'metarules' (i.e., rules that govern other rules) to help it override these biases, such as by forcing it to consider why a particular course of action might not be the best option.  

Another area where advisors can provide value (and where humans have an advantage over robo-advisors) is by acting empathetically, for example, reassuring and supporting clients during stressful periods. Interestingly, one study found that ChatGPT was effective not only in providing high-quality information in response to medical questions posted by patients in an online forum but also in providing empathetic answers (in fact, 45% of the tool's responses were rated as being empathetic or very empathetic by a panel of healthcare professionals, compared with only 4.6% of physician responses to the questions). This suggests that advisors could potentially leverage AI tools to 'scale' their humanity, for example by creating tailored emails for clients during a market downturn.

Ultimately, the key point is that, in the long run, the most likely legacy of ChatGPT and AI for financial planning is not to replace financial advisors, but to help them increase their productivity by streamlining more of the middle and back office tasks and processes. Which, in turn, will either enhance the profitability of firms or allow them to provide their services at a lower cost for the same profitability while increasing the market of consumers who can be served, further growing the reach of financial planning. Or stated more simply, ChatGPT will not necessarily end out as a threat to financial advisors; instead, it is probably more of a useful tool for advisors that will help to grow the market for financial planning advice services!    

ChatGPT Can Give Great Answers, But Only If You Know How To Ask The Right Question

(Jackie Snow | The Wall Street Journal)

For the past year, the Internet has been abuzz exploring the possibilities of ChatGPT, a generative Artificial Intelligence (AI) system that allows users to 'prompt' the program by asking questions and making requests, from providing a recipe for chocolate chip cookies to answering whether it might replace financial advisors. But while it's simple to ask a question to ChatGPT, getting the response one seeks can take a bit of skill and practice.

For example, ChatGPT often responds better to more specific questions. So instead of asking ChatGPT, "Write me a draft email discussing the current state of the markets" (which could end up discussing market segments clients might not be familiar with or include with jargon that clients might not understand), an advisor could instead ask "Write me a draft email putting this week's decline in the S&P 500 into historical perspective based on the last 50 years of market returns, written in layman's terms" to get a better response (which the advisor could then customize based on their needs). Further, ChatGPT allows users to have a 'conversation' with it, meaning that an advisor could ask the tool to further refine its answer to a particular prompt or present it in a different style (e.g., requesting a response in reader-friendly bullet points rather than long paragraphs). And for those new to using ChatGPT can even ask the tool itself for help in crafting a better prompt to get the output they desire!

In sum, while ChatGPT is a relatively simple tool to use developing 'prompting' skills can help users maximize its capabilities, which for advisors could include drafting marketing content and client emails to summarizing lengthy text and translating complex topics into a more digestible form!

Forget ChatGPT And Robo-Advisors – Recommendation Engines Are The Future Of Wealth Management

(Angelo Calvello | RIA Intel)

The investment management field has seen multiple waves of technological changes that have affected how many advisors create asset allocations and manage portfolios. From risk management software tools that help an advisor better assess client risk tolerance to portfolio management and trading software that substantially reduces time spent analyzing and executing investment management decisions, to Turnkey Asset Management Platforms (TAMPs) that allow advisors to outsource much of the portfolio management process, there are a range of options that can save advisors' time (perhaps allowing them to focus more on other planning areas for their clients).  

Amid recent developments in Artificial Intelligence (AI), Calvello suggests that the next investment management innovation for advisors could be the use of recommendation engines, which use advanced machine learning and statistical modeling to anticipate a client's needs and produce recommendations based on the client's past behaviors and history. Notably, while recommendation engines are just starting to be used in the investment management space, advisors will be familiar their use by companies like Amazon and Netflix, which have found success recommending products and programming, respectively, based on a customer's history. And while recommendation engines might sound similar to robo-advisors in their ability to recommend customized portfolios based on individual client factors, recommendation engines have the advantage of using firm- and client-specific data rather than more generalized criteria (e.g., optimizing a portfolio based on Modern Portfolio Theory). Though, given this firm-level customization, building a recommendation can come at a cost, which (at least for now) might limit their use to larger firms that have the budget (and data) to build internal recommendation engines. 

Altogether, recommendation engines could represent the 'next step' in allowing advisors to provide bespoke investment management recommendations for clients in a more efficient manner. Though, given the current costs of doing so (and potential regulation regarding the use of AI for investment management), widespread adoption of the technology could take some time (though, as Calvelo suggests, first movers could give themselves an advantage?). 

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We hope you enjoyed the reading! Please leave a comment below to share your thoughts, or make a suggestion of any articles you think we should highlight in a future column!

In the meantime, if you're interested in more news and information regarding advisor technology, we'd highly recommend checking out Craig Iskowitz's "Wealth Management Today" blog.