Executive Summary
Enjoy the current installment of "weekend reading for financial planners" – this week's edition kicks off with the release of the latest edition of Morningstar's "Mind The Gap" study, which analyzes investor returns based on asset-weighted flows in/out of mutual funds and ETFs, and finds that while the behavior gap does persist, it is "just" about 0.45%/year over the past decade, and is actually positive (i.e., investors on average outperformed) when it comes to asset allocation funds (as the low volatility of such diversified funds appears to drastically reduce the tendency to try to market-time them in the first place).
From there, we have a number of insurance-related articles this week, including a discussion in The Wall Street Journal of Madoff-whistleblower Harry Markopolos who claims that GE and its long-term care insurance unit in particular may be "the next Enron" and that the LTC insurer has understated its future liabilities to the tune of $10s of billions, how the pricing of insurance products (or the participation rates of fixed indexed annuities) is deteriorating in the face of now-falling interest rates, and a new Private Letter Ruling from the IRS that will allow RIAs to receive their advisory fees directly from a fee-based annuity without triggering a taxable event (and in fact, will effectively be paid by the client on a pre-tax basis for any annuity with embedded gains!).
We also have several practice management articles, from the ongoing rise of non-compete agreements at RIAs to prevent employee advisors from taking clients when changing firms (notwithstanding the fact that RIAs historically have been the bastion of no-hands-tied independence), to the business management hazards of valuing an advisory firm based on a multiple of revenue alone, the "exploding" number of options for advisory firms to borrow in order to acquire other firms, the practical challenges of trying to grow by acquisition and actually close on and integrate a newly acquired advisory firm, and the practical value of benchmarking studies as a means to not just evaluate the firm's AUM and growth relative to peers but also its productivity and efficiency in allocating its resources across the firm.
We wrap up with three interesting articles, all around the theme of how to actually make a good decision: the first looks at the "anatomy" of a Great Decision, which ultimately comes down to making a principles-based decision, and using a broad multidisciplinary lens to consider the issue from all angles before making the decision; the second looks at how thinking about decisions more probabilistically as "bets" is a better approach that naturally considers the role of luck and hidden information (and recognizes that the key to a good decision is not to guarantee a good outcome, but simply to minimize the odds of a bad one); and the last discusses the so-called "37% rule", that the best amount of time to allocate to a decision is 37% of the total time designated to the project (but after 37% of the time has passed, it's time to execute the decision and do the best you can with whatever you've got at that point!).
Enjoy the "light" reading!
Mind The [Behavior] Gap 2019 (Russel Kinnel, Morningstar) - The so-called "behavior gap" is the difference between the returns that the markets delivered, and the returns that investors actually earned... where the latter is typically lower than the former, due to some level of ongoing ill-timed buying-too-high and selling-too-low behavior that results in investors failing to achieve even just what the markets were actually giving (and certainly not an excess return above the markets). However, the actual size of this "behavior gap" in investor returns has long been an ongoing debate, with controversial studies like DALBAR estimating that investors underperform the markets by as much as hundreds of basis points in the aggregate year after year. In its annual "Mind The Gap" study, though, the latest data from Morningstar on investor returns - based on Morningstar's own data on returns and fund flows to calculate asset-weighted internal rates of return, and with several methodology updates including a monthly weighting formula to calculate asset-weighted flows and returns, adding in (often most poorly performing) funds that were merged or liquidated, and including ETF flows as well - finds that the behavior gap still exists, but appears to be far more modest, at "just" 0.45%/year on average (over rolling 10-year periods). Notably, though, Morningstar does find the average gap is worse in volatile years (e.g., 2008-2009) than others (when markets are less volatile and consequently investors appear less inclined to try to time their trades), and that the behavior gap does vary by asset class, with the gap being the worst for alternatives, and actually positive (i.e., investor returns did beat the markets) for the traditional asset-allocation fund (ostensibly because its mixture of stocks and bonds makes it less volatile and therefore less likely for investors to try to time). Other notable trends of what tended to reduce the behavior gap and improve investor returns included: simplicity (more complex funds/products tended to have worse results), transparency (the more opaque the fund, the worse the behavior gap), low cost (more expensive funds were more likely to be badly timed), and breadth (all-in-one diversified funds were less likely to be timed than more modular "building-blocks"-style funds, further extending the low-volatility-is-associated-with-less-behavior-gap results). Or stated more simply... it turns out that "boring funds" tend to work best for investors, as they just don't inspire fear or greed in the first place.
GE Is New Target Of Madoff Whistleblower (Thomas Gryta & Mark Maremont, The Wall Street Journal) - In a major research report released earlier this week, Harry Markopolos (known to many as one of the individuals who tipped off the SEC about Madoff years before the story became public, but was ignored) is sounding the alarm against GE, and specifically parts of its Genworth LTC reinsurance unit, comparing it to an Enron scenario and suggesting that the company may need to soon bolster its reserves by as much as $18.5B in cash (given how much more in reserves companies like Unum and Prudential have against a similar block of LTC insurance policies), which in addition to concerns about how GE is accounting for some of its oil-and-gas businesses as well could amount to as much as $38B (or 40% of market value) in untold liabilities. Of more immediate concern, though, is whether GE has enough working capital liquidity to manage its cash needs in the coming years (which currently is $12.5B of liquidity at GE Capital, and $16.9B of cash at its industrial businesses). And the issue appears to be particularly acute at GE's long-term care reinsurance division, where the $18.5B potential boost in cash reserves would come on top of a $10.5B charge the company will have to absorb in 2021 due to a required accounting change, and all on top of a $15B boost in reserves GE has already taken over the past 7 years to cover its Genworth LTC insurance claims exposure (as a result of both higher-than-expected persistency, lower-than-anticipated interest rates, and what Markopolos suggests was inadequate reserves against a large base of "paid-up" policies that were sold by Genworth in the early years of LTC insurance). In addition, the reality is that GE is always under investigation by the SEC and Justice Department for potential accounting issues in recent years, particularly with respect to its insurance holdings (though the company has denied accounting fraud and states it is cooperating with investigators), which raises further concerns about the credibility of Markopolos' research. On the other hand, though, it's notable that Markopolos has acknowledged that his report was produced in coordination with an undisclosed hedge fund, which is betting that GE's share price will decline (and will share in a portion of its profits with Markopolos), raising questions of whether the research report is tainted (or as GE alleges, an outright attempt at market manipulation), though Markopolos maintains that the research is accurate and is seeking to work proactively with the SEC to facilitate a whistleblower investigation against GE as well.
Insurers Pivot Amid Declining Interest Rates (Greg Iacurci, Investment News) - With the Fed cutting interest rates in July for the first time since the financial crisis, and 10-year Treasury yields plummeting even lower in recent weeks (and down by half from 3.24% last November to under 1.6% this week), insurance and especially annuity carriers are finding themselves suddenly under pressure to make rapid adjustments to the pricing and benefits of their various policies being sold. The fundamental challenge is that when it comes to insurance, a core aspect of the model is being able to grow a policyholder's premiums in order to pay future benefits... which means that lower interest rates will require higher premiums to provide the same promised benefit in the future. While in the case of annuity products - particularly with respect to fixed indexed annuities - lower interest rates simply mean less interest available to invest into the various options strategies that deliver their equity-based returns. Accordingly, several major annuity carriers have cut their participation rates and/or caps repeatedly over the past several months, and guaranteed income benefits are beginning to come down as well, which in turn already appears to be leading to a slowdown in fixed annuity sales.
IRS Delivers "Game Changer" Ruling For Advisory Fees From Fee-Based Annuities (Greg Iacurci, Investment News) - This week, Nationwide (and also Lincoln and several other annuity carriers) announced that it has obtained a Private Letter Ruling (PLR) that will allow RIAs to deduct a client's advisory fees for managing a non-qualified fee-based annuity contract directly from the annuity's cash value, without triggering a taxable event. The ruling is effectively a complete reversal of the prior position from the IRS, that any distribution from an annuity on behalf of the annuity owner - including for the fees of an RIA managing the annuity - would be a taxable distribution (with a potential early withdrawal penalty on top). Under the new ruling, the IRS declared that an advisory fee extracted from a fee-based annuity can be deemed an expense of the annuity contract - rather than an expense of the annuity owner - as long as the advice fee is authorized by the annuity owner, is only for the management of that annuity (and not any other annuities or accounts), and amounts to an AUM fee of no more than 1.5%. Overall, the ruling is expected to significantly expand adoption of fee-based annuities amongst RIAs, who can now collect their advisory fees directly from the annuity contract being managed (on what is effectively a pre-tax basis). Though notably, most fee-based annuities still do not effectively integrate with typical RIA technology systems, which may make it difficult for fee-based annuities to gain significant traction (notwithstanding the fee ruling). Still, though, fee-based annuity sales were already $3.2B in 2018 - up 42% from just 2017 alone - with a number of major annuity companies coming to the table in 2019 to roll out new fee-based annuity contracts (a trend which will likely only be accelerated now).
The Fight Over Who Owns The Client Comes To RIAs (Bruce Kelly, Investment News) - In a lawsuit filed last week, Mercer Advisors sued a now-former advisor who left the firm for a competing RIA after working at Mercer for 5 years, claiming that the advisor violated his employment agreement by taking with him the contact information and other details pertaining to the clients he was responsible for at Mercer. Or stated more simply, Mercer is claiming that the former advisor tried to take clients that "belong" to Mercer, and not the advisor who happened to be servicing them. The irony, though, is that it was just two years ago that major wirehouses Morgan Stanley and UBS were criticized for their own decision to leave the Broker Protocol and made it harder for advisors at the firms to leave and take any client information with them, which both independent broker-dealers and independent RIAs have highlighted is a key difference between the wirehouse employee model and more "independent" models. More generally, the dispute highlights the ongoing rise of restrictive employment agreements that are increasingly common (especially at large RIAs), though Mercer emphasizes that in this case the clients weren't even sourced by the advisor in the first place, and instead were brought in by Mercer's own centralized marketing team that feeds 600-900 new clients to its advisors each year (as distinct from typical "independent" platforms, where the advisors themselves are still responsible for getting their own clients). Which ultimately raises the question of whether RIAs in the future will need to make even clearer distinctions between firms that support advisors building their own clientele, versus those where the firm provides the clientele and the advisor's role is "just" to service "the firm's" clients instead?
Revenue Multiples Don't Tell The Story Of Your Firm's Value (Lisa Rapuano, Investment News) - The standard rule-of-thumb for advisory firm owners is that an AUM firm can be sold for 2X its recurring revenue. Which may not be a terrible estimate for many advisory firms, but quickly becomes absurd when drilling down to a comparison between advisory firms - for instance, two firms with the exact same revenue are clearly not worth the same if one is primarily comprised of still-accumulating clients in their 40s, while the other has mostly decumulating clients in their 70s. Similarly, firms with identical revenue may have substantively different staff infrastructure, current or antiquated back-office procedures, and may or may not have a strong brand for attracting new clients. Ultimately, though, the problem with the fact that a simple multiple-of-revenue estimate doesn't capture the nuances of an advisory firm isn't merely that the valuation itself may be off by a little (or sometimes a lot), but that not being cognizant of what are actually the drivers of value in the firm can result in poor business decisions that fail to actually support and increase the value of the business in the long run. So what's the alternative? The starting point is to value the firm using a multiple of its profits, either EBITDA (earnings before interest, taxes, depreciation, and amortization), or EBOC (earnings before owner compensation, in the case of smaller and especially solo advisory firms where the buyer may well just step directly into the current owner's aggregate earnings including the owner's own compensation). Notably, though, it's not just about the amount of cash flow the company generates, but also its "quality" - from the age of clients (which indicates whether they are saving or spending, and how long they're likely to remain alive as clients), the firm's marketing capabilities, as well as its operational ability to sustain its growth (i.e., its talents and technology). The starting point, though, is just to go through the valuation process as an advisory firm... in order to really understand not only what the firm is worth, but to gain the perspective on what it may really take to increase shareholder value.
Capital Options For RIAs Explode (Charles Paikert, Financial Planning) - Recent interest in the advisory industry from private equity firms has led to a massive influx of capital being invested into advisory firm mergers and acquisitions (especially in the RIA community), but the rapid rise in volume of successful RIA M&A transactions is now in turn leading to an influx of capital providers who want to lend and take advantage of the newfound demand for borrowed capital. And the trend is now increasingly feeding on itself, as the rise of buyers who can get third-party financing - and therefore provide the bulk of the purchase price to the seller upfront, shifting the financing risk to the lender and away from the seller - is forcing even more RIA acquirers to find their own third-party lending sources to be able to bring substantial cash down payments to make competitive offers. Accordingly, not only has there been an increase in "traditional" bank-style lenders like Live Oak Bank, PPC Loan, and Oak Street Funding, but there is also a growing range of "alternative" financing options, from SkyView Partners' Merchant Credit Partners that offers a "digital lender marketplace", to Dynasty Financial's new "Capital Strategies" division offering both Revenue Participation Notes and also an 8-year forgiveable loan structure. In addition, a number of private-equity-backed lending pools are also expected to hit the market by the end of the year, providing more alternatives to the typically-SBA-based bank loan options available today. In fact, there's such a range of capital providers that investment banking consultant DeVoe & Company has now launched a new service called "CapitalWorks," whose job is to help match advisory firm acquirers with the "right" type of capital source based on their needs (in exchange for a referral fee to DeVoe from whatever lender is selected).
The Messy Business Of Growth By Acquisition (Taylor Schulte, Advisor Perspectives) - With the ongoing crisis of differentiation, more and more advisory firms are finding it difficult to grow organically, leading to a growing interest in "inorganic" growth by acquisition instead. However, as Schulte notes - having recently bought out another retiring advisor's book of clients as a strategy for his own firm's growth - the strategy of growing by acquisition is not without its own kind of messy challenges. As a starting point, it's important to recognize that acquiring another firm's revenue and clients often means more hiring to expand the existing advisory firm's infrastructure to be able to handle all the additional work it will entail (from trading and operations teams, to more compliance oversight for more advisors and another office location)... which in the extreme could actually cost the firm more in profits than the new acquisition would have generated in the first place, once all costs are considered! In Schulte's own experience, some of the key lessons that emerged from his own acquisition experience included: finding the "right" match is crucial, which means both investment and financial planning philosophies must align (as well as compensation philosophy of whether the firm is fee-only or not); being certain to talk about what the actual processes and procedures will look like in the end (e.g., Will clients be onboarded differently? Where will clients meet going forward? What information will be shared during and after the transition process?); and being certain to hire an objective third party to help facilitate the negotiating process, as even well-meaning parties can still quickly discover that the process of setting and compromising on terms can be more complex than it first appears. Perhaps more important, though, is the simple recognition that if an advisory firm is already struggling to grow, it may be a symptom of deeper problems around the advisory firm's value proposition or the way it is (or is not) effectively delivering advice to clients... in which case acquiring even more clients on top may simply compound the problem, rather than provide a breakthrough to get past it. Or stated more simply: growth does not solve profitability problems in advisory firms... it tends to just compound the problems instead!
How RIAs Use Peer Comparisons To Be Competitive (Karen Demasters, Financial Advisor) - The typical view of financial advisor benchmarking studies is that they're a way to "keep score" for advisory firms, comparing firm size by revenue and assets under management, and perhaps which firms have the best growth rates. But the reality is that benchmarking studies also provide the opportunity to compare an advisory firm on a wide range of Key Performance Indicators (KPIs), to determine whether the firm has the right staff infrastructure, pricing, and whether it is over- or under-staffing its client service team. For instance, an advisory firm might have high profit margins, but if the margins are being generated by advisors who have an above-average clients/advisor ratio, it's a signal the profits may come at the cost of insufficient capacity (that strangles future growth), or that advisors are overworked and may be at greater risk of turnover (rather than just being more "productive" than other firms). Other key insights from leveraging industry benchmarking studies include: whether advisors and other key employees are being compensated appropriately and competitively; how advisory firms typically allocate their resources between advisors, overhead staff, and key functional areas like marketing or technology; and what other advisory firms are offering to be competitive (e.g., tax services on top of financial planning advice).
The Anatomy Of A Great Decision (Shane Parrish, Farnam Street) - It's difficult for many people to improve their decision-making process, because the unfortunate reality is that decisions can't be judged solely on their outcomes alone, as even good decisions can produce bad results (as it's impossible to have perfect information about every possible variable), and can actually prevent us from learning the proper lessons from prior decisions we've made. Accordingly, Parrish suggests that the real way to improve decision-making is to focus on "principles, not tactics", and to look at the situation through a multidisciplinary lens, using a "decision journal" to keep track of the choices made and their results. For instance, when Secretary of State General George Marshall enacted the Marshall Plan in 1947 (to give massive amounts of money to several European nations to rebuild after World War II), the decision to do so was driven first and foremost by key principles (e.g., strong economies minimize social unrest; countries that work towards mutual goals are less likely to fight each other), and then evaluated through multiple lenses (economic ramifications, political impact, humanitarian responsibilities, historical and psychological factors). Which in turn led to several key pillars of the Marshall plan, including that the dollars would be given and not loaned (as the principles couldn't be achieved if the countries immediately had to struggle under a massive debt burden), to requiring the nations receiving the aid to make their own decisions about how to allocate it (as the psychological and historical factors of reparations after World War I revealed that it was crucial to allow the nations receiving aid to have a more constructive role in allocating it), and allowing Russia to partake in the aid despite being a rising threat with the emergence of the Cold War (which ultimately Russia chose not to accept, but the end result was that Russia had to own that the rise of the Iron Curtain was their own choice). The key point, though, was simply that the Marshall plan was emblematic of a Great Decision because it was built on principles, evaluated from a wide range of angles and perspectives.
Lessons From Annie Duke On Making Smarter Decisions When You Don't Have All The Facts (Tren Griffin, 25iq) - One of the biggest challenges in decision-making is figuring out when to stop collecting more data and facts, and actually proceed with making a decision... or more generally, how best to make decisions when it's not possible or feasible to get all the data and facts in the first place. While the challenge is common in the world of business, it's perhaps best epitomized in the game of poker, where everything is about making probabilistic decisions in the face of uncertainty. In her book "Thinking In Bets", poker star Annie Duke shares her perspective on how best to make such difficult decisions, with a number of key insights, including: not all bad outcomes were the result of bad decisions (nor all good outcomes the result of good decisions), as decision skill plays a role, but so does luck; making better decisions starts with recognizing that the outcome is never knowable and certain (both because of hidden information that can't be known, and the uncertain role of luck), which means it's more important to focus on the decision-making process than just looking at outcomes; because of the role of luck and uncertainty, often it's better to weigh decisions not by how certain the outcome is, but specifically by judging how unsure the decision-maker realistically must be about the outcome; when we think probabilistically, "we are less likely to use adverse results alone as proof that we made a decision error, because we recognize the possibility that the decision might have been good but luck and/or incomplete information intervened"; and consequently, "improving decision quality is about increasing our chances of good outcomes, not guaranteeing them."
The 37% Rule: How To Decide When To Stop Wondering And Start Deciding (Tomasz Tonguz) - One of the fundamental challenges in a project is figuring out when it's time to stop just analyzing the alternatives, and actually pick one to implement and move forward with. But according to the book "Algorithms To Live By", there is a very specific answer: 37%. Or more specifically, 37% of the time to be spent on a project should be spent trying to make the decision on what path to pursue. This "exploration period" is when it's best to seek advice, learn about the demands of the project or role, and meet some vendors or candidates. The key, though, is that once you've spent your 37% time, it's time to actually make a decision - hire the best candidate or vendor found so far, and proceed forward to the "exploit" phase of actually seizing the opportunity and capitalizing on it. Thus, for instance, if there's a need to hire a new marketing director in the next 90 days, the firm would spend the first 33 days (37% of 90 days) evaluating candidates, and then pick the best choice and move forward. Notably, though, the 37% rule can be applied more broadly as well. How many of the items on a restaurant should you try before deciding on your favorite dish? 37%. How much time should be spent trying to come up with the next marketing initiative, or new idea in your practice? 37%. Once that time is committed, it's time to move forward and make the best of what you've got.
I hope you enjoyed the reading! Please leave a comment below to share your thoughts, or make a suggestion of any articles you think I should highlight in a future column!
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 as well.
