Weekend Reading for Financial Planners (Jun 27-28)

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 June 27th/28th:

Schwab Rolls Out Robo Offering for RIAs (Charlie Paikert, Financial Planning) - This week Schwab announced the launch of its "Institutional Intelligent Portfolios", the counterpart to its direct-to-consumer "Schwab Intelligent Portfolios" solution but made for RIAs to use in servicing their own clients. The RIA version will allow advisors to choose from a list of over 450 exchange-traded funds across 28 asset classes to build their own custom models, and requires a minimum allocation of 4% in cash. The minimum account size will be $5,000, and tax-loss harvesting can be automated for accounts over $50,000 (to be turned on or off at the discretion of the advisor). Accounts can be opened and funded via a paperless onboarding process, go through an initial questionnaire to get matched to the advisor-designed portfolio based on investing goals and risk tolerance, and with the advisor's client agreement can be enrolled for electronic delivery of trade confirmation, statements, and other communications. Clients will then be able to access the account either using the Schwab Alliance platform or through a dedicated website and mobile app. The offering will cost 10bps for advisors who have less than $100M of AUM already under custody with Schwab, and will be free to RIAs over the total custodial asset threshold; Schwab is expected to make its profits off both the cash position (which will be held in Schwab Bank), and any revenue it generates from the ETFs that are included. Advisors will be able to charge whatever AUM fee they wish for themselves, layered like any other AUM fee on top of the investment offering. Notably, though, Schwab Advisor Services head Bernie Clark predicts that ultimately advisors will segment their clients and eventually "run two businesses - a traditional model, and one for clients under 45" due to the differing tactics necessary to service each.

Marketing Matters To Firms That Want To Grow (Eliza De Pardo & Dan Inveen, Investment Advisor) - For many advisory firms, a lack of emphasis on marketing and business development is a point of pride, viewed as less essential than the delivery of superior client service. Yet as advisory firms get larger - and especially with the potential that at some point markets (and AUM-based revenue) may pull back - the challenge of sustaining growth becomes more critical, and can be especially problematic as firms discover their marketing skillsets are so underdeveloped. In fact, the latest FA Insight study finds that only 13% of firms assess their own marketing plans as effective, and half of firms have no marketing plan at all, despite the fact that 70% of firms now state that marketing will need to play a role in their future growth. Amongst the firms that are executing marketing and business development well, the study found that those firms note only had outright higher growth rates, but were more likely to have a marketing plan, and have a staff position dedicated to marketing or new client growth. Notably, though, the study found that the best growth firms are actually spending less revenue on marketing activities; their superior growth rates came not from spending more, but utilizing their marketing dollars better and executing more effectively, including the fact that all the advisors of the top firms spend about 20% of their day on business development activities. The study also found that the top growing firms are more likely to have a clear target market (at the least defined by criteria like asset minimums, but ideally a more targeted niche as well), and those firms rely on client referrals for 'only' 50% of growth, with the rest coming from external professional referrals, COI relationships, mergers and acquisitions, media, and other channels.

James Osborne Makes A Waiting List Part Of His New RIA's Business After 18 Months (Scott MacKillop, RIABiz) - This article is a profile of Jason Osborne of Bason Asset Management, a 32-year-old advisor in Colorado with a unique advisory firm structure that charges a $4,500/year flat fee (billed quarterly) for investment management... and in under 3 years, has grown to serving about 50 clients and almost $100M of AUM. Client portfolios are passively managed using index funds, and work with Osborne directly for both investment management and financial planning services. Growth has come heavily from the fact that Osborne's fee structure is significantly less expensive than 'typical' AUM fees for his average-of-$2M clientele, and the unique structure resonated especially well with attorneys and CPAs in his area who provide him referrals. Growth has also been driven by Osborne's efforts in blogging and social media (especially Twitter), which took about 18 months to gain momentum but is now the primary driver of his firms' growth.  Notably, some critics raise the question of whether Osborne's business model will face challenges as it grows and becomes more complex and potentially needs more staff and infrastructure. Though on the other hand, Osborne estimates that he can service more than enough clients to comfortably sustain the business and his own lifestyle.

The Best Way For Advisors To Stand Out (Angie Herbers, ThinkAdvisor) - With the ongoing crisis of advisor differentiation, it's becoming harder than ever for advisors to stand out; in the past, just being "independent" or "fee-only" or a "fiduciary" or simply an actual "financial planner" was sufficient to be different, but that's no longer the case as the number of advisors proliferate. In turn, some advisors try to differentiate with their culture of how they serve clients... though Herbers suggests that ultimately that approach will be doomed to fail if it's not consistent with who the advisor really is in the first place. Other firms try to differentiate with their process and approach, though here again Herbers notes that creating a process can only go so far if it's not consistent with the style of the advisor in the first place. In fact, ultimately Herbers suggests that the real key for any advisor is simply for the business to reflect their own authentic passion, whatever that may be; if you love to construct portfolios then build a business to do that, and if your passion is helping other business owners then do that instead. When your build a business around the areas you're most passionate about, that's also what will show through when you talk to prospects - and you should show that passion when you talk to a potential client! - inspiring the confidence that is necessary for them to want to hire and work with you over anyone else. And in a world where so many people have no passion for what they do anyway, that passion-inspired confidence may be the best differentiator of all.

Is Sales Or Better Client Retention The Best Way To Grow An RIA Firm? (Iris.xyz) - The traditional approach to growing a business is to devote more resources to sales and marketing efforts to get more clients. Yet the unique recurring-revenue structure of advisory firms, especially when attached to assets under management that grow (at least on average) over time with the market's real rate of return... means that client retention is a uniquely effective strategy for growing an advisory business. After all, if the market can nearly double a portfolio on average in a decade, then an advisory firm's revenue can double over the same decade, just by keeping its current clients - a notable benefit over the retainer model, which lags the growth of AUM revenue over time! In addition, advisory firms also have the unique opportunity to grow by referrals from existing clients, which itself becomes a compounding benefit - as  a firm grows from 50 to 100 clients, a 5% referral rate generates twice as many new clients as well! And improving a firm's retention rate also ensures there are more clients that remain in the business to refer as well! When projected over the next 10 years of an advisory firm's growth, these dynamics mean that improving client retention rates (e.g., from 90% to 95%) and/or client referral rates (e.g., from 5% of clients to 10% of clients referring) can actually drive far more revenue growth than just getting one new client at a time from external non-client channels. Of course, a focused investment into external marketing strategies can produce more growth as well, but ironically still may not scale as effectively as improving retention and improving referrals from those retained clients. Of course, many advisory firms already try to serve clients well and drive referrals, but the authors suggest that if firms are really serious about executing such a growth strategy, they might even consider hiring a "Director of Client Success" - a position that has become popular in technology firms that also have a recurring-revenue price structure - whose sole job is to focus upon and take responsibility for client satisfaction and to help drive referrals from those satisfied clients.

How Small Mistakes Can Boost Your Credibility (Dan Richards, Advisor Perspectives) - As professional advisors who are paid for their expertise, there's often a great deal of pressure on us to try to appear 'perfect' and all-knowing, for fear that anything less will cause clients to lose trust and faith. Yet such an approach often comes across as being 'overly' polished, and trying to hard to get someone's business tends to make prospective clients defensive, as they feel like they're being 'sold'. Instead, Richards notes research on what's called "the pratfall effect" - where people who make small mistakes are actually viewed as more attractive and appealing. In the context of working with potential clients, this means that having - and admitting to - minor stumbles with a prospect can actually improve credibility, as it makes us seem more authentic and believable (assuming we're otherwise viewed as a credible expert in the first place and the mistake isn't serious enough to actually challenge that core expert credibility). For instance, one study found that when experts express uncertainty about a minor point, it reinforces the overall credibility of their core expertise. The bottom line - it's ok to make and admit small mistakes with a potential client, as making yourself more vulnerable can actually help you make a better connection as a credible expert!

Why 'Smart Beta' Is Really Dumb (Michael Edesess, Advisor Perspectives) - Smart beta strategies have exploded in popularity in recent years, with 164 U.S. equity smart beta ETFs coming out in 2013-2014, and hundreds of recent academic papers about the 'factors' that underlie smart beta strategies. The concept of factor investing dates back to the famous 1992 paper by Eugene Fama and Kenneth French, entitled "The Cross-Section of Expected Stock Returns" which found that market returns have substantial dependencies on the 'factors' of small cap and value, such that by overweighting stocks with those factors, it seemed possible to generate superior risk-adjusted returns. Notably, at the time the concept was attacked as little more than data-mining, especially because there was little explanation at the time of why such outperformance for small-cap and value would be expected (rationalizations of why this might be occurring only came later). Yet as the underlying results have since been supported, ironically what was once called "data mining" is now sometimes labeled as "evidence-based investing" instead, even though much of the small-cap effect itself appears to have dissipated since its discovery over 30 years ago. In fact, Edesess raises the question of whether the explosion of factors 'discovered' since then also amount to little more than adding layer upon layer of data mining, with factors that have little theoretical basis in advance and are only justified and rationalized after the fact. Especially since, even once the 'factors' have been identified, there is still the challenge of constructing an actual portfolio of stocks that will contain/embody those factors on a consistent basis (which can be even more challenging to create on a forward-looking basis!).

Buyback Extravaganza (Patrick O'Shaughnessy, Investor's Field Guide) - In recent years, there has been a rapid uptick in the pace of corporate buybacks, to the point that articles in the Wall Street Journal are raising concerns about whether the buyback pace merits some caution. Yet while O'Shaughnessy does note that the total dollars being spent on buybacks today has nearly reached the levels seen in late 2007 (and we all know what happened next!), when the buyback flows are measured relative to the total market capitalization of stocks (which is higher than it was in early 2008), the buyback volume is not nearly so concerning (only slightly above the average of the past 30 years and well below the early 2008 peak). In addition, when looking at buybacks it's also important to look at the magnitude of those buybacks - companies that are buying back 10% of its shares in a year are behaving very differently - they appear to have a 'higher convinction' - than those that 'just' buy back 2% or so. And O'Shaughnessy finds that the highest conviction buyers really do tend to perform those buybacks when their stocks are at the most favorable valuations (based on metrics like price/book and price/sales ratios); overall, 14% of the highest conviction buybacks occurred at the cheapest valuations, while only 1% of them were conducted at the highest valuation extremes. Furthermore, O'Shaughnessy also finds that in recent years, companies that have been buying back stock while issuing debt are generally performing even better than those who buy back shares but also pay down debt (ostensibly due to today's ultra-low rates). The bottom line: while buybacks are high in absolute dollar terms, the buyback yield remains only slightly elevated, buybacks really do appear to be more likely to be occurring at cheaper (more favorable) valuations, and buying companies that are doing so - even at the 'cost' of issuing debt and not paying it down - appear to actually be favored in today's low-yield environment!

Risk Parity Is Even Better Than We Thought (Cliff Asness, AQR Perspectives) - While risk parity may not necessarily be helpful as a short-term tactical strategy, Asness makes the case that its long-term strategic value is even better over 'traditional' 60/40 portfolios than once believed. The key distinction is to recognize that in practice, most people don't own a risk parity strategy or a 60/40 portfolio; instead, they carve out a portion of a 60/40 portfolio to allocate to risk parity. Which means it's not necessarily about whether an all-in risk parity strategy has a better Sharpe ratio than a 60/40, but whether a 60/40 is incrementally improved by diversifying into risk parity for some of the assets (where even a comparable Sharpe ratio may be appealing if the strategies have a low correlation). And the distinction is important - to go all-in for risk parity would require an expectation of substantial performance (especially given implementation costs), but the hurdle for it to be a relevant diversifier is much lower, especially since the diversification impact is most significant for the first dollars added (i.e., going from 0% to 10% of risk parity adds more diversification than going from 90% to 100%). In fact, Asness finds that if risk parity strategies 'merely' have a 0.7 correlation, and have a cost-implementation drag of 4% over their 'theoretical' gross historical returns, the resulting blended portfolio of risk parity and 60/40 is still comparable to the traditional approach. And even if risk parity merely matches the returns of a 60/40 portfolio, an allocation of 80% to a traditional portfolio and 20% to risk parity still produces a superior Sharpe ratio 96% of the rolling historical 10-year periods. The bottom line: just as with other asset classes and investment strategies that are diversifiers, there are times when it makes sense to add an investment to a portfolio, even if you don't expect it to have better risk-adjusted returns on its own, because its low-correlation diversification still improves the overall portfolio... and that approach is equally relevant when considering risk parity as well (though notably, Asness still believes risk parity can have superior returns as well!).

Richard Thaler's "Misbehaving" And Implications For Investors And Advisors (Joe Tomlinson, Advisor Perspectives) - Richard Thaler, one of the leading reseachers in behavioral economics, has recently released a new book called "Misbehaving", which is a combination of Thaler's personal memoir as an academic researcher and a retrospective look at the rise of behavioral economics as a recognized discipline. Tomlinson notes that the book is a striking complement to Kahneman's "Thinking, Fast and Slow" given that Kahneman studied human decision-making from a psychologist's point of view, while Thaler approached the issues from an economics perspective. In both cases, though, the key distinction is the difference between "normative" theories - how we expect people to behave - versus "descriptive" theories that look at how people actually do behave (in not always rational ways). For instance, normative theory suggests humans are at least mostly rational, and therefore that markets should be efficient, while descriptive theories recognize that we do not actually behave that way and as a result certain investment opportunities may become available; thus, from a normative perspective, phenomena like predicting markets using Shiller's P/E10 ratio shouldn't work persistently, but the behavioral view recognizes that markets may in fact continue to overshoot and that P/E10 can be useful (at least at extremes). The growing body of behavioral research is now also aiming to address issues like the so-called "annuity puzzle" (given the efficiency of annuities to maximize lifetime retirement income for those without a bequest motive, why don't more people buy them?), how to encourage people to save more towards retirement, and are there better ways to tackle the de-cumulation challenge in retirement. On the other hand, the concept of developing government policies to encourage such behavior has itself become controversial, raising the question of whether it's too "paternalistic" and intrusive for government to try to shape behavior using these behavioral concepts.

Why You’re Paying Too Much in Fees (Jason Zweig, Wall Street Journal) - While the topic has been increasingly popular within the industry, in this article it's Wall Street Journal columnist Jason Zweig who makes the case that the AUM fee is becoming outdated... suggesting that most advisors charge "absurdly high fees to manage your money... often with mediocre results." Notably, Zweig actually advocates that there is significant value from financial advisors, in the form of financial planning expertise... but that as robo-advisors make the cost of basic portfolio construction as cheap as 0.25% or less, it is increasingly "bizarre" for advisors to charge for their financial planning expertise on an AUM basis. Especially since much of the value of financial planning advice is specifically what comes outside of the portfolio, from strategies on debt management and saving for college, to income and estate tax planning, retirement spending, and more. After all, an estate planning attorney doesn't charge 1% for drafting a Will to handle the distribution of your net worth after death, and an accountant doesn't charge 1% of income to prepare a tax return... so why do financial advisors charge 1% of investment assets for their services? While arguably asset-based fees were at least an improvement over commissions, especially with respect to conflicts of interest, Zweig notes that AUM-based advisors still face their own conflicts, and that on the progression of reducing conflicts of interest, there's also something more to be said for advisors who charge a standalone fee for service as well. And recent Cerulli research suggests such an approach is on the rise, albeit slowly - the number of advisors expecting compensation from retainers, hourly, or annual fees, is projected to rise to 16% over the next 3 years, up from 14% now.

Personalized Technology Will Upend the Doctor-Patient Relationship (Sundar Subramanian & Carl Dumont & Christoph Dankert, Harvard Business Review) - The rise of wearable technology, implanted devices, and smartphone apps for continuous monitoring of health, is creating an environment where it may soon no longer be necessary to get most/all medical treatment directly via a doctor's office or hospital. Instead, everything from telemedicine to home diagnostics and retail clinics will allow patients to be served where they live and work. The authors suggest that ultimately two business models will emerge in this new landscape - analogizing to the Gold Rush of the 1840s, businesses will either become "Goldminers" who dig deep in one area, or "Bartenders" who offer customized and convenient options to address routine needs. The Goldminers will be large vertically integrated players (e.g., insurers, hospitals, and physicians' groups) that serve the 30% of patients with complex conditions that comprise 75%+ of actual medical spending - serving those patients more efficiently and effectively with technology-supported solutions. The Bartenders, on the other hand, may well be new entrants that even-more-heavily leverage technology to disrupt the traditional doctor-patient relationship. For instance, a woman with random heart palpitations might buy her own ECG and a lifestyle app on her smartphone to track her own situation, gather a rich data set that integrates together her exercise, diet, sleep, and medications, to look for patterns, and then submit her data periodically to a remote doctor to evaluate the situation - rather than the "traditional" approach of visiting a doctor up front to diagnose and evaluate the situation. And in the extreme, the app and tracking service might even detect a heart attack that is imminent or just occurring, becoming a form of "OnStar" for healthcare that allows for an emergency call on the spot. And notably, while the article is written in the context of health care and the doctor-patient relationship, it arguably has significant parallels for financial advisors as well, with the rise of Goldminers like Vanguard, Schwab, and Fidelity serving consumers directly, and both robo-advisors and personal financial management apps as a form of Bartender strategy that is changing the role of how advisors related to clients.

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!