Weekend Reading for Financial Planners (May 20-21)

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 20th/21st:

Focus Financial's 'Extraordinary' Purchase Of $16B AUM SCS Capital And What Stone Point May Do Next (Brooke Southall, RIABiz) - Just last month, private equity firms Stone Point and KKR bought a majority stake in RIA roll-up aggregator Focus Financial for a deal reportedly worth nearly $2B. And in the weeks since, Focus has been on an acquisition tear, acquiring a whopping $18.5B of AUM from a series of ultra-HNW multi-family-office-style independent RIAs (in a world where by one estimate, Focus only had about $40B of AUM between advisory and some non-discretionary transactional accounts). However, the acquisitions don't appear to merely be an effort to more rapidly grow revenue through acquisitions under new ownership; instead, it's rumored that Stone Point may be encouraging Focus Financial to shift its business model and begin to encourage its advisors to cross-sell insurance, as life insurance in particular still has big-dollar potential amongst ultra-HNW clientele who still face substantial estate tax exposure. The intended shift both helps to explain the recent acquisitions – which all focus on ultra-HNW clientele with estate tax concerns – and the willingness of Stone Point to make the Focus acquisition at such a high price point, recognizing the potential for expanding into a new revenue line (and akin to how PE firm Madison Dearborn monetized National Financial Partners since 2013, which also expanded into P&C insurance cross-sales to recognize a 10X valuation in just a few years). The caveat, however, is that the entire strategy is predicted on the advisors at independent RIAs engaging in insurance sales, in a world where many advisors join or found RIAs specifically to get away from the advisory industry's product-sales roots, and may bristle at being asked to push any kind of insurance products, whether life insurance or property and casualty insurance. Nonetheless, the prospective shift is a strong reminder that even as advisory firms evolve away from selling products to selling advice, the allure remains – for advisory firms, and the investors who may acquire them – to reintroduce the cross-selling of products given the trust that clients place in their advisors.

Running An Index ETF Is Harder Than It Looks (Dave Nadig, ETF.com) - Given the passive nature of market indexes, there's a general view that creating an ETF to track the index should be a rather simple affair, particularly once it's set up and can largely run on autopilot. Yet Nadig points out that, just as has been recently highlighted by the VanEck Vectors Junior Gold Miners ETF (GDXJ), which has recently exhibited material performance deviations from the underlying index it's intended to track, running an index ETF is much harder than it looks. Just a few of the prospective challenges and problem areas include: monitoring compliance that all holdings are meeting all ongoing regulatory requirements (e.g., in the case of GDXJ, the problem was that the fund's holdings in some Canadian gold stocks was approaching the 20% limit of fund ownership imposed by Canadian regulations, which would have triggered even more compliance and legal issues had it not been curtailed before crossing the line, and similar challenges are very common in big international ETFs, as countries from Brazil to China have their own rules and limitations, on top of the U.S. regulatory requirements for funds from the SEC, IRS diversification rules, FINRA advertising rules, etc.); handling corporate governance actions, as an index with 500 stocks means 2,000 quarterly reports a year, and numerous headaches like M&A activity, stock splits, special dividends, spinouts, and more, and index providers each have their own detailed guidebooks about how such events should be handled (which, if the ETF manager doesn't match perfectly, will cause tracking error to emerge); proxy voting, which matters more and more as ETFs own a larger and larger slice of companies and are becoming sizable enough to have a role in corporate governance; ongoing cash management, as everything from cash flows to various splits and mergers and cause cash to appear in the fund, and trading incurs costs that can cause the index ETF to lag the underlying index it's aiming to track; and securities-based lending, whether or how much the fund wants to engage in the practice, and whether the SBL proceeds will be remitted entirely to the fund for the benefit of its shareholders, or also to the fund company for handling the process. In other words, even for an index ETF, it's not so easy to perfectly replicate the performance of the underlying index, which doesn't have the responsibility of actually executing all the trades and regulatory requirements that must be handled and complied with to actually own the index in the real world.

The Price Clients Pay For SRI/ESG Investing (Larry Swedroe, Advisor Perspectives) - Socially responsible investing (SRI) is rapidly gaining popularity, and by some estimates as much as 25% of U.S.-based assets are being invested under some type of SRI strategy. However, an open debate rages about whether SRI is a better way to invest, or a form of investing "preference" where the investor must trade off prospective returns to align their portfolio with their social objectives. A recent study on Norway's Government Pension Fund, which adheres to an SRI mandate to exclude companies that produce weapons, thermal coal, or tobacco products, as well as those that have a track record of human rights violations, severe environment damage, or corruption, sided with SRI skeptics, finding that the Norwegian sovereign wealth fund has lagged its FTSE Global All-Cap index by nearly 1.1%/year of annualized returns over the past 11 years, driven primarily by their decision to eschew tobacco manufacturers (costing 1.16%/year in returns), and weapons makers (which decreased returns by 0.75%/year). Although ironically, some suggest that the outperformance of those companies may in part be caused by the inefficiencies created when fewer investors (i.e., those with SRI/ESG mandates) are unwilling to invest in them, which in turn has led to the rise of "vice investing" or "sin investing" funds that explicitly invest in tobacco, alcohol, and gambling stocks to capture the available alpha. This view was supported in a recent paper by Greg Richey, which found that even after controlling for one-factor (CAPM), three-factor (Fama-French), four-factor (Carhart), and new five-factor (updated Fama-French) models, vice/sin stocks appear to show lower beta than the overall market, and persistent alpha in most cases, above and beyond what was predicted by the underlying factors alone, though the five-factor model suggests that their return success is driven primarily by the profitability and investment factors. Other recent studies have similarly found a market-neutral fund of long sin stocks and short non-sin stocks have a positive excess return of 0.29%/year (after controlling for the four-factor model), and a Dimson Marsh Staunton study found that tobacco stocks over the past century have outperformed broader equity markets by a whopping 4.5% in the U.S. Ironically, though, one recent SRI study by Meir Statman and Denys Glushkov found that there are some SRI factors that do appear to be positively associated with outperformance... it's just that their value is offset by other factors that show underperformance. Which means there may ultimately be some potential to create some kind of SRI/ESG strategies that do have positive expected return factors... but the bottom line is that, as always, markets are "surprisingly" efficient, including the recognition that stocks shunned by one group of investors may, as a result of their avoidance, create return opportunities that undermine the very benefit of shunning them in the first place.

5 Ways Big Data Can Improve Risk Tolerance Questionnaires (Craig Iskowitz, Wealth Management Today) - This past week was the 20-year anniversary of when world chess champion Gary Kasparov lost a chess match to IBM's Deep Blue artificial intelligence program, and serves as a good opportunity to look back at how the world of artificial intelligence has evolved over the past 20 years (as Kasparov himself has recently published a book on the subject, entitled "Deep Thinking: Where Machine Intelligence Ends and Human Creativity Begins"). Of course, a computer winning a chess match doesn't mean computers are smarter than humans across all (or even most) domains, but as Kasparov himself noted at the recent Envestnet Advisor Summit, more and more complex tasks are being taken over by software, raising more and more questions about the relative roles of technology and (or versus) humans in the future. Iskowitz suggests that in the world of financial advisor, the current state of Risk Tolerance Questionnaires (RTQs) is ripe for potential technology disruption, given our current state of still relying on often-overly-simple multiple-choice quizzes, that don't necessarily take into account the ever-growing volumes of big data that are available. Of course, Iskowitz isn't the first to note the sorry state of Risk Tolerance Questionnaires (a recent article on this blog as well), and that they often fail to predict subsequent client behavior during times of market stress, but is that really because risk tolerance questionnaires don't work, or simply because we're not using the full breadth of tools and technology available today. So where might RTQs go in the future? Iskowitz suggests several potential paths, including: could account aggregation tools like Quovo or Yodlee someday pull in not only a client's current portfolio, but their entire investing history and personal finance history, and quickly use the big data to build a more effective profile of how the client actually invests and has actually behaved in prior times of market volatility; RTQs are often criticized for lacking the ability to take into account the "human" factors that can only be uncovered with an advisor-client conversation, but are we underestimating how subjective human advisors themselves actually are (as we, too, are humans, and suffer from our own behavioral finance biases!); and of course, just because a client has acted badly in past incidents of market volatility (according to the data), doesn't necessarily mean they should be invested more conservative in the future, if the whole point of an advisor is to help them otherwise ameliorate that bad behavior. Nonetheless, the point remains that, just as with many domains, there are at least aspects of almost any process that computers can do better and more efficiently than humans, which suggests that even if the end point isn't fully driven by robo-risk-tolerance automation, it will almost certainly include more technology (and rely more on big data) than is commonly done today.

Behavioral Finance 2.0: Financial Psychology (Brad Klontz & Edward Horwitz, Journal of Financial Planning) - The world of financial planning is increasingly incorporating psychology theory with the (technical) techniques of financial planning, as evidenced by everything from the most recent edition of the CFP Board's Financial Planning Competency Handbook including chapters on financial therapy, behavioral finance, and marriage and family therapy applications, to the fact that the 2016 Montgomery-Warshauer Award from the Journal of Financial Planning was awarded for a paper on applying Positive Psychology to Financial Planning. Of course, at least some principles of psychology - primarily related to the research on behavioral finance – has been making its way into financial planning for more than a decade now. However, Klontz and Horwitz point out that behavioral finance research is really just the application of one sub-field of psychology to finance – specifically, cognitive psychology, and the study of our mental processes around attention, perception, problem solving, and thinking. And it's been studied primarily through the use of large data sets, that identify anomalies between how large groups of investors "should" behave, and how they actually do behave (dated back to Shefrin and Statman's seminal 1985 article in the Journal of Finance, "The Disposition To Sell Winners Too Early and Ride Losers Too Long"). Yet the questions of what to do about these cognitive errors and biases that impact financial decision making – i.e., "How do I convince my client to actually sell a losing investment when her pride won't let her admit defeat?" or "What should I do when my client is exhibiting a bias towards the status quo?" are not broad-based questions of how the population of investors behave, but "micro" questions of how to help individuals change, a new potential line of research that Klontz has dubbed "financial psychology". Which is important, because arguably it's the research on financial psychology – a form of "Behavioral Finance 2.0" – that may actually hold the answers to how financial planners can actually help clients change and improve their behavior for the better (and not merely observe and lament that it happens!).

5 Warning Signs That Your Client Is Thinking About Leaving You [And What To Do To Win Them Back] (Dave Zoller, Streamline My Practice) - No advisor likes getting the call (or email) that says "Thanks for all your help over the years... but I've decided to go a different direction with my finances." And unfortunately, the reality is that once the message comes, the client has usually already mentally checked out, and is nearly impossible to win back. Which means good client retention is really about spotting clients who may potentially be leaving, before they make the mental commitment to cut ties with the advisor – and even with 95%+ retention rates being common amongst financial advisors, that still means at least 2-3 of your top 50 clients may be thinking about leaving at any given time. Accordingly, Zoller suggests five warning signs to watch for, that may be indicators that clients are on the fence about your services, and what to do about it, including: clients start questioning your fees more (though it's really a sign they're questioning your value, and the best way to handle it is to be transparent about your fees, but then immediately reinforce what value you're actually providing along with it); clients start asking more specific questions around performance (as some clients constantly ask performance questions, but new questions from those who didn't ask in the past are often a troubling sign they're not happy, and is a good time to both reinforce the alignment of their portfolio to fit their specific needs and goals, and maybe even to-do a risk tolerance questionnaire, just to remind them of why they own this particular portfolio, and not a more or less aggressive one); if they suddenly become harder to reach (as they may be avoiding you because they're thinking about leaving you and don't want to face the conversation, but if that's the case, it's crucial to push for a meeting where you can re-engage them with their finances and your value proposition); they start frequently checking their account online (as a sudden spike in logging into the client portal is at the least a sign that something has changed in their financial life that merits a conversation, but could well be an indication they're getting ready to shop you, or have already begun!); and they stop implementing your advice (as while some clients are perpetually hard to move to implementation, clients who used to take your advice regularly, and now stop, may have stopped because they're getting ready to switch advisors and begin implementing with someone else instead, which means it's time to have a check-in conversation, asking them "is there anything you don't like about these ideas" as a way to clarify what's driving the non-engagement).

How To Get The Attention Of Your Ideal Prospective Client (Julie Littlechild, Absolute Engagement) - Even once you've gone through the process of deciding on some kind of niche or specialization, and identified your "ideal client", there's still the fundamental challenge of figuring out what you can bring to the table that's genuinely valuable and unique for those ideal clients, differentiated from what any other advisor could provide. Littlechild suggests that the key is recognizing that you don't have to figure out what your ideal clients in a stroke of brainstorming creativity; instead, do some research to actually ask them what they want! After all, third-party tools like SurveyMonkey have made it relatively easy to design and distribute research surveys. The starting point is to recognize that in order to engage your ideal clients (and prospects) with a survey, you have to ask questions that are meaningful and relevant to them that would make them want to participate (and from which you can glean useful information about how to provide value). For instance, if your target clientele were dentists who own their own practice, questions you might survey about include "creating long-term value in a dental practice" or "tactics to differentiate your dental practice" or "the most successful ways that dentists attract new clients". Then craft a survey of 10-15 questions that get at how your ideal clients are engaging (or not) on this topic; if you have some clients in the niche already, you can run the survey by them first for feedback, and/or create a one-time focus group for further feedback. To amplify its reach, you can even reach out to influencers in your niche that might be willing to support the survey – in this example, that could be a trade publication for dentists, or one of their professional associations. Be certain to offer a summary of the results to those who participate (in exchange for their email address), as that both helps to engage them in the survey and perspective results, but also gives you a way to follow-up with them about your future well-targeted services! Once you get the results, you can use them to both refine your unique advice offering for your clients – for instance, learn the best practices of dentists, and then use dentistry practice management as a service to bolster your advice offering – and also leverage it in further marketing to your niche, including offering a webinar for those who participated, write an article on the results with a trade publication, write one or several articles on your own blog/website, send the results to centers of influence (which helps to highlight your expertise), and create "factoids" that you can share via social media.

The "I Know Better" Fallacy And How It Can Detract From Your Client Experience (Steve Wershing, Client Driven Practice) - As financial advisors, and especially as business owners, most of us try hard to come up with ideas for solutions that our clients will like. Yet one of the challenges in trying to come up with the "right" answers is that it can make us so committed to those ideas, that even when we get feedback from clients that they're not very interested (or outright dislike it), it's often still hard to let our ideas go. Yes, there is the famous saying from Henry Ford that "If I had asked them what they wanted, they would have said faster horses", implying that the "right" entrepreneur can intuitively divine what clients really want, that they don't even realize they'd want, until you give it to them. Yet in practice, more commonly the problem is simply that we design something that we, personally, would like, and assume (or hope) that our clients will as well, potentially committing the business to costs to deliver something that the clients don't/won't actually value in the end. And at worst, clients actually resent what they see as a perceived cost (for some new service or solution you're offering) that doesn't provide them value (as far as they're concerned). Fortunately, having a process for garnering client feedback – such as a client advisory board – can help to avoid these pitfalls. Especially when it comes to not the core product or service you provide, but the client experience of how you deliver it – where your clients are uniquely positioned to share what will or won't enhance the value of that experience for them! Because when it comes to the experiences they enjoy, saying you know clients' feelings and emotions better than they know themselves risks a serious "I Know Better" fallacy that can lead to negative outcomes.

Make Sure Your Retired Clients Stick With You (Gail Graham, Financial Advisor) - For the past several decades, most advisors have focused on helping clients accumulate assets to hit their retirement "number"... yet as clients actually do approach the retirement transition, new questions may start to emerge, which can create problems for the advisor-client relationship, just as their portfolio (and revenue potential) as a client peaks. For instance, if the conversation for years (or decades) has been all about accumulation and reaching retirement, clients may actually begin to wonder whether you have the expertise to even help them in retirement. And with an end to making ongoing savings, a scarcity mentality can kick in, leading to more challenging questions like "we're conservative... I wonder if Vanguard could protect our money at a lower price" or "our 1% AUM fee on our now-$2M portfolio means $20,000/year in fees... couldn't we be using that money to enjoy our retirement lifestyle a little more?" In other cases, the problem is that retired clients have more time on their hands, and may feel like they now have the time to do it themselves. Or they may simply move when they retire, and decide they want a new advisor in their new location. So how do you head off these potential problems as an advisor? Graham offers several suggestions, including: redefine your planning stages to reflect the stages of retirement, where you might help plan for the "bridge to retirement", then the "retirement year", then the "first-five-years" (which are often travel-heavy), etc., so clients better understand the unique value and ongoing value you'll be providing in retirement; create a "retirement discovery process" to re-engage clients in a fresh financial planning process focused on their prospective retirement (and effectively resetting the planning engagement to be more relevant to their current stage); recognize that you may need to be prepared to communicate with retired clients differently as they shift from the working world to the retiree-travel world; and understand (and show empathy) for the kinds of emotional challenges that may arise for them, as they finally reach their retirement number, and then realize they may have to re-purpose their entire lives going forward from here!

Why Retirees Cut Back On Spending: A Growing Pessimism, It Seems (Anne Tergesen, Wall Street Journal) - A growing volume of data finds that retirees tend to spend less in their 60s and 70s than they otherwise "could" based on the income their portfolios produce, often not even keeping pace with inflation over time, and a new study suggests that the reason may be because people are actually becoming more pessimistic about the stock market, the economy, and their own finances, as they age... which leads them to both spend less, and plow their more into more conservative investments (e.g., low-yielding bonds), regardless of whether those investments effectively fit their long-term needs. The study analyzed responses to the University of Michigan surveys of consumer sentiment from 1978 to 2014, and found that in 2014, adults over 64 were 30% to 40% less optimistic about their future financial health and the economy and stock market (compared to people under the age of 35), and the "optimism gap" persisted even after controlling for income, gender, and education. Notably, the study only found a correlation between the two, so it's not certain that the pessimism is actually causing the spending reductions, though the prospective link is intuitively logical. Of course, there are alternative explanations available as well, including the simple fact that those who have frugal habits (which allow them to save effectively for retirement) are hard to break once they reach retirement (even though the persistent spend-less-than-you-make pattern isn't necessary once they already have as much as they need). And of course, there's also the simple mathematical fact that even if retirees intend to spend all their wealth by the end of retirement, they wouldn't likely dip into principal until their 80s and 90s anyway, and would have to spend less than they earn in their 60s and 70s just to build a cushion for inflation in the later years.

The Mental Mistakes We Make With Retirement Spending (Meir Statman, Wall Street Journal) - The most "successful" accumulators for retirement get there by engaging in a lifetime of frugal spending and good savings habits... which can be especially problematic when retirement actually comes, and the whole "point" is to cease those habits and actually stop saving and start spending and enjoying the money! Instead, for many retirees, the personality trait – most notably, conscientiousness – that facilitates their retirement savings accumulators become impediments to actually spending the money in retirement itself... which can lead to a unique type of mental stress, and a potentially far-less-satisfying retirement itself (especially if retirees continue to invest aggressively for accumulation, far beyond the point they still need to). Yet Statman suggests that some of these challenges around what we "spend" vs "save" is a matter of how we frame it. The standard rule is "spend income, but don't dip into capital/principal", but most of us only account for interest and dividends as "income" and not capital gains, which means we may fail to include the appreciation of our investments as one of the key pillars of retirement income. Which means if we re-frame capital gains as "income", or use a "managed payout" fund that simply distributes an aggregate amount (without worrying us on how the underlying components break down), it may be easier to spend. Other tips/issues to consider include: plan for sales of principal, where necessary, far in advance or systematically, to reduce the pain of regret; be certain to appropriately assess life expectancy, and not be so excessively conservative that the retiree just ends out never spending their money; encourage clients not to leave the best for last (as experiences like travel may not be feasible if they wait too long); and help people understand the factors that can drive real happiness from spending (e.g., spend on experiences more than stuff, and be charitable in giving money away), which will make them feel better about the spending they're actually doing!

Would You Rather Have $1 Million Or $5,000 Monthly In Retirement? (Shlomo Benartzi & Hal Hershfield, Wall Street Journal) - A growing volume of websites and smartphone apps make it possible to track, every day, week, and month of the year, the ups and downs of our portfolio and our wealth. But new research suggests that in at least some cases, the way this information is presented can make us feel less confident about our finances. The reason is a recently-studied phenomenon known as the Illusion of Wealth and the Illusion of Poverty, which you can identify by looking at how clients answer the question of whether they'd be satisfied with either a $1M retirement portfolio, or a $5,000/month retirement income payment (which, based on current annuity rates, are roughly actuarially even). People who suffer from the "illusion of wealth" will tend to think that the $1M account is more valuable than the $5,000/month payment, gaining a (false) sense of security from the seemingly large account balance, and potentially misjudging its viability (e.g., failing to recognize that it's still not enough to support an $8,000/month lifestyle). Others, who feel that the $5,000/month is far more valuable, are suffering from the "illusion of poverty", worrying that their assets may run out and therefore expressing a preference for the (guaranteed) lifetime income option. What's interesting is that these effects also scale differently with wealth; the illusion of poverty actually becomes more prevalent as the dollar amounts grow, as $1M and $2M and $4M all feel like "a lot of money", and may not make this with the illusion of poverty feel much better (while increases in monthly income tend to produce more steady increases in the related satisfaction and sense of security). This matters, because virtually all financial tracking tools today look only at dollar amounts and account balances, which can reinforce the distortions of these illusions, for those who are already more prone to succumbing to one versus the other. So what's the solution? Benartzi and Hershfield suggest that retirement accounts should also always project a reasonable level of retirement income associated with the retirement accounts, so people are more grounded in how the two relate to each other, and so those suffering from the illusion of poverty in particular better understand the size and scope of their growing retirement accounts.

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.