Weekend Reading For Financial Planners (May 6-7)

Bill To Ease Regulatory Burden On Small Advisors Sails Through Committee

(Mark Schoeff | InvestmentNews)

For many financial advisors thinking of starting their own firm, the specter of remaining in compliance with regulations governing the business of financial advice can be a factor that dissuades them from doing so. From navigating state regulations as a smaller advisor to eventually switching to SEC registration as it grows (typically once it reaches $100 million of Regulatory Assets Under Management [RAUM]), there is a wide range of rules and regulations that must be followed (which can vary depending on the firm’s regulator and be intimidating for a new firm owner without a compliance professional on staff!). Yet while there are some parts of RIA compliance that are at least simpler for ‘pure solo’ RIAs (who don’t have supervised or access person employees to oversee), the general bent of regulators is to lift compliance requirements over time, potentially squeezing out smaller advisors. Which has led to calls from some industry trade groups that legislators require the SEC to reduce (or at least be more mindful of) the compliance burden on smaller firms.

Amid this backdrop, the House Financial Services Committee on April 26 unanimously approved the Small Entity Update Act, which would direct the SEC to conduct a study and carry out a rulemaking on the definition of a "small entity" to reduce the compliance burden on small businesses, presumably including RIAs. The legislation received bipartisan support from lawmakers (suggesting it could find support in the full House and Senate) and has also received the backing of the Investment Advisers Association (IAA), which noted that the SEC currently considers "small advisers" to be those with $25 million or less in (regulatory) AUM while the SEC registration threshold stands at $100 million (one proposal would tie a future definition of small adviser to inflation so that the definition does not become 'stale' over time). The IAA would prefer that the definition of “small adviser” be based on the number of employees, or another metric other than AUM, recognizing that RIAs serving the mass affluent can have a lot of size without necessarily being high in AUM (e.g., with the rise of subscription fees), while investment-only firms can scale a significant amount of AUM without necessarily having a very large 'size' and headcount.

Ultimately, the significance of legislation to ‘protect’ small businesses (in particular, smaller RIAs) from SEC regulations doesn’t mean that smaller RIAs wouldn’t be regulated; simply that regulations would have to account for the costs and burdens that smaller firms may not have the size and resources to manage as large firms would. For instance, the SEC’s recent proposal for additional due diligence obligations for RIAs that outsource might receive particular scrutiny (especially since the proposal would likely fall hardest on the smallest RIAs, which are most likely to outsource!), as would the SEC’s proposed updates to the custody rule (in particular regarding the requirements for RIAs that are deemed to have ‘custody’ solely because they manage on a discretionary basis even while using a third-party custodian).

In the end, while this legislation works its way through Congress (and potentially offers a regulatory reprieve for smaller firms, or at least a slowing in the pace of new SEC regulations that might impact smaller firms), RIAs registered at either the state or SEC level can consider ways to ensure they meet their current regulatory requirements, from crafting an annual compliance calendar (to ensure no tasks fall through the cracks!), to engaging with a compliance consultant to using 3rd-party technology solutions to help manage ongoing compliance tasks!

Top Democrat Opposes Bill Facilitating E-Delivery Of Investment Documents

(Mark Schoeff | InvestmentNews)

As the usage of email and the internet have become nearly universal in American society, many forms and documents that were previously delivered in hard copy have transitioned to electronic delivery. Which offers many potential advantages, from quicker delivery and cutting down on paper use to cost savings for companies (which do not have to pay to print and mail the documents). Currently, consumers typically have to ‘opt in’ to receive electronic copies of documents (and otherwise receive paper copies by default). But legislation working its way through Congress might change that.

On April 26, the House Financial Services Committee approved the Improving Disclosure For Investors Act, which would require the SEC to write a rule that permits RIAs, broker-dealers, and other financial entities to deliver investor communications (e.g., account statements and Form CRS) automatically via email, rather than hard copy. Under the legislation (which has been a priority for major asset managers and some other financial firms and industry groups), those who would prefer to receive paper copies could still do so by ‘opting out’ of electronic delivery, but Rep. Maxine Waters, the ranking member of the committee, said the bill could hurt seniors who are not tech savvy (and might not know how to opt out of automatic electronic delivery) and suggested that electronic disclosures are read less often than those received in hard copy. She has been joined in opposition to the bill by the AARP and some other interest groups representing seniors.

Altogether, while it remains to be seen whether this legislation will make it through Congress in its current form (as it could be amended along the way to make it easier to receive paper documents), it would potentially allow advisors to reduce the amount of time and money spent on sending hard copy documents to clients. Further, it could also serve as an opportunity for advisors to review with clients how they currently receive documents from financial companies and, more generally, why certain documents and disclosures are important to review in the first place!

RIA Channel Leads Industry In Asset Growth, Cerulli Says

(Jennifer Lea Reed | Financial Advisor)

2022 was a challenging year for investors, with both the stock and bond markets seeing losses over the course of the year. Not only did this weak performance put a dent into investor portfolios, but also hindered the growth of Assets Under Management (AUM) at advisory firms (and, for many, their revenue). Nevertheless, firms can still grow during turbulent markets, whether organically through new client acquisition or through headcount acquisitions, and a recent study suggests that independent and hybrid RIAs fared better than their wirehouse counterparts during the year.

According to research and consulting firm Cerulli Associates, independent RIAs saw AUM grow 12.9% in 2022, while hybrid RIAs grew at a 13.6% pace, with wirehouses only gaining 7.4% in assets. Further, independent RIAs saw advisor headcount increase by 3.3% over the past decade, with hybrid RIAs seeing a 5.5% increase; meanwhile, wirehouse headcount fell 1.6% during this period. However, at the same time RIA assets and headcount are growing, the number of RIAs fell by 6% between 2020 and 2021, and by 1% annually in the preceding 5 years, according to Cerulli. The most affected segment was smaller RIAs with AUM of $100 million or less.

Cerulli attributed the declining number or RIAs in part to an aging advisor population. The firm found that more than one-third of advisors at RIAs intend to retire in the next decade, and 25% of these individuals are unsure about their succession plan. This environment has led to a period of robust M&A activity (at least until the end of 2022), as RIA 'aggregators' and larger firms acquired smaller practices (often with the help of private equity funding, which has been attracted to the profit margins RIAs can achieve). Altogether, the largest RIAs now control of 75% of industry assets and employe more than 60% of RIA advisors, according to Cerulli.

Notably, among firms surveyed, 80% identified compliance responsibilities and filings as their top challenge. Beyond compliance, larger firms also cited the cost to maintain staff, offices, and infrastructure, as well as maintaining and integrating technology, as key challenges, while smaller firms expressed concern about their clients’ confidence in working with them and uncertainty about future regulation.

In sum, Cerulli’s data indicate that while the RIA space continues to see growth in AUM and the number of advisors in the channel, industry consolidation has meant that the total number of firms has not kept pace. And while smaller RIAs looking to grow might not be able to compete with the marketing budgets and other resources of larger firms, they do have the opportunity to specialize and offer a unique value proposition to certain clients that larger, more generalist firms might not be able to match!

'Non-Ideal' Clients Present Productivity Challenge For Advisors

(Holly Deaton | RIA Intel)

A common problem facing financial advisors throughout their careers (and especially at the beginning) is simply getting in front of prospective clients and then convincing them to actually become paying clients. However, for those advisors who eventually reach the point where their business is sustainable, the problem can easily morph from not having enough clients to keep the lights on to having too many clients to be able to serve effectively (and no remaining capacity to add more and grow further). And so, as a client base grows and a firm identifies its target market, some of these clients (often those who came on in the early days of the firm) might no longer be a 'fit' for the firm, whether in terms of needs, specialties, engagement levels, or the revenue they generate.

In fact, advisors responding to a recent survey by research and consulting firm Cerulli Associates identified serving too many non-ideal clients as their top productivity challenge (with 64% calling it a major challenge and 27% saying it is a moderate challenge). Further, while Cerulli found that advisors are effective when they serve about 100 clients (in line with previous research on how many relationships an individual can manage at one time), senior advisors in the survey reported serving about 160 clients (and 29% of senior advisors said they manage more than 200 client relationships!). And while bringing on new staff is one way to take pressure off of a lead advisor serving a growing client base, sometimes it makes the most sense to let go of a client who is no longer a fit for the firm (to provide the advisor with more time to serve their other clients or even have more time for themselves).

And while ending a client relationship can be fraught for both the advisor and the client (who might have been working together for many years, or even decades), advisors have several options when they decide to move on from a client. For those working at larger firms, transitioning the client to a different (perhaps newer) advisor could at least allow the client to maintain ties to the firm (and avoid having to go through the onboarding process at a new firm!). For advisors without this option, alternative strategies include raising their minimum fee (and letting the client decide for themselves whether they value the advisor’s service enough to pay the higher fee), offering to refer them to another advisor who can better meet their specific needs, or perhaps ‘graduating’ them to becoming self-directed. And whatever path the advisor chooses, communicating that decision in a way that empowers the client and makes them feel respected can increase the chances that the relationship will end on a positive note!

The Extra Effort Top-Performing Advisors Put In

(Matthew Jarvis | Advisor Perspectives)

"Practice makes perfect" is a common refrain heard throughout childhood, whether in reference to studying for a test or rehearsing for a concert. But the need to practice does not end once an individual enters the working world. And for financial advisors, this means putting in the ‘reps’ to be prepared for the high-leverage situations they will frequently face.

For instance, while advisors might spend hours putting together a financial plan to present during a client meeting, they might not actually spend much time preparing for the meeting itself. For example, creating an agenda (and practicing it), anticipating questions the client might ask, and ensuring other team members understand their roles in the meeting can increase the chances that the meeting will be successful (and that the client will remain with the firm in the years ahead!).

Practice is also crucial for advisors when it comes to creating and presenting content. For example, while an advisor might feel like they ‘know’ the material they plan to present during a seminar or webinar (and therefore believe they don’t have to script the presentation or practice it), they might freeze up when the lights are turned on and they are expected to perform live in front of an audience. And so, whether it is practicing a seminar with a literal bright light in your face or with noise in the background (to prevent you from being distracted during the actual presentation), advance preparation can help ensure the event will be effective.

Ultimately, the key point is that becoming a successful advisor does not just ‘happen’, but rather requires hard work and practice. But this investment of time can ultimately reap substantial dividends, from attracting and retaining more (and more profitable) clients to running a more efficient practice!

Dear Advisors: Stop Building To Sell

(Morgan Ranstrom | The Value Of Advice)

Many owners of growing financial advisory firms (often those that reach $100 million to $300 million of assets under management) end up becoming 'accidental business owners', who spend much of their time managing their business (e.g., teaching and training employees) rather than working directly with their clients (which is why they might have become a financial advisor in the first place). Some firm owners in this position might lean into their role as a business owner, spending most of their time managing and scaling the business rather than on client work. Others might decide to sell their firm, cashing out what might be their most valuable asset and perhaps returning to a client-facing role as an employee of the acquirer (though some of these advisors might find the combined income from their salary and a reasonable withdrawal rate from the proceeds of the sale might not match what they were earning as a firm owner).

Another option for these 'accidental business owners' is to reduce the size of their client base, which has the potential to result in significant time savings without necessarily putting a major dent in their income. For instance, an advisor with 100 clients might look at their client roster, find the 20 who are their least favorite and/or bring in the least revenue (there might be overlap between the 2 groups), and offer to refer them on to another advisory firm. In this way, the advisor might be able to reduce their workload by 20% while their revenue is reduced by a (potentially much) smaller amount. Further, the advisor might find that as they shrink their client base, they no longer need as much staff support. As the number of staff members is reduced (either by natural attrition or by helping them find a new role at another firm), the firm owner could not only find themselves with more time (as they no longer have to take the time to train and manage the employee) but also fewer costs (due to no longer paying a salary and benefits).

In the end, 'right-sizing' a firm’s client base could allow an advisory firm owner to spend more time working with clients (rather than on managing others) and create free time for themselves (potentially allowing them to reduce their work hours) without a dramatic reduction in earnings. Which could ultimately create a more sustainable lifestyle for the owner while still bringing in a solid income!

The Case For Tax Adjusting A Portfolio

(Allan Roth | Advisor Perspectives)

Preparing a net worth statement is often one of the first tasks for an advisor working with a new client in order to get a better idea of the clients’ assets and liabilities. However, a client’s total assets as they appear on a net worth statement do not necessarily reflect the resources that they have available to spend. Because it is very likely that the client will have investments in traditional tax-deferred accounts or taxable brokerage accounts (with embedded capital gains), the client might have to 'share' a portion of these assets with the government at some point through taxation.

This situation raises a few potential challenges for advisors. One issue is that the taxable nature of different assets could skew a client’s asset allocation. For instance, an advisor recommending a 50% stock/50% bond portfolio might put the stock portion (expected to have higher long-run growth) in the client’s Roth IRA (where the gains will never be taxed, at least under current law) and the bond portion in their traditional IRA. But because the assets in the traditional IRA will (likely) be subject to taxation when distributed, in reality, the allocation to bonds is smaller than it appears. A similar issue could occur if the client has a combination of Roth and taxable investment accounts, as taxes could eventually be due on the capital gains in the account.

But recognizing that assets in certain accounts might be taxed in the future is just the first step, as advisors face the challenge of estimating the tax rate to which these assets will eventually be subject. For instance, an advisor might ‘reduce’ the value of a working client’s traditional IRA by their current marginal tax rate, but this rate could change significantly when they actually make distributions from the account in retirement (whether due to changes in the client’s income or in tax rates more broadly). In addition, investments in taxable investment accounts could face a variety of eventual tax rates when they sell their investments, from 0% (if the client’s income allows them to 'harvest' capital gains at a 0% rate) to 20% or more (depending on their income and whether rates change by the time they sell the assets).

Altogether, while 'tax adjusting' a client’s portfolio can be a valuable exercise (as it can provide a more accurate picture of the client’s 'after-tax' asset allocation and the resources they will eventually have available to spend), it can also lead to false precision (as the advisor will have to make assumptions regarding future tax rates and other variables). And beyond ‘tax adjusting’ a portfolio, advisors can also add significant value to create a more tax-optimized portfolio in a variety of other ways, whether through asset location, strategic (partial) Roth conversions, or other strategies!

Understanding Securities Lending In ETFs

(Zachary Evens | Morningstar)

For managers of index-tracking Exchange-Traded Funds (ETFs), it can be challenging to gain an edge over their benchmarks (or other funds pursuing a similar strategy) to attract investor interest. One way to do so is through securities lending, by which the ETF lends out portfolio securities (e.g., stocks or bonds) to broker-dealers, hedge funds, and other investors (who want the securities to implement an investment strategy such as short selling), receiving a fee in the process, which can be used to counterbalance a portion its expense ratio (a sweetener for potential investors), or, in extreme cases, even exceed the fund’s fees.

However, there are risks and considerations for advisors considering allocating client assets to funds that are active in securities lending. First, funds that offset their fees the most through securities lending often invest in riskier assets (as the fee received is typically higher for securities that are small, illiquid, or otherwise unpopular), so that the return a fund earns from securities lending could be overwhelmed by losses of the underlying fund assets. For example, the Global X Cannabis ETF earned a 2.87% return through securities lending in 2022 (well surpassing its 0.51% annual fee), but its price fell by 67% that year (far exceeding the losses of the broader market). In addition, funds could face reinvestment risk if they incur losses on the invested funds received from the securities lending (e.g., this was an issue for some funds that sought higher yields leading up to the 2008 financial crisis).

Ultimately, the key point is that securities lending can provide a boost to net returns for fund investors. But seeking out funds that offer high returns securities lending returns can be a risky proposition, and it might be more valuable to consider whether the fund’s strategy makes sense for a client in the first place!

Stocks Beat Cash Even If You Could Time A Recession

(Nir Kaissar | Bloomberg)

The question of whether the U.S. economy is heading toward a recession has been one of the hottest topics in financial media in recent months (though it can sometimes seem like a perennial conversation topic). Predictions of a coming recession might lead some advisory clients (and perhaps a few advisors) to consider moving out of riskier investments like stocks and into cash to ride out the storm. But stock market performance leading up to and during previous recessions suggest that ‘recession timing’ might not actually be profitable.

According to the National Bureau of Economic Research, there have been 30 recessions since 1871 (the longest period for which performance data is available for the S&P 500 Index and its predecessor compilation of U.S. stocks). In the 6 months leading up to these recessions, stocks produced a positive total return 21 times, suggesting that trying to ‘get ahead’ of the recession might not necessarily be an effective strategy. And even if an investor could time the beginning and end of a recession exactly, an investor still might not beat the market, as stocks produced a positive total return during 12 recessions. Overall, during the periods beginning six months before and ending six months after each historical recession, the market produced a positive total return 22 times, with a median total return of 16%, a formidable benchmark to beat (and this assumes that an individual could predict accurately when a recession will begin and has ended, and be willing to take their cash off of the sidelines!).

In the end, a potential recession is a legitimately scary prospect for clients given its potential impact on markets and the broader economy. At the same time, this provides advisors with an opportunity to help put a potential recession into perspective for nervous clients, whether it is by showing how stocks have performed in previous cycles or by helping them remember how they (and their portfolio) made it through previous recessions!

I Found The Perfect Replacement For Twitter. It's LinkedIn.

(Morgan Meaker | Wired)

These days, many Twitter users are looking for a new social media home (or at least are saying they are), perhaps due to recent changes to the site or just wanting to get away from the latest 'hot takes' from anonymous users. But the available Twitter-like alternatives (e.g., Mastodon, Post, or Hive) have left some users wanting. So instead of searching for a new social media home, Meaker decided to engage more with an established, but often derided platform: LinkedIn.

While LinkedIn claims almost 900 million users (far exceeding Twitter’s 250 million), some of its users see it as a professional necessity rather than an attractive place to find content (as the platform has a reputation for 'humblebragging' and self-congratulatory posts from its users). But after diving back into LinkedIn, Meaker found that many individuals were posting interesting, high-quality content (e.g., high-achieving individuals discussing their past failures and vulnerabilities openly). In addition, while many users' Facebook connections are purely personal and Twitter follows are largely professional (or anonymous), LinkedIn offers a unique combination of personal and professional contacts, allowing users to see posts and updates from friends, former classmates, co-workers, and others (potentially offering a ‘one-stop’ social network).

In sum, while LinkedIn might not be viewed as a 'fun' social network, it could be one of the most relevant thanks to its large user base and mix of personal and professional content. So whether you want to expand your (online) professional network, engage with industry experts, or just see where your college classmates are working now, LinkedIn could be a useful social media destination!

Chatbots Are Digesting The Internet. The Internet Wants To Get Paid.

(Christopher Mims | The Wall Street Journal)

The tech world has been abuzz in recent months exploring the possibilities of ChatGPT and other similar Artificial Intelligence (AI) tools that can answer questions, converse, and even argue with users, all while sounding plausibly human-like in their conversations. And while these tools have introduced a range of potential productivity-enhancing possibilities (from crafting marketing copy to drafting emails), the introduction of these tools has also raised a range of concerns, such as its impact on the workforce (though perhaps not financial advisors).

One of the more intriguing features of ChatGPT and related tools is their ability to respond to prompts with seemingly original text. But in reality, these tools require significant amounts of 'training', where massive amounts of text (or images, in the case of image-generating AI tools) are uploaded to help the AI system ‘learn’ and generate better responses. And it turns out that much of the training data used to build these AI tools came from the open Internet, including from sites such as Twitter and Reddit as well as from newspapers and other publications. This has led to calls from these and other websites for the companies developing AI tools to compensate them (perhaps through licensing fees) for these data. Because while ‘scraping’ (i.e., copying data that is available on the open web) is legal in some cases (e.g., websites might give search engines access to its data to move up the search rankings), the potential for ChatGPT and other tools to obviate the need for the other sites (by using their own content) represents a potential threat to their business. And beyond published content, some observers have raised concerns that by scraping the Internet, the AI tools may have ingested significant amounts of personal data (though ChatGPT creator OpenAI says that it has trained the system to reject requests for personal information).

In some ways, the debate over AI tools’ use of data from the Internet represents a new front in the battle over who ‘owns’ information published online. And in the case of ChatGPT and similar tools, it appears that many of their users also helped ‘create’ the responses the AI tools produce through their previous online activity!

Google Rolls Out Passkey Technology In 'Beginning Of The End' For Passwords

(Josh Taylor | The Guardian)

One of the small, but persistent, annoyances of modern life is setting (and keeping track of) a seemingly endless list of passwords for websites that you visit. And while password managers (e.g., 1Password or LastPass) can help reduce the need to memorize them, some security vulnerabilities and requirements to change them on a regular basis persist. This has led to interest in developing more convenient and secure methods for user authentication online.

This week, Google took a step in this direction by rolling out 'passkey' technology, which is designed to replace passwords by allowing authentication with fingerprint ID, facial ID, or a Personal Identification Number (PIN) on the phone or device used to log in (other web services that already use passkey technology include Docusign, Ebay, and PayPal). According to Google, this technology will prevent scammer from using phishing (getting users to divulge their passwords through social engineering), SIM-swap (where an outsider can gain access to an individual’s phone number, including their text messages, which are sometimes used for two-factor identification), and other methods of accessing user accounts. Google said users will still be able to use passwords when they do not have a passkey-enabled device available, though the company said it will pay closer attention to these accounts for signs of compromise.

Ultimately, the key point is that while Google's passkey technology might not mean the end of passwords quite yet, it appears to be a step in the direction of more secure (and convenient) user authentication online. And in the meantime, advisors can help their clients keep their online accounts secure, from ensuring they use strong passwords to creating a layered security structure (that might include the use of a Virtual Private Network [VPN], password manager, and/or private email!).

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We hope you enjoyed the reading! Please leave a comment below to share your thoughts, or make a suggestion of any articles you think we should highlight in a future column!

In the meantime, if you're interested in more news and information regarding advisor technology, we'd highly recommend checking out Craig Iskowitz's "Wealth Management Today" blog.