Weekend Reading for Financial Planners (May 13-14)

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 May 13th/14th:

Testing DALBAR's Claims About Mutual Fund Investors (David Blanchett, Advisor Perspectives) - The DALBAR Quantitative Analysts of Investor Behavior (QAIB) report has long been cited by the financial services industry as "proof" of how (mutual fund) investors make poor timing decisions that result in a gap between the returns of investment markets and the returns of investors themselves, by as much as 600 basis points per year. Yet a number of articles in recent years have questioned the accuracy of DALBAR's reported 600bps behavior gap in investment results, from a guest post here on Nerd's Eye View years ago, to a more recent analysis by Wade Pfau. The issue generally isn't whether there is an investor behavior gap, but the magnitude; for instance, Morningstar's "Mind The Gap" research from Russ Kinnel finds a behavior gap of "just" about 100bps per year - which is sizable, but 1/6th the DALBAR results. In fact, it's actually hard to believe that investors could be underperforming by as much as 600bps, given that asset-weighted alpha must add up to zero before fees; in other words, just as the market in the aggregate can't outperform itself (and thus why positive alpha is a zero-sum game), so too must negative alpha be a zero sum game. Of course, mutual fund investors aren't the whole market - and the data is clear that investors tend to add more to funds at market peaks, and withdraw at market bottoms, suggesting there is some timing loss (with the opposing gains ostensibly going to the non-mutual-fund investors on the other side of those purchase/redemption trades). But the gap in the DALBAR data in particular appears to be, as noted previously on this blog, an apples-to-oranges comparison of a lump sum investment to someone who dollar cost averages. In other words, DALBAR appears to compare investor to investing returns over the past 20 years by looking at the cumulative return of markets over 20 years, versus actual investor inflows and outflows over the past 20 years... which fails to recognize that a substantial portion of the investor dollars are simply people earning money and adding it to their savings over time, which means they didn't miss the bull market of the late 1990s by bad timing, but simply because they didn't have the wealth to invest dalyet! In addition, DALBAR compares all equities to the S&P 500, rather than segmenting asset classes more specifically, or using a broader-based total market index. By contrast, the Morningstar "Mind The Gap" analysis actually looks at the dollar-weighted internal rate of return calculation of each mutual fund itself, considering all the intervening cash flows as investors systematically save (and also add and subtract due to market timing). Extending the Morningstar analysis further, Blanchett evaluates the internal-rate-of-return comparisons of mutual funds by Morningstar category against their actual benchmark index returns, and finds that the behavior gap since 1990 was -1.56% in broad equity asset classes and -1.28% in fixed income (although notably, the behavior "gap" for intermediate government bonds was actually a positive 0.60%!). And notably, the bulk of these timing issues were actually in the 1990s, and for a period were actually positive; overall, the average five-year behavior gaps are just -0.32% for equities and -0.16% for fixed income, and the behavior gap actually appears to be shrinking over time. Although DALBAR has already posted a response to Blanchett's article, the bottom line conclusion from Blanchett remains: DALBAR's numbers are wrong, and should not be cited as evidence of the investor bad-market-timing behavior gap, though the behavior gap is real and affirmed by the mutual fund data (just to a much smaller extent than what the DALBAR study suggests).

Six Social Media 'Can Do's' From FINRA Update (Richard Satran, Reuters) - Last month, FINRA issued Regulatory Notice 17-18, which provides further clarification on a number of "grey" areas regarding how broker-dealers and their registered representatives can use social media (without violating the rules on advertising to, and communication with, the public), particularly when it comes to using/posting third-party material. The basic rules remain the same: that electronic communication should be archived, that advertising about products and services should be reviewed, and that neither may be misleading or offer unrealistic promises or guarantees (regardless of where/how it is published). The specific points of clarification from FINRA include: 1) Broker-dealers can use social media sites that allow the public to make comments that are unsolicited (even if they "Like" the content or make positive comments that read like testimonials)... in other words, posting content to Facebook or LinkedIn, where consumers (including clients) might comment or click "Like" is OK, and doesn't constitute a testimonial; 2) social media posts can include articles/content of 'social interest', from sponsored charitable events, to job openings, or "human interest" items, and those posts are not subject to FINRA Rule 2210 on advertising and are considered personal posts, as long as the post is not about the firm's products or services; 3) firms can post links to third-party websites and articles on those websites (yes, that includes permission to share our Nerd's Eye View articles!), as long as the content isn't known to be false or misleading, the site is independent, and the broker-dealer doesn't have influence or control over the third-party content (and if they do, that third-party content is adopted as the broker-dealer's and becomes subject to compliance/advertising review); 4) It's permissible to respond to inaccuracies on third-party sites, to correct factually inaccurate information, without having it considered firm communication that requires review; 5) broker-dealers can publish "native advertising" (i.e., sponsored post) articles in the media, as long as it's clearly labeled as such; and 6) Registered reps can share a favorable social media comment with customers or the public, though it must be labeled as such.

Merrill To Halt Conventional Recruiting, Test Salary Plan (Jed Horowitz & Mason Braswell, AdvisorHub) - After years of participating in expensive recruiting battles for veteran brokers, Merrill Lynch will reportedly stop offering signing bonuses to experienced brokers as of June 1st, to be replaced with a new hiring package that will only rarely be available to the rare "franchise" player from another big firm and will require heavy vetting. The Merrill recruiting pullback follows on a similar announcement last year by UBS, though a growing number of analysts have questions for years whether wirehouses were even able to profit at the available payouts, which in many cases exceeded even the valuation multiples of sizable independent RIAs! However, while Merrill is winding down its lucrative recruiting deals for "big" brokers, it is rolling out a new "Professional Transition Advisors" (PTA) program targeting brokers with 3-8 years of experience, who have the CFP marks or similar certification, and will offer them a core salary as compensation (supplemented by a small grid-based payout and performance-related bonuses), which will transition to a conventional "grid" program after 3 years. Merrill apparently hopes the new PTA program will attract brokers at regional broker-dealers like Edward Jones, Baird, and other mid-sized independent broker-dealers and banks, who would be attracted to the compensation stability and resources of Merrill. In addition, Merrill is also renewing its support for its Practice Management Development (PMD) program, its 43-month training program for new advisors. Overall, the changes suggest that Merrill is aiming to make a substantial generational shift in its broker workforce, to those who are more focused on financial planning and working on teams, rather than continuing to recruiting amongst the generation of veteran big-producing brokers.

RIA M&A Activity Hits All-Time High But Average Sellers Are Smaller (Charlie Paikert, Financial Planning) - Industry M&A tracking firm DeVoe & Company reports that there were 44 transactions for independent RIAs in the first quarter, which was the highest number the tracking service has ever recorded in a single quarter. However, the composition of firms being sold is shifting, with more "smaller" firms – with $100M to $250M of AUM – now being sold, and, as a result, the average AUM of sellers this quarter was "just" $588M compared to an average of over $1B per seller in 2016. In addition, the nature of the buyers is changing as well; bank transactions comprised 16% of all RIA deals last quarter (up from an average of just 2%-3% per quarter), a whopping 60% of deals were from aggregators (e.g., Focus Financial, HighTower, Snowden Lane, and Mercer), and a whopping 22% of all (non-breakaway) RIA transactions in Q1 were done as "sub-acquisitions", which are purchases by larger RIAs that themselves were previously purchased by an even-larger investor (e.g., Buckingham, Colony Group, etc.). And involvement of banks in particular is also driving up advisory firm valuations, as banks view RIA acquisitions as more strategic, with the potential for cross-selling that increases the relative value; overall, RIAs in the $100M to $250M range are being sold for 4-6X EBITDA, while those with $250M to $750M are selling for slightly more, and $750M to $1.25B firms are valued at 6-8X cash flow (while "mega" firms at $1.25B+ are getting valuations of 9X EBITDA or more). Although it's not entirely clear what's driving the uptick in sales now, DeVoe suggests that fears about economic and market uncertainty, after 8 years of a bull market, and a controversial new president, could be driving sales... and of course, the average age of experienced advisory firm owners continues to move further towards retirement age over time as well.

Advisor Interest In SRI Nearly Doubles Since Last Year (Karen DeMasters, Financial Advisor) - In the recent Eaton Vance Top-Of-Mind study, a whopping 40% of advisors now report that socially responsible investing is important to them and their clients, up from only 21% who said that in 2016. Eaton Vance suggests the uptick may be, at least in part, an indirect backlash against the election of President Trump, with some clients who are concerned about his policies on environmental and social issues, and therefore deciding that if the White House isn't going to promote environmental and social causes, they will do so directly with their own money. Though the rising uptick in socially responsible investing has been underway for several years already – predating the election – and appears to also be driven by demographic trends (with Millennials more interested in SRI), and a growing number of research studies suggesting that good governance practices can actually lead to better performance anyway (and that SRI isn't an "alternative" to maximizing returns, but actually a path to doing so). Other notable statistics in the latest Top-Of-Mind study included: 53% of advisors are bullish/optimistic on U.S. equities, though 40% believe the market is overvalued, and 52% are bearish on the bond market; in addition, there was a 16% increase in advisor interest in finding income for their clients over the last quarter (as more and more advisors shift to a focus on retirees and their retirement income needs?).

Vanguard's RIA Leaps To $5B/Month As Schwab's RIA Robo Jumps To $1.3B/Month (Ramsey Flynn, RIABiz) - The first quarter results are out, and Schwab's Intelligent Portfolio solution added $3.6B in the first quarter, and it has grown as much in the past 9 months as it did in the first 15 (now approaching $16B in AUM). Notably, Schwab does acknowledge that almost 2/3rds of the robo assets were already on Schwab; nonetheless, that still means that Schwab has brought in more than $5B of external assets through its robo program. Though the Schwab growth numbers still pale in comparison to Vanguard's Personal Advisor Services, which hit $65B by the end of Q1, up a whopping $15B in just 3 months. Notably, though, Vanguard's superior growth is also for a substantively different service, as the firm is building not around a "robo" service, but a whopping 500 financial advisors with CFP certification (up from just 400 last August). And even Schwab, despite the growth in its robo, is pivoting to a human-based advisory service as well, with the launch of Schwab Intelligent Advisory (which pairs together its Intelligent Portfolios investment solution with a CFP professional). Given these successes, all eyes are now on other retail brokerage competitors like Fidelity and TD Ameritrade, and whether they will pivot to offering such "cyborg" tech-augmented human advisor services as well, especially given the fact that Fidelity acquired its own robust financial planning software, eMoney Advisor, two years ago, and arguably TD Ameritrade's Selective Portfolios (formerly known as Amerivest) already is a robo/human advisor hybrid (albeit not staffed by CFP professionals). Though notably, perhaps the real question is whether the sheer volume of cyborg advisor growth from firms like Vanguard and Schwab will impact the rest of the independent advisory community as a competitive threat, given that the two companies are on pace to grow at nearly $80B of AUM this year alone, which would represent 2% of the growth rate of the entire RIA community!

Morningstar's New Funds Gambit: Opportunity Or Controversy (Beverly Goodman & Leslie Norton, Barron's) - Morningstar was founded 33 years ago by Joe Mansueto on the principle that individual investors needed more, and better, information. And as the mutual fund (and now ETF) industry proliferated, so has Morningstar's role in helping investors, and increasingly advisors as well, sort through the choices, most commonly through their data and research services, and their popular (albeit sometimes controversial) star ratings. But now, in an effort to further expand their scope with financial advisors, Morningstar has announced that it is launching its own family of nine mutual funds, which some view as an inevitable necessity as the rise of passive investing has diminished the demand for Morningstar's data and expertise in evaluating the predominantly-active mutual fund landscape and researching individual stocks and bonds. Ironically, Morningstar may have so effectively educated investors about the poor performance of the mutual fund industry, that it is rendering its own core business less relevant. In this context, it is perhaps not surprising that Morningstar began to grow its own Investment Services division, which helps advisors who want to not just use Morningstar to research investment portfolios, but outsource those portfolios to Morningstar altogether; today, the Managed Portfolios solution has nearly $200B of assets, which comprise 17% of the firm's $799M of revenue. And the new mutual funds will only be used in those Managed Portfolios, which Morningstar chose to do because it allowed them to remove a layer of distribution and administrative costs (over other third party funds and fund-of-funds), cutting investor fees by about 20%. However, the shift now means that Morningstar, long respected for its independent in rating mutual funds, will now be competing against those it rates. Of course, the star rating system is purely quantitative, which means Morningstar's new funds will get rated like any others (under the exact same criteria), and Morningstar has already stated that it will not provide (clearly more conflicted) qualitative analyst ratings on its own funds. On the other hand, the fact that Morningstar still provides qualitative ratings to its competitors, which can impact their flows (and the opportunity for Morningstar to gain or lose market share), means a conflict remains, and its decision is still being widely debated. Yet as the investment industry continues to shift, Morningstar has clearly decided that the risks to perception are worthwhile in pursuit of growth going forward from here.

Bogle's Dire Forecast For The Mutual Fund Industry (Robert Huebscher, Advisor Perspectives) - As the investment industry continues to shift, Vanguard founder Jack Bogle has a dire forecast for the world of actively managed mutual funds: that most will simply become "cash cows" for their corporate owners, who will dial back on marketing and simply let them be profitable as long as they can until the business runs off, and then eventually sell off whatever is left at the end for a substantial loss. For those mutual fund companies trying to navigate the challenging landscape, Bogle offered two strategies: for closely-held firms, the optimal strategy is to avoid change, "stand still", don't both trying to compete by offering competing index funds or other lines of business, and see what success they can maintain simply by staying focused on their core strategies and capabilities; for mutual funds owned by banks and financial conglomerates, though, Bogle suggests that mutual funds will simply operate as "cash cows" that yield profits to their parent company while they can (as some mutual fund companies have profit margins as high as 50%!). In fact, Bogle suggests that in both cases, actively managed mutual funds probably won't benefit much by, and shouldn't even bother, trying to cut fees – as they're unlikely to be able to cut fees (and costs) enough to matter, and doing so when it won't lead to a sustainable advantage will just harm their own shareholders. Of course, sticking with their often-high costs won't necessarily be sustainable either, but that's Bogle's point; if the business is in trouble anyway, the best strategy is to make money where possible and as long as possible (as a fund company), or try to stay focused and create some value that can justify the cost as is. (Michael's Note: And because, ostensibly, Bogle still believes that Vanguard is going to eat their lunch in the end, either way?!)

For The Future Of Financial Advice, Look To Mutual Funds (John Rekenthaler, Morningstar) - For years, the mutual fund industry charged customers an annual fee of around 1% of assets, and few complained, as the cost seemed reasonable, and financial markets were rising, which meant portfolio values were easily growing in excess of costs anyway. Then came Vanguard, with costs far below the norm, and initially sales were modest, as many implied that "buyers generally get what they pay for" (so when you buy a low-cost mutual fund, what do you expect to get?). But over time, consumers began to buy into the Vanguard story, and as the evidence mounted that cheaper didn't meant shoddier – instead, it meant that lower costs allowed investors to keep more – the marketplace began to change its buying habits, and now new sales have vanished almost entirely for the highest-priced 80% of the industry. Rekenthaler suggests that this story may well have some real – and dangerous – parallels for financial advisors themselves, who similarly have historically charged 1%, had clients supported by rising markets, and often suggest that lower-cost advice means inferior quality. Which means just as consumers at first eschewed low-cost Vanguard, and later came around, so too might consumers initially be reluctant about robo-advisors – does their low cost imply less quality and service – and then come around later to a more positive view. Of course, the challenge is that consumers can't compare advisors to robo-advisors as easily as Vanguard to other mutual funds; performance is not routinely published and made available by most human advisors, and there's no Morningstar-like service to compel the collection and reporting of that data. And of course, the other caveat is that technology may be better suited to investment selection than more holistic personal financial advice; in other words, robo-advisor and technology may still only threaten a certain segment of financial advisors and their business lines, but not what the advisor does holistically. Nonetheless, the difference in services, and the value of having another human being to sort through complex personal financial problems, means at least some human advisors should remain, and may even allow them to defend their charges. Still, though, Rekenthaler suggests that the technology revolution to be wrought by robo-advisors may still only be beginning, and that just as it was a mistake to count Vanguard out after its sluggish growth for the first decade or two, beware discounting the "risks" of robo-advisors to traditional advisors as well.

The 5 Levels Of Fiduciary (Don Trone, ThinkAdvisor) - The idea of being a fiduciary advisor to your clients is becoming ubiquitous... yet as Trone notes, that can actually create a number of problems. The first is that it means being a fiduciary is no longer actually the differentiator it once was, and will be even less so if the DoL fiduciary rule comes to pass (which appears likely at this point). The second is that there's a tremendous variability in the required training and experience to become a fiduciary, which means even if most or all advisors hold the fiduciary label, it doesn't mean they'll provide consistent levels of fiduciary competency. Especially since there are now some independent "registries" and platforms that simply allow you to present a credit card, make a payment, and immediately claim you're a "registered" fiduciary! Ultimately, Trone suggests that this means "fiduciary" may even become a word of distrust, as consumers realize that in an "everyone's a fiduciary but not everyone is a competent or good one", that fiduciary is just a marketing label that doesn't convey any value anymore. So what's the path forward? Trone suggests that, just as not all leaders are great leaders, and not all fiduciaries will be great fiduciaries, that fiduciaries can become great by advancing themselves similar to how leaders can. And just as both Jim Collins ("Good To Great") and John Maxwell ("The Five Levels Of Leadership") have written about five levels of leaders, Trone believes there are five levels of fiduciary as well: Level 1, which is simply an advisor who claims to operate under a best interests standard (but there's no actual standard to measure/compare to); Level 2, which are fiduciary advisors who followed a series of rules about how to be a good fiduciary; Level 3 is a principles-based best interest fiduciary standard, where advisors don't just try to meet the letter of the law, but its spirit around executing their fiduciary duty wisely and objectively; Level 4, which adheres to a principles-based fiduciary duty, and have a clear fiduciary code of conduct against which he/she can be judged; and a Level 5 fiduciary, which should not only operate according to fiduciary principles, and adhere to a code of conduct, but take on the responsibility to lead by fiduciary example and amplify their behaviors across the entire firm. How will you differentiate your "fiduciary-ness" in the future?

How Financial Literacy Programs Can Do More Harm Than Good (Daniel Munro, Macleans) - Many (or even most?) consumers make bad decisions from time to time about saving and spending, often driven by a limited capacity to properly evaluate all the different borrowing, saving, and investment choices available today. To help, a wide range of organizations, from the government, private, and non-profit sectors, have introduced a wide range of "financial literacy" initiatives over the years; in Toronto, financial literacy will become part of the 10th grade curriculum starting next year. The problem, though, is that it's still not clear that financial literacy programs actually help; a major meta-analysis in 2014, looking at over 200 studies on financial literacy programs, found that the programs explained almost none of the final differences in participant behavior, and what little gains were apparently typically disappeared within two years (which raises the question of whether Just-In-Time financial literacy is a better approach). Ironically, it appears that old-fashioned math classes that help people to think and reason through math problems appear to be better at improving financial knowledge than financial literacy programs. Yet for those who at least ask "why not try to offer financial literacy anyway, just in case it helps a few", the additional problem is that some studies show people's willingness to seek financial advice decreases as their confidence in their own financial knowledge increases. Which means, if financial literacy classes make people think they are more financially literate but don't actually make them more financially literate, it can cause harm by also reducing their desire to seek help (as they will be less likely to realize they need help when they do!). Furthermore, the rising focus on financial literacy often leads to the implication that those who struggle with poverty aren't financially literate, and that their poverty is caused by that (implied or actual) illiteracy, rather than acknowledging the other causes of poverty that may be more relevant and impactful. In other words, the focus on financial literacy may be leading us to overstated the idea that poor choices are the cause of individuals' financial difficulty, and ignore their actual circumstances. For instance, a 12-pack of toilet paper might cost $9, and single rolls are $1.29 each, which means buying single rolls appears "irrational"... unless, of course, you only actually have $3, in which case it was the right thing to do. More generally, this raises the question of whether a lot of problems we frame as being about financial (il)literacy are actually people making the most rational decisions they can with the limited resources they have available... none of which will be solved with financial literacy education?

Impact Of Employee Financial Stress Higher Than Thought (Mark Singer, 401(k) Specialist) - A growing body of research is finding that financial stress takes far more of a toll on employees, and therefore on employers, than previously recognized. One recent study suggests that as many as 1/4th of all American workers experience distractions at their jobs due to personal financial issues, and stress over finances at the workplace impacts a whopping 60% of Millennial workers. And the financial stress spans the spectrum, with those making $100,000 or more per year still reporting substantial financial stress at work. The consequential costs to employers are myriad and substantial, from increased medical expenses and time off for injuries or illnesses due to financial stress, to higher absenteeism (with one-in-five workers reporting they had to leave work early, or missed work altogether, to attend to personal financial problems), and studies of line supervisors and HR officers similarly reporting that financial concerns of employees are taking a toll on production. As a result, there is rising interest from employers in providing financial education and financial wellness programs... though a meager 6% of employees polled by Gallup report that they feel their employers are providing them with sufficient help. Which suggests that there may still be a coming boom in employer-driven financial planning and financial wellness programs!

Why Do So Few Individuals Seek Professional Financial Advice? (Maher Alyousif & Charlene Kalenkoski, Advisor Perspectives) - In a 2012 national financial capability study by FINRA, a whopping 75% of respondents reported not being satisfied with their personal financial situation, yet few sought out financial advice, with a mere 9% seeking debt counseling, and only 30% seeking insurance advice. Which inspired Alyousif to conduct his PhD dissertation on the topic to figure out who does choose to work with an advisor, in a recently published study entitled "Who Seeks Financial Advice?" Focusing in particular on women (as the empirical literature shows that females score lower than males on average in financial knowledge tests, and are less likely to be satisfied with their personal financial situation), and the young (those aged 18-44, who also tend to have a weaker understanding of basic financial knowledge), and the financially illiterate. The conclusions of the research found a number of key insights, including: 1) Income, and rising income that leads to more investor sophistication but also more complexity, is a driver for seeking out financial advice (though notably, those with less risk tolerance are less likely to seek out advisors, perhaps because they can't tolerate the uncertainty of trying to find a good one!); 2) More financial literacy is associated with a greater likelihood of seeking out an advisor, as it seems the education leads to a greater awareness of the complexities of financial planning, which in turn results in demand for advice); 3) Subjective assessment of financial knowledge (and the implied financial self-confidence) impacts the demand for financial advice, as those who are less confident are less likely to seek out advisors (again, likely because those without confidence are uncertain about their ability to pick a "good" advisor); 4) financial fragility makes consumers less like to seek financial advisor; and 5) overall education levels has a consistent and positive effect on the willingness of people to seek out financial advice. Overall, while some of the results are not surprising – for instance, that consumers are more likely to seek advisors as their income and complexity rises – it is notable that the fear of incorrectly picking a wrong/bad advisor appears to take a substantial toll on the willingness to seek out an advisor at all!

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.