Tuesday, May 14, 2013

On the Future Size of Investment Advisory Firms Under a Fiduciary Standard

This morning I opened my e-mails to find another article about how advisors must "consolidate" their practices with other advisors, in order to survive. While there are some valid economic arguments here - economies of scale, for example - I believe the future of the investment advisory and financial planning professions is quite different, if a fiduciary standard is applied to all providers of personalized investment advice.

IS THERE AN ECONOMIC IMPERATIVE FOR CONSOLIDATION? First, permit me to posit an opposite economic view, centered around the themes of technology outsourcing, portfolio management outsourcing, and compliance outsourcing.

Technology outsourcing is enabling small firms to access software solutions at reasonable cost. From customer relationship management (CRM) software, to outsourced Portfolio Management Systems (PMS) (including services to reconcile the data downloaded), to investment policy statement software, to online data storage and document management software. Several integrated solutions also exist. Research software from Morningstar and other sources is also available online. All of these are available for reasonable fees to small, independent RIA firms.

I do believe that investment security and product due diligence takes time, and expertise. Yet, here again, outsourcing is available. For example, many independent RIA firms utilize the investment strategies and mutual funds / ETFs available from firms such as Dimensional Funds Advisors (www.dfaus.com) and Vanguard (www.vanguard.com). The use of mutual funds enables broad diversification among and within various asset classes, a requirement (in my view) under the Prudent Investor Rule. Substantial educational resources on portfolio strategies and portfolio management are available from these firms. The cost to the advisor? - None, at all. Discount brokers, such as TD Ameritrade, Schwab, Fidelity, and many others, offer not only custodial services but also sophisticated software solutions for online access to client accounts and trading within such accounts. While delegation of the duty of due care (and, within in, due diligence on product selection) cannot completely be undertaken by the independent advisor, the time spent to update due diligence research (typically annually, with quarterly interim reviews) is not substantial. Advisors can also attend educational conferences to learn of new investment strategies and products. For those advisors who do not desire to undertake any due diligence on their own (they may feel that they lack the ability to conduct same), outsourced solutions exist for reasonable fees.

While the use of discount custodians and low-fee mutual fund complexes may rule out investment opportunities which require greater due diligence expertise and greater time to conduct due diligence (including but not limited to the use of options to hedge portfolios, hedge funds, oil and gas partnerships, IPOs, etc.), the academic research supporting the inclusion of these asset classes in a portfolio is mixed, at best. (Just because an investment strategy is complicated, illiquid, or non-transparent does not make it good.)

Compliance can also be outsourced. As the owner of a small RIA firm myself, I discovered the benefits of compliance outsourcing a year ago. For a reasonable fee my compliance consulant (Cindi Hill of Hill Advisors, www.hilladvisors.com) monitors my IARD filings, prepares or reviews my Form ADV Part 2A and 2B, and reviews other forms utilized in my practice. Many other similar compliance solutions exist.

Other online software solutions exist, including financial planning software, document management, online storage solutions, and more. Even financial plan development can be largely outsourced today Payroll and bookkeeping services can likewise be outsourced; many vendors exist. Virtual office assistants can provide telephone answering and other services.

Of course, a brand new advisor, with very limited capital, may find it difficult to commence an RIA firm, even with the outsourcing set forth above. First-year fees and costs for outsourcing may well be $30,000 or greater (with E&O insurance, office space if needed, etc.). Yet, even then, solutions exist for new advisors. For example, Garrett Investment Advisors, LLC (www.garrettinvestmentadvisors) enables new financial planners and investment advisers to start work, under supervision, for a reasonable monthly fee, with full compliance, operational support, CRM and financial planning software, and much more. And Garrett Planning Network members are well-known for their sharing of knowledge with newer advisors. In fact, most financial planners freely provide advice to new planners, often through online discussion forums such as those maintained by the National Association of Personal Financial Advisors (www.napfa.org) and the Financial Planning Association (www.fpanet.org).

To summarize, with the availability of online software solutions and various means of outsourcing, no huge economic advantage exists for firms of very large size, when providing personalized investment advice, in my view. In fact, smaller firms may possess far lower overhead (especially when advisors work out of their home, perhaps renting office space by the hour if and when needed).

This is not to say that there are not some marketing advantages to possessing a larger firm. Yet, even with larger advertising budgets, the advisory business is all about building trust. This can be done by any size advisory firm. In fact, I would submit that building trust is nearly all about person-to-person interactions. And prospecting remains best done through niche marketing and networking.


If and when the fiduciary standard of conduct is provided to the delivery of all financial planning and investment advisory services, we shall become much closer to a true profession. And we need only look to other professions for the likely type of firms which will emerge.

Most lawyers and certified public accountants practice in small firms. Why? First, because economically they can. Second, because like so many Americans, they are entrepreneurial.

This is not to say that large law firms and CPA firms exist. The primary reason for the existence of such large legal and accounting firms is the existence of large clients - corporations. In the delivery of personalized investment advice, large clients exist in the form of multi-family office structures and retirement plan sponsors. Yet, investment advice can be delivered to these clients by smaller firms (with some outsourcing, such as plan participant education). And the delivery of investment advice and financial planning advice is, for most Americans, a one-on-one experience.

While large firms may emerge, I suspect that given the entrepreneurial spirit and independence sought by many financial and investment advisors, smaller firms will continue to dominate the RIA world.


Of course, broker-dealer firms know that the application of the fiduciary standard of conduct is the "extinction event" which is long overdue to the outdated system of  the "sale" of investment products. I have previously written extensively about the increased complexity of the financial markets, evolving investment theories, and other imperatives for a shift away from caveat emptor (let the buyer beware) product sales, and toward trust-based advice (which consumers need and desire). [See http://scholarfp.blogspot.com/2013/01/changes-in-financial-services-industry.html.]

The effects of the transformation will be pronouced.

  • No longer will expensive investment products be hyped and sold. The fiduciary standard of conduct requires that fees and costs be taken into account. This does not mean that the lowest-cost product must be sold; there may be valid reasons why a more expensive mutual fund or other pooled investment vehicle is worthwhile. But the expenditure of client funds must be undertaken with due care, by the advisor, on behalf of the client.
  • Variable (or differential) compensation structures fall by the wayside. No longer will various back-door means of compensating brokerage firms be permitted, such as the insidious payment for shelf space, soft dollar payments, and sponsorships of marketing and educational seminars by investment product providers for broker-dealer firms and their registered representatives.
  • 12b-1 fees will disappear. They are simply indefensible in a fiduciary environment. [See http://scholarfp.blogspot.com/2013/03/12b-1-fees-rias-and-registered.html].
  • Initial public offerings will not be "hyped" so much. Much academic research suggests that the returns, on average, of investments in IPOs of common stock underperforms (over the subsequent 2-3 year period, and longer) the returns of the overall market. Due diligence will require greater scrutiny by investment advisers of the prices paid for newly issued securities. This will, in turn, drive down investment banking fees, thereby eroding the large bonuses paid to so many on Wall Street involved in the investment banking industry.
In essence, the business model of current broker-dealer firms must adapt to the fiduciary model. With such adaption, a much lower extraction of rents from customers occurs, which results in the individual consumer getting a far greater (and more equitable) share of the returns.

As the number of fiduciary advisors grows, so does the pressure on product manufacturers (insurance companies, mutual fund complexes) to lower fees. As this army of "purchaser's representatives" expands, so will their scrutiny of investment products.

Additionally, greater competition will exist among fiduciary advisors. This will continue the downward trend of advisory fees. AUM fees may go by the wayside, unless the investment adviser is actively managing a portfolio of individual securities for a client. Professional-level compensation, in the form of project fees, annual retainers, and hourly fees, will grow to dominate the marketplace.

In essence, through the application of a fiduciary standard to all investment and financial advisory activities, regulators will create a much more efficient and competitive marketplace, and a far greater share of the returns of the capital markets will flow to investors.


Hence, if the fiduciary standard is applied, I see the continuing demise of the large wirehouses. Aided by technology and outsourcing, hundreds of thousands of small investment advisory and financial planning practices will exist. Larger regional and national firms will also exist, but - lacking customers which are very large in size - they will not likely grow as large as the largest law firms and CPA firms of today.

Do we desire this evolution to occur? From the standpoint of larger broker-dealer firms, the answer is clearly "no" - as it disrupts their business model and leads to their demise.

From the standpoint of independent RIAs of today, the answer might appear to be "no" - for who in their right mind would want a great deal more competition? Currently fee-only RIA firms have a marketing advantage as true fiduciaries, which would evaporate if a bona fide fiduciary standard is applied to all providers of financial planning and investment advice.

Yet, most advisors I speak with acknowledge that the evolution - the embrace of a bona fide fiduciary standard for all personalized investment advice, and the resulting move toward a true profession - is the right one. It will increase the demand for financial planning and investment advisory services, once consumers know that they can actually place trust in their advisors. It will lead to lower levels of compensation among fiduciary advisors, driven by increased competition, as the shift toward professional-level compensation takes place.

Why should we embrace such a change? Because it is right for our fellow Americans, who struggle to find trusted advice as they deal with the complexities of planning for their future retirement and other future financial needs. It is right for America itself, as greater levels of trust will lead to greater trust in our financial markets, leading to greater capital formation, lower cost of capital, and newfound economic growth. Moreover, if our fellow Americans are better enabled to provide for their own retirement security, the burdens placed on governments to step in and assist will be reduced.

In conclusion, I foresee that the future investment and financial advisory firm landscape will not be dominated by large firms, resulting from consolidation. Rather, if a fiduciary standard is applied, small professional service firms will dominate, as they do in the legal and accounting professions.

Let us move in that direction, by urging the DOL/EBSA and the SEC to adopt a true fiduciary standard for all providers of financial and investment advice to our fellow citizens.


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