Given the general trend of advisory firms charging on some percentage of assets under management, market growth can also be a strong indicator of advisory firm growth. For firms with revenue tied to portfolio performance, the additional income that can accompany a healthy market outlook allows firms to dedicate more resources to marketing and other processes to help grow the firm. However, while this business model has worked well with the strong markets that have dominated the last 15 years, there is also an inherent risk that comes with inevitable market corrections, bear market years, and recessions, which poses the question: How can advisors structure their firms to protect against market corrections?
In the 147th episode of Kitces & Carl, Michael Kitces and client communication expert Carl Richards discuss how advisors (especially those who joined the industry after the last correction) can protect their business against the market volatility risk inherent to a business model that uses AUM fees.
As a starting point, a firm's profit margin is usually the first line of protection against a bad market. The average established firm has a profit margin of 20–30% after employee, technology, and operational expenses during 'good' market years. During bear market years (or quarters), any AUM-correlated profit margin will have a corresponding drop, and that profit margin may then drop to 0%. However, unless the profit margin drops below 0%, an advisory firm will likely be able to remain operational as is, without being forced to make difficult decisions to shrink the business. While maintaining a 0% profit margin for a quarter or few may not be pleasant, the advisory firm that is aware of this 'feast-and-famine' cycle and is prepared for it can situate itself to pull through bear markets with minimal business adjustments.
To better visualize how a recession would impact a firm's long-term growth, advisory firm owners may want to model how their business would be affected by several quarters of 'bad markets' and consider how they would need to answer these questions: How would payroll get impacted? What expenses would need to be adjusted? How would several quarters of bad markets impact the firm owner's ability to pay themselves and maintain their lifestyle? These considerations can help advisors better understand their options and the adjustments that would need to be made in the short- and long-term.
Importantly, it's essential to be mindful of the emotional toll along with the logistical side of bracing for a recession. In a bad market, advisors are constantly required to absorb client uncertainty and fear – often while they are equally unsure of what will happen. And, for advisors who are also firm owners, the toll grows as employees are also emotionally stretched to absorb the chaos of an uncertain market – and even more so if owners need to let an employee go to keep the business afloat. Emotional preparation usually poses a different challenge than reviewing a business plan. However, much as how a firm needs a certain level of profit margin to ensure that it will have the resources it needs during tough times, so too can advisors ensure they have the resources they need to maintain their own emotional wellbeing. Even basic self-care practices like maintaining a healthy diet, getting enough sleep, and exercising can provide a crucial barrier against the emotional and physical strain of stress.
Ultimately, the key point is that market corrections, slow years, bear markets, and recessions are inherent risks for firms with revenue models that rely on assets under management. However, advisors who are mindful of the effects of these trends can proactively make small adjustments before an emergency strikes – better protecting their clients and their firms in the long run!
