Weekend Reading for Financial Planners (July 23-24)

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.

Advisers Asking DOL For Clarification On Fiduciary Rule's Impact On Compensation (Mark Schoeff, Investment News) - It's been three months since the Department of Labor issued its fiduciary rule, and the DoL reports that the biggest concern it's hearing is how (large firms) must change their compensation and incentive structures to comply. For instance, if the firm's business model relies upon revenue-sharing and 12(b)-1 fees, and offers a limited menu of investment products to their advisors (based on what asset managers will pay such incentives), is that compliant (because the advisors' compensation is level across the choices) or still a material conflict of interest (given what went into the selection process for those limited number of level choices on the menu)? In fact, the Investment Company Institute notes that the mutual fund industry overall is still trying to decide whether or how 12(b)-1 fees fit into the DoL's fiduciary future. More generally, the DoL notes that it has received a large number of questions that are basically just asking for clarification or further expansion on the rule itself, from the Best Interests Contract requirements, to key sections of the explanatory preamble that was issued alongside the rule; accordingly, the DoL has indicated that it will soon release additional guidance (perhaps in the form of a Frequently Asked Questions & Answers format), though no exact date for the release has been announced yet.

What's New In Advisor Technology? (Joel Bruckenstein, Financial Advisor) - As the pace of technology change accelerates, a gap is emerging amongst financial services firms, with some using the latest tools, and others still relying on software originally developed nearly 30 years ago. One of the most obviously notable trends in advisor technology is the whole "robo" movement, which started out as a direct-to-consumer movement but has exploded into an advisor technology trend in the past two years, from Schwab Intelligent Portfolios (which reports that more than 500 firms have signed up to use its Institutional offering) to Blackrock purchasing and offering FutureAdvisor to advisors, and a host of independent robo-advisor-for-advisors solutions including CLS Autopilot, NestEgg/Vanare, Marstone, Trizic, and Wealthminder. The trend now appears to be accelerating further, particularly amongst broker-dealers, where the Department of Labor's fiduciary rule appears to be a catalyst to accelerate the trend of technology adoption (even including wirehouses, given the recent UBS-SigFig deal). Though some companies note that direct advisor demand is also on the rise, as firms try to improve the client experience across all channels. In fact, the growing focus on the software experience - both for the end client, and the advisors who use the software - is itself a major trend in advisor technology, where for years companies competed largely on price and features, but not "user experience". Other key advisor technology trends include: the ongoing growth of interest in (increasingly sophisticated) financial planning software (as financial planning advice has been the anti-commoditizer to the robo-commoditization forces on investment management and asset allocation), and a growing range of financial planning software platforms with several new entrants; account aggregation as a tool for both giving clients a more holistic view of their net worth, and to provide operational efficiencies for advisors (e.g., reduced data entry as account aggregation automates data inputs/updates); and better analytics as advisors look for their technology to not just power their business, but provide relevant "big data" business intelligence about the health of the business and the tracking of its Key Performance Indicators.

Did Vestorly Just Right-Place, Right-Time Itself Into An Advisor Content Force With Dow Jones Deal? (Lisa Shidler, RIABiz) - The Vestorly platform is a B2B service for advisors that makes it easy for them to create customized content/news feeds for their clients, and last month the company signed a major deal to distribute the content of Dow Jones as a part of its platform. The deal appears to have gotten done in part because a major wirehouse approached Vestorly with interest, and Dow Jones came to the table to be a part of the distribution that the wirehouse's advisors would use. The upside for Dow Jones is that across all their media publications, Dow Jones produces 12,000 pieces of content per day, but struggles to get the right content to the right readers, which is where Vestorly's content distribution capabilities are appealing (including its "artificial intelligence" matching algorithms that try to share with readers the articles that would be most likely to interest them). And Vestorly readers will benefit by getting direct access to all Dow Jones content, including the Wall Street Journal, without going through the typical Dow Jones paywalls (though notably, Vestorly reports that a lot of the most popular shared content is actually weighted towards lifestyle, arts, culture, and leisure, not just financial news). The distribution potential for Dow Jones is emphasized by Vestorly's reported deals with more than 900 firms already on the platform, which include some major insurance companies and broker-dealers, having a potential reach of nearly 100,000 stockbrokers, insurance agents, and financial advisors (though Vestorly does not report what percentage of them have actually adopted and use the platform). With a major wirehouse deal looming - and the potential for more to follow - Vestorly has rapidly grown its staff headcount from 26 to 50, hired a new VP of Growth, and is preparing to raise another round of capital (to augment its $2M of angel capital in 2015 and $4.1M round earlier in January).

FinPlan Shootout: Finance Logix Review (Craig Iskowitz, WM Today) - FinanceLogix is a financial planning software solution that Envestnet purchased last year for approximately $30M. For the past year Envestnet has been working on integrating FinanceLogix into its flagship ENV 2 product, which will allow the client's investment data to automatically flow into the planning software (along with other data sourced from previously from Fiserv's CashEdge and ByAllAccounts, but soon via Envestnet's Yodlee acquisition, and a host of other third-party integrations), and also make it easier for the financial planning goals to be exported back to ENV 2 to create a new investment proposal. Notwithstanding the rising integration capabilities, though, Iskowitz notes that FinanceLogix is also a very capable stand-alone financial planning software solution as well. From the perspective of user (advisor) experience, FinanceLogix is well designed in some areas, but a bit "clunky" in others (though Envestnet has hired a U/X firm to help overhaul the interface), though it has the 'standard' dashboard interface to access clients and various planning modules. FinanceLogix was also an early player in the world of client Personal Financial Management (PFM) tools, in the form of both a client portal and a smartphone app, which both allows clients to self-enter key data, and gives them their own dashboard to keep track of their financial lives and run their own financial planning "what-if" scenarios. In terms of the financial planning capabilities themselves, FinanceLogix can accommodate both goal-based and cash-flow approaches to plan projections, and is broken into five core areas (Asset Allocation, Retirement, Education, Insurance, and Estate). The retirement plan module is built to be interactive, using real-time 'what-if' sliders to see what happens as plan assumptions change (though not with the same depth as MoneyGuidePro's "PlayZone" module). From a cost perspective, FinanceLogix is $1,080/year ($90/month) per license, or $1,620/year ($135/month) with data aggregation, placing it at comparable levels to most other financial planning software competitors, though ultimately Iskowitz ranks FinanceLogix slightly below the capabilities of MoneyGuidePro and eMoney Advisor (particularly in the areas of mobile accessibility, client portal, and user experience).

Explaining Differences In Funds' Securities Lending Returns (James Rowley & Jonathan Kahler & Todd Schlanger, Vanguard) - Securities lending is the practice of an broker/dealer (or sometimes an investor) loaning out a stock or other investment, most commonly to a short seller (who then sells the stock short, and later buys it back to return the security), who pays a small cost for the privilege of borrowing the stock (a securities lending fee). Securities lending is significant not only in the world of brokerage accounts, though; in the case of mutual funds and ETFs, securities lending represents an additional opportunity for the fund manager to generate income, which at least in some cases is used to defray the cost of the fund itself. Unfortunately, though, there's very limited data on whether or how much securities lending is being used by various asset managers. Overall, Vanguard finds that total securities lending income has been on the rise, generating $834M in 2014 from a subset of funds actively engaged in the practice, though total assets being loaned out is still only about 1% to 2% of total fund assets, and the securities lending revenue itself is only equivalent to about 2.7 basis points of fund assets (though the impact rises in bear markets, as more short sellers emerge and the demand for securities lending rises to facilitate the trades). In addition, Vanguard also finds that securities lending activity various by asset class, with the least activity in U.S. large-cap and fixed income, and the most amongst small-cap funds and sector rotation funds (where the most targeted short-selling seems to occur). Perhaps most notable, though, is that Vanguard could also measure clear differences in securities lending activity from one asset manager to the next, indicating that some appear to proactively use the strategy systematically across their entire fund complex, while others are not proactively engaged at all. Unfortunately, though, there was no apparent relationship between expense ratios and securities lending impact, suggesting that either securities lending is still too small of a total impact, or at the least that securities lending is not being used systematically as a benefit to fund investors to lower investment costs.

Capital Market Expectations and Monte Carlo Simulations (Wade Pfau, Journal of Financial Planning) - One of the virtues of Monte Carlo analysis is that it allows investors to see how varying sequences of return can lead to a wide range of financial outcomes, especially for retirees where ongoing withdrawals mean that different returns receive different money-weightings over time (given how much of the portfolio is or is not remaining when the return occurs). However, it's difficult for investors (or advisors) to then translate these returns back into what the implied straight-line investment return would have been to produce the same results, which matters as a baseline for determining and explaining what assumptions are being used in a retirement planning projection. For instance, a retirement plan that projects a 50/50 stock/bond portfolio for 30 years, assuming an arithmetic average real return of 5.6% (and a standard deviation of 10.8%), produces median wealth equivalent to getting a 5.1% return (the difference between 5.6% and 5.1% is due to the volatility impact of compounding), while the 5th percentile would be equivalent to a 2.0% average annual growth rate, and the 95th percentile is akin to an 8.3% return. On the other hand, for a retiree who is taking ongoing withdrawals, the results are slightly different, due to the impact of sequence of return risk - the median wealth result is equivalent to just a 4.9% real return, while the 5th percentile is only a 1.3% return, but the 95th percentile is a 9.3% return, as unfavorable results plus withdrawals drag the portfolio down but favorable results plus withdrawals still allow it to compound higher. The fact that sequence of return risk effectively drags down the implied returns of the Monte Carlo results, though, implies that if advisors are going to run straight-line projections for retirement plans, they should use at least slightly reduced returns, to account for the potential impact of withdrawals-plus-volatility (which is more significant than just volatility alone).

When The S&P 500 Breaks Out REITs, You May Get A Tax Bill (Laura Saunder, Wall Street Journal) - On September 16th, the S&P 500 and MSCI indexes will be shifting publicly-traded real estate investment trusts (REITs) out from the financial services sector (where they constituted about 20% of the sector), and into a sector of their own. For investors who hold financial-sector funds, this means a potential taxable event (at least in a taxable account) as the fund is compelled to liquidate the REITs that may have a gain to reinvest into the remaining financial services sector stocks. In addition, those who buy their investments based on sectors may also find themselves under-invested in REITs after the change, unless they explicitly go out to separately purchase a new REIT sector fund. Notably, some actively managed financial services funds use their own discretion about what constitutes the "financial services" sector, and either might choose to continue to own REITs, or alternatively may not have been owning much in REITs already. Accordingly, the impact will be most noticeable on financial sector ETFs and other index-tracking funds, that must by definition change their investments and reconstitute themselves to match the official changes in the indices. In fact, the Financial Select Sector SPDR from State Street plans to split the fund proportionately for all investors on the switchover date, providing them a new Financial-Services-only sector ETF and a new REIT sector ETF in the appropriate weightings - a strategy to both minimize the tax consequences of the split (as the new REIT shares will be paid largely as an in-kind special dividend), and also potentially reducing the market impact of the requisite trading activity that would otherwise have to occur (given that the REIT portion of the financial services sector has a whopping $609B of market cap). Other financial services funds are choosing to simply wind down the REIT positions leading up to the switchover... which means it will also vary fund by fund as to whether any tax consequences will occur (with Vanguard and Guggenheim reporting no anticipated impact, but Fidelity stating that it's too early to tell yet).

Death Of The Risk-Free Rate (Chris Brightman, Research Affiliates) - With global bond yields continuing to decline, including and especially on government bonds (where some have even reached zero or turned negative), the whole concept and assumption that modern finance is built on a "risk-free" rate is under fire. In fact, negative risk-free rates can potentially lead to a desire for new forms of money, when there is effectively a new form of "storage cost" to hold money as such, rather than reinvesting it into other physical goods or forms of capital. Fortunately, technology is already facilitating much of this, as virtual currencies using blockchain technology compete as a potential unit of account, and using cash as a medium of exchange is less and less relevant in a world of credit cards (or linking a credit card or mobile payment app directly to a brokerage account to pay for food and drink with the latest stock dividend!?). Yet as investors choose to store their value not in 'money' and 'risk-free' government bond assets, but instead in other forms of digital or real/capital assets, the entire mechanism of central banks manipulating interest rates to drive consumer/investor behavior just breaks down further, and even threatens the ability of the Fed to serve as a lender of last resort if investors don't hold the bulk of their assets in banks but in securities, where the "run on the bank" risk is not the risk that a bank fails but that a securities firm goes under (for which the Fed has very limited lending/funding tools to provide a bailout). In the meantime, the limited impact of traditional interest rates as a form of monetary policy are raising the questions of whether central banks will pursue more direct monetary injections, which still risks unleashing new inflation. On the plus side, Brightman suggests that declining yields and central bank impotence have stoked a fear of deflation, which means some inflation-hedging asset classes are "on sale" (by trading at a discount or providing more appealing defensive yields), such as commodities, bank loans, REITs, and emerging markets.

The Laws Of Capitalism Are Being Rewritten (Josh Brown, Reformed Broker) - The foundation for investors today is Harry Markowitz's Modern Portfolio Theory, and Bill Sharpe's Capital Asset Pricing Model that was built on top of it, which aims to explain all investment returns as a combination of the risk-free rate and a return premium for risk. Yet as government bond yields move lower and lower - and in some countries, have gone to zero or even negative - these models for evaluating investments appear to be breaking down as the risk-free rate approaches zero and behaviors around investments and debt appear to be changing. For instance, Quantitative Easing ended 19 months ago, and the stock market hasn't cracked, which is raising questions after the fact about whether or how much QE was actually driving stock returns while it was in place (given that its end doesn't appear to have done much to abate the bull market). Similarly, margin debt peaked 13 months ago, and while historically contracting margin debt was also an indicator of a market top, instead the market continues to make new highs. Continuing the theme, household fund flows have turned negative and the pace of selling has accelerated, yet still the market makes new highs (most recently during a time where corporate buybacks were mostly in a blackout period as earnings season approached, so apparently corporate buybacks aren't/weren't the driver either). Further complicating the situation is the fact that even for "risk-free" government bonds, the biggest driver of government bond returns is the price return and capital appreciation (as rates continue to decline), which are trumping the actual bond yields by as much as 5:1. And some of the most "expensive" parts of the market are the ones that would usually be the most defensive, as investors pile into high-dividend stocks and "low volatility" funds are enjoying the biggest investor inflows for the past year, leading blue chip stalwarts like Hershey to trade at a whopping 25x earnings (despite mere single-digit earnings growth). In other words, bonds are now the new stocks driving capital appreciation, while stocks are the new bonds for generating income, and the links between volatility and reward are steadily being shattered.

How Millionaires Under 40 Manage Their Money (Jonnelle Marte, Washington Post) - A recent World Wealth Report by Capgemini reveals some interesting new trends in how millionaire under 40 are investing and managing their money. One revelation is that young millionaires are even more conservative than their Baby Boomer counterparts, and are significantly more likely to hold cash. In fact, the study found that young millionaires are holding about 1/3rd of their total assets in cash, either physical cash or money kept in the bank (e.g., in a checking account); some were holding cash to be ready to pounce on the right (investment) opportunity when it arises, while others were holding cash to live their lifestyle (perhaps an lingering behavioral impact of their prior years of holding hefty student loan debts?). In addition, young millionaires are less likely to invest in stocks, and are more inclined to invest in various alternatives like real estate or in a business (e.g., their own); more generally, they appear to be far more likely to diversify very broadly, beyond "just" traditional portfolios. Other notable trends from the study: young millionaires are more likely to turn to family, friends, and the internet for financial guidance, than to turn to a financial advisor (with only 17% of young millionaires using an advisor, compared to 27% of all millionaires); and young investors increasingly want to see that their dollars are invested towards social causes that matter to them (i.e., socially responsible investing strategies).

Apps That Make Saving As Effortless As Spending (Ann Carrns, New York Times) - A wide range of new software tools and smartphone apps are beginning to crop up to help consumers save. For instance, Qapital allows users to set up multiple (shorter-term) savings goals, and transfer cash into savings based on certain rules - such as depositing $5 into their savings account every time they buy a latte - and tying the savings goal to easy tracking (via account aggregation) and visual images (e.g., a picture of the goal) appears to be helping to actually change their behavior. Similar apps to help automate savings behavior without thinking about it include Digit and Dyme, and an app called Acorns helps contribute savings not just to a bank account but actually invest spare change into a brokerage account to buy stocks (via ETFs). Notably, many attribute the growing consumer challenge of insufficient savings to the increasingly "frictionless" ability to buy anything we want (between credit cards and now smartphone payment systems), and so the hope is that apps which allow for frictionless saving may help to turn the tide (e.g., by pulling small ongoing savings contributions most consumers wouldn't notice anyway, but can substantially add up over time). Unfortunately, though, because most of the apps are "third-party" tools and not financial institutions themselves, using them requires granting access to bank account numbers and passwords (to link the accounts), which makes some users nervous about account security. And because the apps are usually not tied directly to a financial institution, they must make money by charging their own fees, although with small accounts even small fees (e.g., Acorns charges $1/month) can add up quickly until/unless users get some real momentum on their savings. Still, in a world where 41% of households lack the liquid savings to cover an unexpected $2,000 expense, anything that helps to facilitate some improvement in a "pay yourself first" form of automated saving is arguably a good thing.

Financial Stress Hurts, Literally (Diana Kwon, Scientific American) - A recent study by Eileen Chou in Psychological Science finds that the financial stress of economic insecurity - e.g., when facing unemployment or mounting debts/bills - can literally lead to feelings of physical pain. The study analyzed 33,720 households and found that those with higher levels of unemployment were more likely to purchase over-the-counter painkillers, and in a follow-up experiment found that simply thinking about financial insecurity can actually increase feelings of pain (e.g., subjects who were primed to feel anxious about future employment prospects had less physical pain tolerance when holding their hand in an ice bucket). This connection between financial insecurity and decreased pain tolerance may also help to explain why and how the recent recession may have been a factor in fueling the country's prescription painkiller epidemic. Notably, other studies have also found that financial stress appears to amplify emotional pain as well (e.g., making less money intensifies the pain felt from difficult life events, from divorce to poor health and loneliness), as we feel less in control of our own lives. Fortunately, though, other studies have found that social support can help protect against both the psychological and physical pain associated with financial stress... raising the question of whether a good financial planning could play a similar pain-ameliorating role, too?

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, you may want to check out this recent video - a trailer for a new 'documentary' film from Mark Hebner of Index Fund Advisors and Robin Powell of Evidence-Based Investor - which goes in depth into the history of investments and market theory, the problems with various forms of active managers (from stock pickers and manager pickers to "time pickers"), and the rising role of index funds, based on Hebner's recent book on the topic.

You can view the somewhat controversially titled "Index Funds: The 12-Step Recovery Program for Active Investors" trailer below, and check out full film here.