Weekend Reading for Financial Planners (Aug 29-30)

Author: Michael Kitces

Team Kitces

Michael Kitces is Head of Planning Strategy at Buckingham Strategic Wealth, which provides an evidence-based approach to private wealth management for near- and current retirees, and Buckingham Strategic Partners, a turnkey wealth management services provider supporting thousands of independent financial advisors through the scaling phase of growth.

In addition, he is a co-founder of the XY Planning Network, AdvicePay, fpPathfinder, and New Planner Recruiting, the former Practitioner Editor of the Journal of Financial Planning, the host of the Financial Advisor Success podcast, and the publisher of the popular financial planning industry blog Nerd’s Eye View through his website Kitces.com, dedicated to advancing knowledge in financial planning. In 2010, Michael was recognized with one of the FPA’s “Heart of Financial Planning” awards for his dedication and work in advancing the profession.

Read all of Michael’s articles here.

Weekend reading for August 29th/30th:

Blackrock Acquires FutureAdvisor For $150M As Yet Another Robo-Advisor Pivots To Become An Advisor #FinTech Solution (Michael Kitces, Nerd's Eye View) - This week, asset manager Blackrock announced that it was acquiring the "robo-advisor" FutureAdvisor, in a deal rumored to be worth more than $150M (by contrast, FutureAdvisor had raised "just" $21.5M of venture capital, and their Series B round in 2014 pegged the company's valuation at $75M). Notably, though, the deal doesn't appear to have been focused on FutureAdvisor's existing direct-to-consumer robo model, which only had $600M of AUM after 5 years and an estimated $3M of revenue at their 0.50% AUM fee. Instead, Blackrock has indicated that they will package the technology platform for broker-dealers, insurance companies, banks, and custodians, offering the tool as a robo-advisor-for-advisors solution. The deal may have been spurred on by the success of Schwab Intelligent Portfolios in particular (as well as Vanguard's Personal Advisor Services), which have made the point that robo-advisors can function as a distribution channel for asset managers, and therefore may be a significant opportunity for Blackrock to grow the AUM in its iShares ETFs. Yet if Blackrock ultimately offers their solution "for free" as a means to encourage adoption of (iShares) ETFs, allowing advisors to add their own AUM fees for the advisor's value-add, it may put even greater pressure on the existing direct-to-consumer robo-advisor platforms like Wealthfront and Betterment to justify charging any AUM fee at all!

Stock-Market Tumult Exposes Flaws in Modern Markets (Bradley Hope, Wall Street Journal) - The volatile sell-off at Monday's market open raised some troubling challenges for the recently popular investing vehicle, exchanged-traded funds. Circuit breakers, normally designed to (rarely) pause trading in single stocks and ETFs during big moves, were triggered nearly 1,300 times on Monday (and themselves were instituted for ETFs after the disruptive May 2010 "flash crash"). As a result of intermittent trading in both the ETFs themselves, and many of their underlying stocks, trades became difficult to value as market makers were uncertain about the value of the underlying holdings, and arbitrageurs that normally keep the price of ETFs extremely close to their intrinsic NAV could not function properly. The end result was that not only did many ETFs have extreme volatility - even large funds like Vanguard's $2.5B Consumer Staples ETF and its $5.8B Health Care ETF plunged 32% within minutes of the open (and were halted 6-8 times throughout the day) - but that the ETFs actually declined far more than their underlying holdings (e.g., the underlying holdings of Vanguard's Consumer Staples ETF were only off 9% that morning). The turmoil has raised questions about whether the circuit-breaker systems need to be adjusted or redesigned for today's increasingly ETF-centric investor marketplace, and that Monday's problems signify a material problem in the current market structure. On the other hand, virtually all ETF shares eventually normalized as trading continued through the day, so those who didn't have to trade first thing Monday morning may have never noticed the issue in the first place, although some advisors and investors who had placed stop-market orders for nervous clients may have found their trades triggered at extremely unfavorable prices at Monday's market open.

Understanding ETF Flash Crashes (David Nadig, ETF.com) - As noted in the prior article, Monday experienced a "flash crash" in a number of ETFs when the market opened. Nadig looks a particularly extreme example, the Guggenheim Equal Weight S&P 500 ETF (ticker: RSP), which is normally extremely liquid and has ample opportunity to arbitrage out price discrepancies, yet traded below $50/share in the first hour of market trading, even though the value of its underlying stocks collectively never dropped below the equivalent of $71/share. The reason this "flash crash" happened actually starts in the pre-open. Normally, NYSE market makers provide indications of opening prices before trading gets underway, but due to the chaos of Friday's market sell-off, the NYSE had invoked the rarely used "Rule 48" which allowed market makers to wait until the markets actually opened to set their prices (removing a level of pre-market information); as a result, the only bids and offers at the exact moment of market open were standing orders from the Nasdaq, with an extremely wide bid/ask spread. And the moment an initial 70,000 shares got traded at the market open, many of those bids and offers got taken out, exploding the bid/ask range even further. In turn, this led to RSP going through a series of halts (which occur any time a trade occurs outside a 10% band in a 5-minute window), limiting trading to only 15-30 second bursts before another automated halt was triggered as the ETF gapped down and then back up again, but always with such limited time that the trading couldn't become orderly. Nadig suggests that this extreme disruption in orderly market pricing was triggered by a number of overlapping factors: market makers stepped away (as the markets were acting 'too' irrational); high-frequency trading was likely overwhelming and further distorting the few trades that could occur (as even HFT algorithms can't function properly in 15-second bursts of halted markets!); and downside selling was likely exacerbated by stop-market orders getting triggered as the price fell. Notwithstanding these disruptions, Nadig notes that the trades will not likely be cancelled, as trading did occur in an orderly and logical fashion for the markets, just at extreme prices due to market orders in very thinly traded markets. Nonetheless, Nadig does affirm that the current market structure doesn't seem to be well-suited to the current dominance of ETFs (where halts and limited information can exacerbate deviations between ETF prices and their underlying intrinsic NAV), and that regulations seem to have lagged in a world where we have 5-minute trading halts but computers (whether high-frequency traders or automatically triggered stop-market orders) can trade in milliseconds.

A New Computer Glitch is Rocking the Mutual Fund Industry (Kirsten Grind & Bradley Hope, Wall Street Journal) - Earlier this week, in an event that appears to have been entirely separate from Monday's ETF trading turmoil, Bank of New York Mellon (the world's largest mutual fund custodian) experienced technology-related problems in its Sungard Data Systems software that prices a number of mutual funds and ETFs, leading to price discrepancies deviating as much as 1% or more from their true value. By Wednesday, Morningstar noted that 796 funds were missing a reported net asset value, and the problem was wide-reaching, from Goldman Sachs money market funds to Guggenheim ETFs and mutual funds of Federated Investors. The situation has led to emergency meetings at custodians and asset managers across the industry, that are struggling to ensure that trades occur at appropriate prices, as the problems impact both the ability of custodians to properly settle mutual fund trades at the end of the day, and for traders to accurately assess the intrinsic NAV of ETFs throughout the day. In turn, these problems have reduced trading volume and liquidity and widened bid/ask spreads for some ETFs, and some investors who were trying to sell their mutual funds on Monday were still unable to settle the trade two days later. And as of now, it remains unclear whether the fund company or BNY Mellon will be responsible for any damages incurred by investors who traded based on the faulty pricing, though a separate WSJ article encourages investors to contact their mutual fund companies if a problem occurred to ask for compensation.

Quit Marketing, Start Smarketing (Gail Graham, Financial Advisor) - While advisors engage in a wide range of marketing activities, Graham cautions that too often there's no connection or alignment between an advisor's marketing process to find prospects, and the subsequent sales process to actually turn them into clients. Thus, for instance, they might do some print advertising, but not long enough to gain momentum and follow-through; or they might do a seminar or two, but then switch to calling on COIs, and then gather a good list of prospects but not put them into a CRM system to continue drip marketing to them. The alternative - what Graham calls "Smarteking" - is to recognize that the entire "funnel" from stranger to prospect to client requires a coordinated process. At the top of the funnel are the advertising, speaking, and PR activities that build awareness amongst strangers. In the middle of the funnel at the emails, events, and interactions that engage strangers and turn them into bona fide prospects. And then at the bottom of the funnel come the actual sales efforts that turn prospects into clients. If there's no top-of-funnel activity, there are no prospects coming in, while if there's no middle-of-funnel activity the prospects aren't being moved towards a sales opportunity to do business. And if there's lots of top and middle-of-funnel activity, but no structured process to reach out and do business with the prospects, no actual new clients will result. Thus for example, while one advisor might attend a local tennis tournament, network with a few people, advertise there occasionally, entertain some prospects, and maybe get a few clients, a structured "smarketing" process would include targeted content, pre-event emails, giveaways to collect more email addresses, social media efforts to connect others in to the event, and post-event outreach to the prospects to engage with them deeper and invite them to come in for a meeting to eventually convert them to clients. While the latter approach may be more intensive and time consuming, Graham makes the point that it can generate exponentially more revenue and growth in the long run.

Lights, Camera, Action! (Jeff Schlegel, Financial Advisor) - While adoption has been slow, an increasing number of advisors are beginning to use video as a means to market themselves, tell their story and convey their investment philosophy, and reach consumers who have faster and faster internet connections but seem to have shorter and shorter attention spans (especially when it comes to reading websites). Yet even with adoption, the manner in which it's done varies significantly; some advisors are opting for polished, professionally shot videos filmed in multiple locations at a cost of thousands of dollars by hiring local videographers, while others are doing it themselves as a low-key effort using computer webcams or smartphones (which looks less "professional" but can be more intimate to connect with viewers). Arguably, there is no "optimal" style, except that however the video is done, it should reflect the style and brand of the advisory firm. Though for all advisors, the efforts seem to evolve over time, finding what works best for them, updating/improving prior videos, and getting better with practice at everything from on-camera delivery to watching out what's being recorded in the background. For some advisors, videos are used for their "bio" and "meet our team" pages, while for others it's actually a means to provide ongoing content, whether blog posts to build audience for prospects, or market updates to communicate information to existing clients; one advisor is launching a quick 5-minute update every week to convey market commentary to clients after initial success with the advisor video marketing firm Blu Giant. Overall, the starting point for some short professional videos seems to be around $1,000 (although do-it-yourself equipment costs less), moving up to $5,000 for longer or multiple videos, and rising from there for especially complex, high-quality, or long videos that need to be edited and refined.

Smart People Doing Dumb Things (Mark Hurley, Financial Advisor) - While financial advisors are generally very educated people, Hurley notes that many advisors are far better at applying their brainpower and advice to their client situations than to their own businesses, leading them to do surprisingly "dumb" things they would never advise to a client in a similar scenario. For instance, while advisors are increasingly working with compliance consultants for advice and guidance, they fail to recognize that ultimately consultants are meant to help manage your existing compliance program, not give you legal advice (they can't); in addition, advice from a consultant is not "privileged" (unlike with an attorney), which means if the SEC ever has to investigate, they can actually subpeona your compliance consultant and use his/her testimony about problems of the firm against you! Other problems include: too many advisors hire mini-me versions of themselves with less experience and capabilities, which may save on staffing costs in the short term but significantly undermines business value in the long run (especially when the founder wants to exit and sell the business!); cultivating just one or two key centers of influence for referrals and then becoming overly reliant on those referral sources (which again diminishes the business' value due to the marketing concentration risk) rather than fully scaling the advisory firm's marketing efforts; and setting up the advisory firm as a C corporation instead of a pass-through entity and/or failing to convert to a pass-through entity later (as buyers generally pay less for C corporations, due to both less favorable tax treatment, and the fact that they have to take on the business' liability exposure by buying the stock). Ultimately, though, Hurley suggests that the biggest problem for many advisors is complacency about the lack of growth in the firm; with the S&P 500 up over 200% in the past 6 years, if an (AUM-based) advisory firm is "only" up 25%-30% from 2009, the firm is actually at significant risk of falling behind and may already be attritioning clients and assets with a negative organic growth rate.

Why Advisors’ Profits Are Falling (Angie Herbers, ThinkAdvisor) – A recent research study from Herber’s advisor practice management consulting firm Kaleido finds that despite the ongoing rise in advisory firm revenue, profitability for advisors has actually been falling (along with referral rates and close ratios). The biggest driver for these issues is simply that, for the first time, independent financial advisors offering comprehensive financial planning are facing real competition, ranging from breakaway brokers at the high end of the market to robo-advisors at the low end, and the lack of clear differentiation or any focused target clientele are becoming a problem. The problem is exacerbated by the fact that historically firms have offered financial planning as a loss leader and “sold” asset management, but as asset management gets commoditized the financial planning is shifting from the loss leader to the leader (and can’t be made up by advisors offering robo-advisor solutions, which won’t help because few advisors have the marketing plan necessary to create the necessary volume of small clients). Ultimately, Herbers recommends a four-step process for advisors: truly commit to who you want to service; go deeper to determine what their unique financial needs are; consider internally what you really can deliver to that focused group of clientele; and then decide how to execute what will basically become a niche financial planning offering for those clients. And Herbers emphasizes that the changes for advisors must begin sooner rather than later, as declining profitability and then being hit by a bear market could be very destructive for many firms. In the meantime, you may want to check out a full copy of the Kaleido research white paper, “X-Cell: The New Frontier Of Client Advisory Service”.

Illustrative Tools For Synthesizing Concepts (Deena Katz, Financial Advisor) - In this article, Katz talks about how she explains to clients the trade-offs between expected returns, withdrawal rates, and how long money will last in retirement. Rather than just talk about "rules of thumb" like the 4% rule, though, Katz created a visual aid: a chart that shows a grid of various withdrawal rates, expected returns, and the number of years until the portfolio is depleted, allowing clients to visually understand the trade-offs. Another chart that Katz uses illustrates market volatility by giving clients a range of portfolios varying from low to high risk (in both the short-term and the long-term), and then provides an indication of the portfolio's long-term expected returns, 12-month drawdowns, and bear market drawdowns (top-to-bottom decline during the financial crisis). Again, the purpose is meant to help clients visually assimilate a wide range of information about the various trade-offs inherent in taking on more (or less) market risk for varying expected returns. Similarly, Katz also draws charts for clients to explain the efficient frontier, graphing the frontier line, and then drawing dots to illustrate where stocks, bonds, cash, and various combinations might lie - and how the (unachievable) ideal is the high-return zero-risk portfolio, but that in practice it requires a trade-off along the (efficient frontier) spectrum. Ultimately, the fundamental point is not the particular graphs that Katz uses, but the ideal that clients can better understand complex information about markets and trade-offs through visual aids, which an advisory firm can make once and then use repeatedly with all clients. On the other hand, some advisors may even want to reproduce their own versions of Katz's charts, which are included as visuals in the article itself.

Stock Drop: What To Tell Clients (Charlie Paikert, Financial Planning) – With the recent market volatility through the beginning of this week, more clients are calling (or emailing) advisors looking for guidance and/or comfort. But what should you say/do? The first tip is to get proactive on communication; many advisors report sending an email out to clients last Friday or at the market close on Monday, simply acknowledging the volatility, that it was scary, and reaffirming the firm’s core diversified strategy. The point is not to accentuate a focus on the market, but it’s essential not to just ignore it and pretend clients aren’t seeing news headlines. Of course, for some clients the outbound messaging alone won’t be enough, and there needs to be an in-person meeting or at least a telephone call to talk through the fears. In this scenario, it’s crucial to acknowledge and affirm the client’s feelings (are they frightened? fearful?); just offering statements to placate the situation without making the client feel heard and listened to first will be ineffective (i.e., active listening is crucial!). Other strategies include: put the volatility in proper client context (e.g., it may seem like a big point drop, but it’s a moderate percentage of the index, and an even smaller percentage of your portfolio); put the volatility in historical context (e.g., “since 1900 there have been 35 declines of 10% or more in the S&P 500, and the index fully recovered its value an average of 10 months later”); remind clients of realistic expectations (the market went straight up for nearly 6 years and almost tripled since early 2009, which is not “normal” either!); and of course, there’s always reminding clients of (and executing) rebalancing and tax loss harvesting opportunities along the way.

Myths About The Investment Company Act On Its 75^th Anniversary (Matthew Fink, Investment News) – This past week was the 75^th anniversary of the Investment Company Act of 1940, which regulate mutual funds and other investments companies. And notably, the law that set what is still the current structure for mutual funds had an interesting early history. It originated largely as a follow-on to the Revenue Act of 1936, which provided that if an open-ended mutual fund met certain regulatory tests (including diversification requirement, a limit on short-term trading, and a maximum on how much of a company could be owned), it would not be taxed separately (with income/gains instead passed through to shareholders). In the year that followed the Revenue Act, there were a number of mutual fund industry abuses, and the SEC released a report highlighting them and proposing new regulations, which were widely expected to be voted down and not supported by the industry. However, it turned out the fund industry supported the regulation, in part because the tax preferences under the Revenue Act of 1936 were only for open-ended mutual funds, and closed-end mutual funds (which were a larger part of the industry) cut a deal to support the SEC’s regulatory legislation in exchange for the SEC encouraging Congress to adopt new tax legislation that would allow closed-end funds to get equal treatment. Once approved, the Act provided for relatively simple powers for fund directors (approve advisory and underwriting agreements, select outside accountants, and oversee valuation of portfolio securities). Notably, though, the Investment Company Act of 1940 was at the time just focused on investor protection, and ignored systemic risks associated with mutual funds, since at the time mutual funds were still a relatively small part of the overall market (unlike today!).

Technology Is Only Making Social Skills More Important (Nicole Torres, Harvard Business Review) – As technology, automation, and “robots” continue their rise, a number of studies have raised concerns about how many jobs will ultimately be replaced by computers altogether, and what jobs will be left for actual human beings. A recent NBER working paper suggests that ultimately, it will be jobs requiring social skills and collaboration that will survive and thrive, given how much more difficult those jobs are to automate; in fact, nearly all job growth since 1980 has already been primarily in occupations that are relatively social-skill-intensive, and even highly-analytical cognitively complex (e.g., math-focused) jobs have been on the decline. Though this doesn’t mean analytical skills will become irrelevant; to the contrary, the data already suggests that the bulk of job and wage growth is occurring in jobs that require both strong cognitive and social skills, particularly around tasks that are complex and not routine. It’s this kind of work which is becoming increasingly team-based, and where social skills are necessary to determine how all the team members will collaborate together and take on specialized roles. And notably, while the article wasn’t written in the context of financial advisors at all, it arguably goes far to support both why social-skills-centric financial advice is on the rise, and how and why the most social advisors working on teams may be the most likely to survive and thrive.

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!