Executive Summary
The big news this week was the "record-breaking" drop (at least in absolute point decline) in the stock market on Monday, the incredible blow-out of the VIX, and the challenge that inevitable comes when market volatility rises: the need to check in with clients, talk them through what’s happening in the markets, evaluate whether it’s necessary to make any portfolio changes, and try to talk them off a ledge if they’re really freaking out. But the reality is that being able to proactive communicate with clients, and have effective client meetings, during times of market volatility, is actually heavily impacted by how you construct your client portfolios in the first place, and the extent to which you customize those portfolios for each client.
In this week’s #OfficeHours with @MichaelKitces, my Tuesday 1PM EST broadcast via Periscope, we examine the problem with financial advisors customizing every client portfolio, particularly once we experience volatile markets, and how financial advisors (and asset managers) should look at "customization" going forward!
In a world where advisors are trying to become less product-centric and add more value to clients, there does appear to be a nascent trend of advisors trying to create more customized portfolios for clients. Though this idea isn't exactly new (it has occurred for decades in the form of selecting stocks and mutual funds for clients and adapting at every client review meeting), the rise of rebalancing software (or “model management” software tools more broadly), has made it easier to systematize the process of customizing individual client portfolios, while still being able to monitor and manage them centrally.
But I think this week’s market volatility is actually a really good example of the problem that arises with trying to create drastically customized and different portfolios for every client: if every client has their own “customized” portfolio, then it is really hard to keep track of all of your different clients and their portfolios. And so, instead of being able to easily send out broadly applicable communication to your client base, you’ll end up spending an hour to prep for every meeting and write every personalized client email during volatile market times. Simply put, customizing every client portfolio isn’t scalable for the client relationship itself (regardless of the scalable back-office technology to support it).
The challenges of the trend towards customization is notable with respect to asset managers as well. Because asset managers are – justifiably, I think – afraid of their future in a world where advisors are less product-centric, and looking to retool their own businesses. And the discussion I’m hearing more and more from those asset managers is “if advisors don’t want to use standard mutual fund products anymore, then we have to pivot and go the other direction. From products to customization instead!” But here’s the problem: when we look at the advisory firms adopting ETFs and eliminating mutual fund products, they’re not really customizing that much anyway. Even advisory firms that have dropped mutual funds and are building model ETF portfolios, not customized ETF portfolio (allowing them to keep charging their 1% fee while disintermediating the cost of the mutual fund manager, and effectively turning themselves into portfolio managers). So the real shift is that the client buys the investment “product” from the advisor and the advisor’s firm, not from the mutual fund company or other asset managers. The opposite of product isn’t customization. The opposite of product is advisor. When our value proposition is based on what we do, we don’t want to sell a third-party product, of any type. We want to sell ourselves!
So where does all of this leave us? From the advisor’s perspective, and particularly for those of you who are now struggling to figure out how to assess the damage of this week’s market volatility because all of your clients have "customized" portfolios... let this be a call-to-action for you of how not scalable you’re making the client relationship management needs of your business. There are a lot of firms that are growing just fine without customizing every single portfolio differently for every client. There may be times when some customization is still needed, but it is better to customize from a planning perspective (e.g., for tax purposes) rather than an investment perspective.
And for Asset Managers, particularly mutual fund managers, trying to figure out how to reach advisors and stay relevant… I can only caution you that the push towards making more customized solutions is not likely to work out well for you. If you want to stay relevant as financial advisors transition from salespeople to actual advisors, figure out how to make better products that cost less and are truly best in class at what they do. Because as advisors, if you can pass our screens and get to the top of the list, you get all of our money in that fund or category. And if you can’t, you’re never going to get in the door in the first place anymore.
The bottom line, though, is just to recognize that customizing portfolios for every client is simply not a scalable model, not because of technology limitations but in light of the stress and communication challenges that come with trying to help our clients through volatile markets. Which means this may be a great opportunity to begin the process of standardizing your investment process (if you haven't already) so that you can actually be more proactive with clients, when you’re not spending all that time re-analyzing every client’s portfolio one at a time!
(Michael’s Note: The video below was recorded using Periscope, and announced via Twitter. If you want to participate in the next #OfficeHours live, please download the Periscope app on your mobile device, and follow @MichaelKitces on Twitter, so you get the announcement when the broadcast is starting, at/around 1PM EST every Tuesday! You can also submit your question in advance through our Contact page!)
#OfficeHours with @MichaelKitces Video Transcript
Welcome, everyone! Welcome to Office Hours with Michael Kitces.
The big news this week was the record-breaking drop in the stock market on Monday, at least in terms of absolute number of points that the Dow declined and the incredible blowout of the VIX that went along with it, and then the challenge that inevitably comes when market volatility rises, which is the need to check in with clients, talk them through what's happening in markets, evaluate whether it's necessary to actually make any portfolio changes, and occasionally talk them off the ledge if they're really freaking out about it.
But the reality is that being able to proactively communicate with clients and have effective client meetings, particularly all the ones that are maybe already lined up this week, when market volatility crops up, that whole process is really heavily impacted by how you construct your client portfolios in the first place and the extent to which you are customizing portfolios for each client. And so that idea of portfolio customization in light of market volatility is what I actually want to talk about today.
The Problem With Customizing Every Client Portfolio [Times - 1:17]
In a world where we as advisors are becoming less product-centric and trying to add more value to clients, I've observed that there does appear to be this kind of nascent emerging trend of advisors trying to create more customized portfolios for each and every client. To be fair, the idea of customized portfolios isn't exactly new. It's effectively occurred for decades as we crafted mutual fund portfolios and before that stock portfolios for clients, which was some combination of investments we were recommending at the time, ones that the client was interested in, ones that fit their investment needs.
And because we didn't have any technology tools to manage all this, historically, over time, our practice would become a bit of a mess because every client ended out with a different portfolio customized to whatever stocks or funds were being recommended the last time they came in for a client meeting, and then usually didn't get changed until the next time they came in for a client review. We would print our Principia Pro reports from Morningstar and try to evaluate whether to make any changes.
In recent years, we have the rise of rebalancing software (or really what probably should more broadly at this point be called model management software tools), and they've made it easier to systematize the process of creating models for clients, including customized models for each individual client, and then being able to monitor and manage them more centrally. So everything from existing rebalancing software tools like iRebal and Tamarac or even newer players like Capitect that are building software to facilitate the creation of customized model portfolios for each client. And so, customized portfolios are becoming less of a technology barrier issue than they were in the past.
But I think this week's market volatility is actually a really good example of the problem that crops up when trying to create drastically customized, different portfolios for every single client. And it's the stress that it introduces into our advisor-client relationship. Because the truth is that when every client has their own customized portfolio, your brain just can't keep track of all the different clients and all the different stuff that's in all their different portfolios. If you have half a dozen standard model portfolios that you use for clients with, you know, varying levels of risk, it probably took you about 5 minutes this morning to figure out what the damage was from yesterday's market volatility even if you've got 100-plus clients. I know some advisory firms that even yesterday were already sending out messages to all their clients communicating their thoughts, putting the market decline in context of how their clients are invested. More advisors are sending messages out today and queuing them up for the week.
Unless, of course, all your clients have individually customized portfolios, in which case it's probably going to take you days or even weeks just to evaluate the damage, analyze one security at a time for one custom portfolio at a time to figure out what if anything you're going to do or not do and then communicate with the clients, which you have to do one at a time because each client's portfolio is different. And heaven forbid all the client review meetings you already had this week you're probably scrambling right now just trying to figure out what your talking points are in all those client review meetings because every review meeting is different when every client portfolio is different, when, you know, markets do crazy things and some clients are more impacted than others just based on whatever it is that they happen to own.
Simply put, customizing every client portfolio this way just isn't scalable... and certainly not if you're serving dozens or 100-plus clients at a time. And not because we don't have the technology tools to manage so many different models, which it really is getting better with all the model management software, it's because of the client communication and client meetings. The process of talking clients off a ledge isn't scalable when your brain has to try to relearn and keep track of a conversation for every single client in every single meeting, all of which are different because every client's portfolio is different.
The Opposite Of Product Isn’t Customization [Time - 5:16]
Part of the reason that I point this out is that it's actually also an interesting trend towards customization that's coming down from a lot of asset managers as well. Because a lot of asset managers, and mutual fund companies, in particular, are justifiably quite afraid of their future in a world where advisors are becoming less product-centric. You only have to look at the nearly $1 trillion of outflows from mutual funds over the past decade since the financial crisis to see this trend unwrapping. And the discussion I'm hearing more and more from asset managers is something to the effect of, "If advisors don't want to use standard mutual fund products anymore, then we have to pivot and go the other direction for products to customize solutions instead." You know, this idea that if they can better customize their asset management strategies for our clients and then maybe use technology to distribute them, they can regain their market share.
But here's the problem: When we look at advisory firms even today adopting ETF's, eliminating mutual fund products, they're not really actually customizing that much. Most advisory firms I see that drop mutual funds that are building model ETF portfolios are building model ETF portfolios. Typically, you know, maybe half a dozen different options from very conservative, very aggressive on the risk spectrum because they're...but they're not building different customized portfolios for every client because it's not scalable for us, because it's not scalable for the advisor-client relationship to do so.
Instead, as I've discussed on this blog in the past, I think the real reason we're seeing so many advisors shift away from mutual funds and ETFs in the first place is that effectively, we're disintermediating mutual fund managers. We're cutting out their fees and their layer and then trying to earn it ourselves. After all, if I'm an advisor who charges my 1% advisory fee and then I have to stack it on top of a mutual fund manager's fee, if I can shift to a strategy where I manage low-cost ETFs instead, I save my clients the difference in fees between the fund manager and the low-cost ETF, I use technology to manage it efficiently for myself, I get to keep my whole 1% AUM fee, and the client's cost go down, right? Who doesn't want that? I've got a solution where your portfolio gets cheaper and I add the value directly. Of course, that's why we're seeing such a shift. You know, in essence, we're making ourselves into the portfolio managers, but since we typically don't have time to do individual stock analysis and are more focused on the asset-allocated portfolios these days, we use the easiest building blocks for asset-allocated portfolios, which are ETFs.
But again, when you look at the kinds of ETF portfolios that most advisors seem to be building, especially the largest firms that are fastest growing and the ones that care the most about the scale, I find they're the ones least likely to be customizing portfolios for every client. Most aren't even trying to, they're trying to instead develop a centralized investment team to make the best possible models that their advisors can use with all of their clients.
In essence, the large advisory firm is making its own in-house managed account products. Larger RIAs are doing it, increasingly broker-dealers are doing it as well with their own shift to in-house accounts. If they're not comfortable with their in-house capabilities, they sub-advise out to a TAMP if they don't have the time or the inclination to do it internally. But in all these scenarios, the client is still essentially buying an investment product if you want to call it that, it's just the product is a managed strategy from the advisor in their firm, not from a third-party mutual fund company or other asset manager. That's the real shift here.
You know, it isn't a shift from product to customization, it's a shift from product to advisor. When our value proposition is based on what we do, we don't want to sell a third-party product of any type. We want to sell ourselves. Otherwise, we fear that at some point the client will say, "Why am I paying you for a product that I could just get directly online for myself?" That I think is the reason why we're seeing ETFs grow so rapidly but actively managed ETFs are not, because advisors don't want to use actively managed ETFs, we want to actively manage the ETFs ourselves because then the client perceives us as bringing the value to the table, not selling a third-party product.
And frankly, I think the situation is probably only exacerbated by the fact that in the real world clients often have a behavioral bias that just leaves them towards, let's call it, the disaggregated solution. So some people call this the naive diversification bias. It's the phenomenon that if you show a client a portfolio of 500 stocks, they believe they're very diversified. If you show them a portfolio that has a 100% in the S&P 500, they feel concentrated and risky. Same 500 stocks, same allocations, but if you put 1 line item on that statement instead of 500 of them, it feels less diversified.
Now granted we don't do this much as advisors with individual stocks, but I think this is another reason why there's so much pressure on mutual funds, especially fund-to-fund strategies because not only is there an extra layer of cost, but clients like to see all those line items. And even the trading and rebalancing that occurs, that shows them, you know, the advisor is doing something and being engaged.
Now, I realize not all this is rational, and it's not even always good activity because of a lot of bad overmanagement and overtrading that could come from this phenomenon, but you can't ignore the power of behavioral biases that are there and the perceptions of what happens when you don't just roll everything up into one solution. The advisor, you know, owns the line items because they own the ETFs or they own the components, rather than just letting the third-party manager do it all in mutual fund format.
The Path Forward For Advisors (And Asset Managers) [Time - 10:48]
So where does this leave us? From the advisor's perspective, particularly for those of you who are now maybe struggling a little to figure out how to get a handle on what's going on on all your clients' portfolios, figuring out if you're going to make any changes and then how to communicate them or you're waiting for each client review now to do it because you couldn't even possibly reach out to all your clients at once, you have to wait for each client review, which means now you're just not communicating with your clients, it's because your clients have all these different customized portfolios. And let this be maybe a little bit of a call to action to you about how not scalable you're making your business. If you've wondered why are other advisors getting messages out to clients same day or within 24 hours and you're going to stagger it over the next 3 to 6 months of client review meetings, this is why.
There are a lot of firms that are growing just fine without customizing every single portfolio differently for every client. You know, if you're not sure that your client will buy a standardized portfolio that you create, or to be fair, you know, a range of them, at a minimum you're still going to have something that goes from very conservative to very aggressive just to cover the normal range of risk, don't try to do more customization, just spend more time and resources trying to make better, more compelling portfolios. Or maybe just spending a little bit more time on your marketing materials so you can better explain the value you are creating for your clients with that standardized portfolio, and then figure out what your talking points will be for clients about why you're not customizing. It doesn't even have to be all that complex.
I'll tell you how we typically handle it when you come up for prospects because we run standardized models for clients. Range of risk, but here's our portfolio. So what do I say when a potential client asks, "Why aren't you customizing this more for me?" You know we say, "This is the risk you need and want to take to achieve your goals. And we have a dedicated investment team that spends all their time researching to find the highest quality and the lowest cost ETFs to get market exposure in all the areas that we want to invest for our client portfolios. So if you really want to, I'll go through all the recommendations that we're making to you, and you can tell me which lower quality higher cost ETFs you want us to substitute in instead of the ones that we're recommending. But I can assure you we don't have a super-secret list of extra-special higher quality investment ideas that we hold back for certain clients and give everyone else something inferior. This is the list of the best portfolios we believe we can construct. And we spend all of our time focused on these portfolios, and once we find something that we think is the best, we implement it for all of our clients. Does that seem reasonable to you?" We don't get a lot of objections after that.
Now to be fair, there are some circumstances where even our firm does customize, but it's not from an investment perspective, it's from a planning perspective. It's the clients that have unusual embedded capital gains circumstances or portfolios that we need to transition over time. Our firm is based in the Washington, D.C. metro area so we have a lot of government employees and various agencies where sometimes we have to work around their industries. Some people at certain levels of Department of Defense can't own defense stocks... some people tied to senior levels at NIH (National Institutes of Health), can't own medical company stocks or biotech stocks... so those are planning situations and we'll adapt as necessary. There's some good technology in the rebalancing software these days to handle that. But that's a matter of planning customization, not investment customization.
And for asset managers (and particularly mutual fund managers) trying to figure out how to reach advisors and stay relevant, I can only caution you that the push towards making more customized solutions is not likely to work out well for you. Because the truth is, even in the mutual fund age, advisors already had a ton of choices of different mutual funds to customize for each individual client account, and usually what ended up happening, most of us would end up using a small subset of mutual funds that we were comfortable with, learn the stories of those funds, you know, American Funds and The Growth Fund of America story or PIMCO Total Return in the days of Bill Gross, and then we tended to recommend the same common set of mutual funds for every client.
Not because technology was the limiting factor (although it wasn't great at the time), but because when you're sitting across from clients, you have to know what you're talking about and you have to be able to convey confidence to clients. And if you can't even keep track of all the stuff that you own, which you can't if you've got dozens or 100-plus clients who all have different customized portfolios, it is a surefire path to losing client confidence and eventually getting fired.
Simply put for asset managers, if you want to stay relevant as advisors switch from product salespeople to actual financial advisors, figure out how to just make better products that cost less and truly are the best at what they do, because as advisors, if you can pass our screen to get to the top of our list, you get all of our money in that funding category because that's what happens when we standardize and don't customize. And if you can't get to the top of that list, you're never going to get your foot in the door in the first place.
But this isn't about product versus customization, this is about whether we create as advisors our value through your products or create the value ourselves. And selling your product, which is what we did historically but now is something that any client can buy from any online brokerage account anyways, doesn't reflect well on our value and that's what's driving the shift.
I hope this is some helpful food for thought. Maybe a fresh opportunity for some of you to use the pain of this week's market volatility and the stress of trying to figure out how you're going to communicate with all of your clients on all their customized portfolios, in order to begin the process of not customizing so much in the future and standardizing more of your investment process. And you can actually be more proactive with clients, rather than needing to spend all this time reanalyzing every client's portfolio, and actually just spend your limited investment resources, whatever you've got, focusing on one set of the best investment opportunities you can find for clients and not trying to relearn and reinvent every portfolio every single time.
This is Office Hours with Michael Kitces, normally 1 p.m. East Coast time on Tuesdays. Got a slightly late start today, but thank you for joining us and hanging out, everyone, and have a great day.
So what do you think? Have you used a TAMP? Have you thought about outsourcing your investment management? What types of services would you like to see TAMPs provide going forward? Please share your thoughts in the comments below!
Count me in the camp that believes outsourcing investment management to a TAMP is a bad idea. The notion that all investors’ interests may be served by a handful of portfolio models makes little sense to me, and runs counter to personalized financial planning. Aside from the fact that such portfolio models can be horrible inefficient tax-wise in non-qualified accounts, there are plenty of scenarios where individual securities have distinct advantages over ETF/Mutual fund models. As a simple example, in a rising rate environment, my clients will be much happier with our laddered CD portfolios than with the bond funds/ETFs in XYZ TAMP, thankyouverymuch. I will also take my rising (qualified) dividend stock portfolios in income-oriented taxable accounts over a TAMP model (with its unpredicable capital gains distributions and unpredictable dividends) any day of the week. Don’t get me wrong, Vanguard ETFs and Admiral Share index funds are staples in my practice, but individual securities still provide important functions that model portfolios alone cannot. It also helps to differentiate me from the Betterments of the world and from the legions of homogenous advisors who are all pushing model portfolios for all objectives.
I also don’t understand why it should be any more difficult to for me to communicate with my clients in a down market than it is for an advisor using a TAMP. No two clients of mine have the same portfolio, but, It really doesn’t matter if one client owns 3M and another owns Illinois Tool Works – all clients are impacted by macro developments.
I am also surprised that people are making such a fuss about the recent market downturn. So what if, portfolio values are back to where they were in December? Sometimes the stock market goes down. Anyone who bought into the stock market in October 2007 (when the Dow first hit 14,000), saw the market lose more than 50% of its value over the next two years. Were they still okay if they held on until today? You betcha. “But,” one younger client asked, “what if the Dow falls all the way back to 20,000?” “You mean way, way back to what it was on January, 25, 2017?” I replied. Hmmmm.
Don’t get me started on “rebalancing”… 🙂
OK, so where is my $2,000,000 client (and I’ll use him as an example) today compared to where he was on 12/31/2017? Down -4%. Compared to 12/31/2006? Up 7%. What does my client need to earn on an annualized basis to meet his goals (he’s retired) of not running out of money? Approximately 4% if he wants to maintain his capital base; 1.3% if he’s willing to spend half his capital. If you focus on understanding your clients’ needs and understand the concept of investing for and planning toward a goal, you can take the clients’ focus off the daily fluctuations in their account. Being down 4% in a world where the FAANG’s are down 10% isn’t too shabby. We can live with that.
Where your value comes in is not in securities selection or market timing. It’s in explaining to him/her about how and how often the returns on different assets change over time. Stocks may not earn that 10% compound rate of return that you might have assumed a few years ago when you did his plan. In fact, over the next 10 years the best your client could earn might be 5-6% annually. Who knows? Plug that into your program and then tell him you will meet with him to review the assumptions on a regular basis and compare them to the actual returns he is getting. He will want to know how he is doing. You are then someone who is focused on his problem and his goals and not just another asset gatherer.
The ROBOT isn’t going to do that.
Ah yes, I remember my first job in the industry, back in 2010. Not that long ago, but I was working for one of that original wave of solo practitioners, My boss (the sole prop) came from an insurance and brokerage background, and each of her 50-ish client household’s portfolios was different. And 99% of the time, they didn’t get touched except for the client’s annual meeting. At which point the newest batch of the most popular mutual funds were evaluated.
All your points are so well taken, Michael! It absolutely WASN’T scaleable, or replicatable (I couldn’t figure out how to recreate her investment process; and I’m not dumb…it just was idiosyncratic). And if anything happened to a particular sector, market, company, there was so much effort to find WHICH clients have those investments. What a mess!