Executive Summary
Enjoy the current installment of "weekend reading for financial planners" - this week's edition kicks off with recent discussion from Rep. French Hill (R-Ark.) who stated he plans to explore introducing legislation that would give FINRA the authority to examine RIAs, as the regulator originally created to oversee securities dealers continues in its efforts to gain oversight of registered investment advisers as well.
From there, we have a few practice management articles this week, including: guidance for advisors on how to be more secure online; tips on guidance that advisors can give to clients about how to protect themselves from identity theft; a look at how DocuSign is making a big push into helping advisors not only with electronic signatures but creating entire digital workflows; tips on how advisors leaving a broker-dealer can avoid or manage an unfavorable Form U5 filing; and a discussion of how large advisory firms can serve Gen Y profitably today (not just as a feeder system for future AUM).
We also have a few investment-related articles this week, from a look at the ongoing rise of Vanguard and the question of whether their growth may soon slow as the company goes into competition with the advisors it serves via its new Personal Advisor Services platform and as regulators scrutinize whether it is a "too big to fail" company, to a discussion of target-date bond ETFs that have a fixed maturity as a means to invest in a rising interest rate environment, and a look at how the "best" diversifier with a consistent negative correlation to stocks is actually the much-unloved long-term government bond.
We wrap up with three interesting articles: the first looks at the rapidly emerging trend of states creating their own state-based retirement plans to provide a means for small businesses to offer payroll deduction contributions to an IRA or other tax-deferred retirement plan; the second discusses the release of the new book "Misbehaving", a 'professional memoir' of behavioral economics pioneer Richard Thaler that tracks both his own career and the rise of the behavioral economics movement; and the last is a discussion of the little "white lies" we tell ourselves about money, like the idea that money will provide us safety and security when ultimately money can only ever go so far to provide those comforts (and relying on money to do so can mask more significant spiritual and internal challenges we may be facing along the way).
Enjoy the reading!
Weekend reading for May 30th/31st:
Talk of FINRA as Advisor SRO Rears Its Head Again (Melanie Waddell, ThinkAdvisor) - This week, Representative French Hill (a Republican from Arkansas), a member of the House Financial Services Committee, stated that he plans "to explore" introducing a bill that would give FINRA the authority to examine RIAs, possibly functioning as a 'third-party' examiner under SEC rules, stating that the SEC's current exam rate for investment advisers is too low and that FINRA has "an excellent network of offices [and] they know how to do exams". The potential push for FINRA to become a third party examiner aligns with SEC Commissioner Mary Jo White's statements earlier this year that the agency is 'discussing' whether to advance rulemaking this would to require third-party advisor exams, though White did state that such exams were "not an optimal place to go." Notably, RIA advocates have complained that a third-party exam approach could prove more costly for smaller firms, and may be part of a broader effort of FINRA to take authority for RIA oversight altogether. Accordingly, the Investment Adviser Association continues to advocate that Congress should either increase SEC appropriations directly, or permit the SEC to levy reasonable user fees on RIAs to support greater exam frequency without shifting RIA oversight to FINRA, though both increasing the SEC budget and user fee proposals have still not garnered much support on Capitol Hill.
Advisor Guide To Online Security (Jay Palter, Ticoon Blog) - Hackers are regularly in the news these days for their attacks on large businesses and government websites, but a recent 2014 cybersecurity examination from the SEC found that 88% of broker-dealers and 74% of RIAs report having been the targets of online attacks as well (most commonly in the form of fraudulent emails attempting to solicit fake wire transfers). Accordingly, Palter provides suggestions on ways advisors can protect themselves, their firms, and their clients, in four key categories. The first is password security - hackers now use software tools that can try thousands of passwords per second, so if you're using a password that is a standard sequence of numbers (e.g., "123456") or a word in the dictionary, it can be cracked quickly and easily. To combat this, a combination of randomness and sheer password length is crucial, though that doesn't actually require random numbers and digits; in fact, just stringing together four otherwise unrelated common words is actually a better password than a single word that has various numbers substituted for letters (e.g., "Tr0ub4dor" instead of "troubador"). Better yet, if you have a large number of sites you use, the best solution is to use password managers like LastPass or Dashlane that create strong passwords for you (different for every site), requiring you to just remember one long "master" password to access their solution. Other article tips on advisor security includes: be certain to secure your "mobile" devices (from smartphones to tablets to laptop computers) with a strong password (ideally, the mobile device should also have data encrypted, and/or just have no client data on it in the first place); be cautious about data sharing, as emails are not secure (even if your computer is) because emails are typically not encrypted or protected on the various servers that are used to transmit the email from your computer to its destination (instead, use secure file exchange services like Sharefile or Box); and recognize that you (and your staff) are perhaps the most vulnerable, in a form of hacking called "social engineering" where data is compromised by convincing a human being to 'unwittingly' make a mistake (e.g., hackers might leave a USB drive with an enticing label in your parking lot, and when you plug it into your computer to see who it belongs to, the hacker's malware is installed on your servers) by being persuaded with a fake email request... which is why it's always crucial to contact a client directly by telephone to confirm any wire transfer!
Don’t Let Clients Become Identity Theft Victims (Geoffrey VanderPal, Journal of Financial Planning) - In addition to the risk of advisors being hacked in a manner that compromises client data, clients themselves - especially affluent individuals - are often the target of hackers and identity thieves; accordingly to one recent survey, 65% of those earning more than $175,000/year felt personal privacy risk and identity theft were very serious concerns, and overall an American becomes a victim of identity theft every 2 seconds, with losses from identity theft totaling $24.7B in 2012. Notably, though, identity theft itself actually spans a wide range of types, including: financial identity theft (illegally accessing the victim's bank accounts or credit cards, or using the victim's identity to originate loans or get new credit cards); driver's license identity theft (criminals sell the victim's driver's license, and now if the buyer gets in trouble in a traffic incident, the original victim gets in trouble for the offense, including failure to show up in court to answer to the charges!); Social Security or IRS identity theft (tax refund fraud is now a fast-growing tax crime); medical identity theft (to make false health insurance claims); child identity theft (again used to commit crimes, create fake accounts or loans, etc., as the child's record is otherwise 'clean' so it can actually be easier to use illegally); and synthetic identity theft (mixing together several victims' personal identifying information to create an entirely new identity). So what can clients do to protect themselves? The greatest tool in preventing information from being stolen or used illegally is the security freeze, which requires a credit reporting agency to lock down a credit file so it can only be opened with specific permission and a PIN code (though notably, this can create hassles for the client themselves, too!). A less severe option is to request a fraud alert via the credit bureaus, though these typically need to be renewed every 90 days; clients can also use consumer reporting agencies (e.g., the Medical Information Bureau [MIB]) to add a note on file to take extra steps to verify identity. Other strategies include: get a postal box (not a P.O. Box) that can accept mail or packages or a Private Mailbox (PMB), so your home address doesn't get out there into the public domain; sign up for credit monitoring services; use two-factor authentication for any sites that offer it; and always use a Virtual Private Network (VPN) service when using public WiFi.
Beyond E-Signatures (Joel Bruckenstein, Financial Advisor) - While the advisory industry has made some progress when it comes to being a "paperless" office, from providing digital reports to clients as .pdf files to providing full digital portals, and even (with some custodians and broker-dealers) mobile check deposits and electronic wire authorizations, Bruckenstein suggests that the industry still has a long way to go when it comes to full adoption of "e-signatures" (electronic signatures) and related technology that support a digital workflow. For instance, while some firms are using platforms like DocuSign for electronic account openings and asset transfers, the fact that DocuSign maintains electronic document tracking means it could also be relevant to establish proof of delivery for the annual distribution of the firm's disclosure documents or its latest Form ADV. An advisory firm could also use an e-signature platform for new employee paperwork, again not even just documents for electronic signature but anything for which an (electronic) proof of delivery is valuable; similarly, legal departments could use the technology for not just contracts but also non-disclosure agreements. More generally, the key point here is that ultimately a fully digital office goes beyond just electronic signatures and .pdf electronic versions of documents, but an entire digital workflow that weaves together digital paperwork and materials into the advisor's CRM and supporting platforms to allow for "straight-through processing" (where digitally created and signed documents are immediately "processed straight through" to the end point of opening the account or transferring the assets). And beyond even that point is a stage of "digital transaction management" where all functions of the firm (for the advisor and the client) exist digitally, with data that flows seamlessly across systems. So with all these capabilities from solutions like DocuSign, why has the industry been so slow to adopt? Bruckenstein suggests sheer inertia has been the primary driver, but with the rise of the robo-advisors - who have generally conquered these challenges - there is a newfound desire of advisors and their platforms to step up and implement this new kind of technology, and many broker-dealers and custodians and the supporting advisor CRM software solutions are working on workflows and integrations to make this easier to implement.
U-5 Protection 'In Case Of Emergency' (Scott Matasar, AdvisorHub) - For advisors who are leaving a broker-dealer, either by choice or due to an outright termination, a common fear is the risk that the terminating firm will "smear" the advisor on Form U5. For those who are concerned, the first step is to contact the (former) firm's compliance department in writing, ask when the firm expects to publish the Form U5 (it must be posted to CRD within 30 days of termination, but can happen sooner), and ask (and demand to review and comment on) what the firm intends to say about the reasons it terminated you. While you cannot force the old firm to change the language it plans to use just because it is not to your liking, the prior will likely take your comments into consideration before finalizing, especially if you point of specific statements that are misleading or demonstrably false (and if you hire a lawyer to handle the process, the firm will likely take your objections even more seriously). Once the U5 is filed, you will receive a copy, which gives you further opportunity to set the record straight if you're unhappy with the results; first, you can submit a "Broker Comment" request form to provide context to the information disclosed on BrokerCheck (which becomes part of the public record) as long as it meets basic requirements (i.e., it must be signed and notarized, comments must be written in the first person and related to the BrokerCheck report, etc.). If this is not enough - if the old firm has filed a truly false and damaging U5 (which sadly sometimes happens as the firm uses the U5 filing as "an economic weapon to try to persuade the clients of the terminated advisor to fire him and keep their accounts at the firm") - the next step is to write the former firm and formally demand a retraction, pointing out what specific statements are defamatory. From there, the next step (and last resort) is to bring legal action to get the U5 amended or expunged, which requires filing an arbitration case against the former firm with the Dispute Resolution department at FINRA, and making the case that the U5 is "defamatory, misleading, inaccurate, or erroneous". Though notably, if the firm is found guilty of some charge besides the U5 being defamatory and the U5 still isn't expunged, it then still takes an additional step of a separate lawsuit in civil court to convert the arbitrators' Award to a court judgment, which can then go back to FINRA to modify your CRD. Though again, the challenges in resolving a U5 dispute are again why being proactive early on - before the U5 is filed in the first place - is the best approach to head off problems before they occur.
Smart Way To Make Serving Gen Y Profitable (Samantha Allen, Financial Planning) - At the recent NAPFA National conference, XY Planning Network co-founder Alan Moore showed how advisory firms can serve Gen Y clients profitably with a combination of a monthly financial planning retainer fee, upfront planning fees, and a small ongoing AUM trail. For instance, a firm with 100 clients who each have $50,000 worth of investments can be served via a $150/month retainer fee plus 1% of AUM, which amounts to $230,000/year of recurring revenue, allowing for a very healthy profit margin for an advisory firm even after paying a "junior" advisor a $60,000/year salary to service the clients; and of course, that total number of clients will take time to accumulate, but if clients also pay a $1,000 upfront fee for their initial plan, the model can generate additional revenue in the initial years while it gets up and running. And for established advisory firms that already have infrastructure, the start-up costs (outside of the advisor staff themselves) are minimal; even new advisory firms serving Gen Y can get started for under $10,000 (mostly to cover essential technology solutions). In fact, Moore notes that the biggest challenge for established firms is simply that they don't give young advisors enough room and latitude to execute on the model, noting that young advisors can't build their clientele and establish their necessary expertise in Gen-Y-related issues (e.g., student loans, buying a first home, etc.) when they have to serve/support baby boomer clients and study retirement-related strategies like Social Security optimization instead. But the bottom line is that once fully loaded with a reasonable number of clients, young planners can serve their young peers who don't have significant assets but are willing to pay a monthly retainer, in a manner that isn't just a pipeline to future assets for the firm but is actually profitable on the combination of AUM and planning fees today.
Vanguard’s Commanding Position (Stephen Foley, Financial Times) - Early on, Vanguard set its sights on challenging established mutual fund companies like Fidelity, during the heydey of the mutual fund when money poured into equity funds run by star stock pickers... yet several decades later, Vanguard's audacious goal is working, as the most popular funds are increasingly those with rock-bottom fees that often do nothing more than track the market, and Vanguard has captured almost 20% of the US mutual fund industry (including having both the world's largest stock fund and now the world's largest bond fund) and pulled in $215B in just the last year alone as total assets now approach $3.4 trillion. Given its momentum, is there anything that could stop Vanguard from here, given its unique non-profit structure that allows it to operate essential "at cost" (plus amounts necessary for business investment) but without needing to generate a profit for outside shareholders (as Vanguard investors in its funds effectively are Vanguard's shareholders)? Foley ultimately raises three issues of note. The first is that the shift to passive investing that has catapulted Vanguard in recent years may still prove to be at least partly cyclical; with respect to bond funds in particular, that face a significant headwind if/when/as interest rates rise, critics suggest that investors may shift to seeking more active funds when the inevitable bond price declines set in. Though Vanguard itself notes that it runs actively managed bond and equity funds, too, and that it is more of a "low-cost" shop than a pure "indexing" shop. And Vanguard's rise has also been driven heavily by the explosion of assets into target-date funds as they became permitted default investment options in retirement plans for the first time (Vanguard is the market leader in target-date assets with a 27% market share). Another threat to Vanguard includes its move into giving financial advice, which could cause friction as advisors who previously utilized the company for its funds may now fear it as client competition. And ultimately, perhaps Vanguard's biggest challenge is the 'danger' that regulators could decide to step in and stop the firm from becoming too big to fail if it continues to be "too" successful!
A Little-Known Bond Vehicle for When Interest Rates Rise (Bernice Napach, ThinkAdvisor) - Thus far, target-date bond ETFs have toiled in relative obscurity; although they've been around since 2010, they collectively have only $7.75B of assets, a miniscule fraction of the roughly $3.3T in bond fund assets. Yet with the potential for interest rates to rise in the coming year(s) as the Federal Reserve eventually shifts policy, some predict that target-date bond ETFs will become more popular. Their benefit is that, like buying individual bonds directly, they can be held until maturity (as the whole point of target-date bond ETFs is that they hold a fixed portfolio of bonds until they mature at the target date), and the whole point is that the underlying ETF itself owns bonds that all have a similar maturity date that will come due together (and self-liquidate at the end). However, unlike with individual bonds, using an ETF structure allows for investors to better diversify across multiple bonds (as the minimum size of bond trades makes it difficult for all but the wealthiest individual investors to diversify effectively when buying bonds directly), and ETFs can potentially execute the bond purchases at lower cost (relying on the ETF provider to use its size and scale for better execution). At this point, target-date bond ETFs are provided by two companies: Guggenheim Investments offers a series of 18 different BulletShares with maturities ranging from 2015 to 2024; and Blackrock's iShares offers a series called iBonds ETFs with varying target maturity dates. Notably, though, so far the target-date bond funds have slightly above-average expenses compared to other bond funds (varying from 0.24% for corporate ETFs to 0.43% for high yield), and some have raised concerns that while ETFs themselves are nominally liquid there may be liquidity challenges along the way if an investor does want to sell out of such ETFs before their maturity and the ETF itself has trouble selling the underlying bonds to raise the cash for redemptions.
The Best Diversifier Has Been the Simplest (Christine Benz, Morningstar) - When it comes to diversification, the security types that investors frequently use to round out their portfolios and balance against equity risk - from precious metals to commodities to real estate and market-neutral funds - have had mixed success at best when it comes to diversification results. For instance, market neutral funds had lower correlations for a while, but their correlations have been rising in recent years, raising questions about their diversification value going forward. Real estate was 'worse' in many ways, with lower correlations in recent years (as rising rates have challenged interest-rate-sensitive REITs) but a dangerously high correlation during the financial crisis when it mattered most. Foreign equities correlations have been declining in recent years, though it's not clear whether this signifies a diversification value to foreign equities, or is just an indirect result of the shift in the direction of the U.S. dollar. Instead, the one asset class that seems to most consistently deliver a negative correlation that connotes 'good' diversification is old-fashioned high-quality bonds, especially long-term government bonds which have both performed poorly during the equity bull market and rallied during the 2008-2009 bear market (the true essence of negative-correlation diversification). And notably, it's really just the long-term government bond category that shows the negative correlation; intermediate term bonds, especially when mixed to include corporate bonds, show a moderate positive correlation to equity returns (as they experience price declines when risk rises and corporate-risk-based yield spreads widen).
States Tackle America’s Retirement-Savings Shortfall (Anne Tergesen, Wall Street Journal) - Last week, Washington state became the second state (after Illinois) to authorize its own state-run retirement savings program that will allow employers to deduct contributions directly from employee paychecks and funnel them into retirement accounts; the effort is targeted primarily for small businesses that don't currently offer retirement savings plans to employees already. What's more notable, though, is that state-run retirement programs appear to be a rapidly emerging new trend, with 25 additional states either studying similar state-run solutions or that are actively considering legislation to establish one. The details vary from one state to the next; an early Massachusetts plan is primarily for nonprofits with 20-or-fewer employees, while the Washington state plan is for 'small' businesses with 100-or-fewer employees who will still have a choice of whether to voluntarily participate; by contrast, California is conducting a feasibility study of a program that would require private sector companies with five-or-more employees to automatically deduct contributions from employee paychecks and deposit them into IRAs (with study results expected by year-end and a potential legislative push to implement the approach in 2016). Ultimately, the retirement accounts would still be run by the private sector in most proposals - in Washington, employees would either open a SIMPLE IRA, a regular IRA, or a Federal MyRA, and a private company will oversee what IRA custodians can participate directly in the program, and what default investment options are included (such as target-date funds and balanced funds). Notably, in the Washington proposal, to pass muster a retirement plan working with the state could not charge any administrative fees for the plan itself, and must cap investment management fees at 1% of assets per year. While such legislation to facilitate payroll-deducted retirement contributions into IRAs has been explored at the Federal level as well - in theory, the recent rollout of the MyRA program has laid the groundwork for it - states seem to be more motivated to address the issue quickly, in part because states have realized that failure to provide for retirement means much of the burden of under-saved retirees will fall on local public assistance programs anyway.
The Economist Who Realized How Crazy We Are (Michael Lewis, Bloomberg) - Lots of industries are facing a current age of disruption, especially those that have historically made decisions by 'gut instinct' and are now being challenged by businesses analyzing reams of data for better insights as computer power gets cheaper and cheaper. Though the idea that this would even be possible - that experts or even entire industries could be wrong and be making big, systematic mistakes - was itself a subversive idea that took time to be accepted, tracking along with the rise of behavioral economics and the idea that the humans participating in the economic system could actually be part of the problem. And one of the founders of the behavioral economics movement, Richard Thaler, has recently published a 'professional memoir' called "Misbehaving" that explores not only Thaler's own career, but the rise of behavioral economics as well. For instance, some of Thaler's early work back in graduate school focused on how people value themselves - for instance, what higher wages do people in higher-risk occupations require over those in less dangerous jobs - but took an interesting turn when Thaler discovered in a parallel experiment with his class that asking students about their own willingness to expose themselves to dangerous conditions gave varying outcomes depending on the nuanced way he asked the question... despite the fact that economic theory suggested that a rational human being should answer the question the same way, regardless of how it was framed. In fact, this early incidence led Thaler to begin making a list of things that people did that were contrary to the economic models of rational choice, though the real breakthrough was when subsequent research by others like Tversky and Kahneman began to find that humans weren't just randomly irrational (making mistakes that cancel each other out), but instead were making systematic mistakes, and Thaler championed their research to help create an entirely new field and is now a perennial candidate for the Nobel Prize.
Money’s White Lies (Mitch Anthony, Financial Advisor) - Anthony makes the case that far too often, we rely on Money to solve problems that are ultimately spiritual or internal in nature, and discover too late that the "promises" that money will make us safe and secure are not realistic. For instance, the sad reality is that those with significant money often have to struggle more to be safe, as they become the target of the greedy, the criminally inclined, embezzlers, and litigious deceivers. And of course, it's hard for money to provide us security when the very nature of markets requires us to take risks in order to grow that money; even "job security" is not what it once was, nor is the 'security' of pensions after many have watched their companies default and been forced to fall back on the lower pension guarantees of the PBGC (or worse). Sure, money can put in place some basic physical safety (a home) and provide health coverage, and insure against some disasters, but even then the 'safety' value of money is ephemeral. After all, insurance coverage might replace your physical house if it is destroyed, but you will still have to grieve the loss of your home, its atmosphere, and its precious tokens and mementos. The bottom line: money can help us manage some external realities, but ultimately our ability to feel safe and secure, and to handle the challenges when they arise, must come from within... and relying solely on money to do it for us may just create more problems than it solves.
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.
Great stuff, Michael. Thanks for doing this every weekend.
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