One Young Breakaway Broker’s Story Of Navigating The Broker Protocol And Choosing An RIA Custodian And Technology

EXECUTIVE SUMMARY

The reality of starting out as a financial advisor is that it’s hard to know what type of advisory firm structure will be best in advance; often, the best strategy is just to dive in, get a job at any reasonable firm that will allow you to launch your career, and after you get some experience, decide whether it’s really the right fit for the future. Of course, the caveat to this approach is that if it turns out you do need to make a change later, that change can be scary – so frightening, in fact, that many advisors never make the subsequent changes they should, fearing the unknown and finding comfort in an (admittedly not ideal) current firm or environment.

In this guest post, financial advisor Noah Morgan shares his own transition process in making the leap, first from his original advisory firm to an independent broker-dealer, and then subsequently to an independent RIA. Accordingly, Noah gained a wide range of experience and perspective about what it’s like to make these transitions, from vetting RIA custodian platforms to navigating the Broker Protocol and compliance concerns, to selecting the entire suite of technology necessary to sustain the new advisory firm.

So if you’re an advisor who’s currently unhappy at your current firm, and considering the process of transitioning to something new, hopefully this will be helpful to you in gaining an awareness of the issues that you need to consider if you’re really going to make a switch in the future!

Your First Step In Breaking Away From A Broker Dealer Is The Discovery Process

That moment when you seriously consider leaving. There is no denying the benefits of independence, however the inflection point lies in the factors that are involved to take your business to the next level, not only for yourself but for your clients.

The looming questions you want to ask in your initial meetings with prospective custodians such as Schwab Advisor Services, TD Ameritrade Institutional, or alternatives like Betterment Institutional, are mirrored around how many of your clients will come with you? Other questions you might ask include “What types of systems and technology are available for financial planning or a CRM? Will I still have access to the same money managers, products and services? How will you help me with the conversion?”

Yet while these are all important questions to consider, they are only the tip of the iceberg.

You’ve Made The Decision To Break Away, Now Here Are Some Important Things To Focus On

ESSENTIAL CHECKLIST FOR BREAKING AWAY FROM A BROKER DEALER TO START AN RIA:

1. Get a securities attorney to answer transition questions as they relate to you
2. Call and interview firms who have recently made the transition from your existing Broker-Dealer
3. Identify clients that will likely transition through a Yes, Maybe, and Unlikely analysis to determine realistic conversion ratio
4. Identify a model RIA or hybrid with BD, and interview the major custodians to find a best fit from a pricing, product and values aspect
5. Set up a website, marketing campaign, and identify a niche for your new firm
6. Hire a firm to register your new RIA, set up your firm policies, client agreements and obtain E&O insurance
7. Be prepared and set realistic expectations for your workload and the support you will get from a transition team
8. Identify ongoing additional roles and responsibilities of working independently as an RIA including Billing, Accounting, Setting Up a Lease, Setting Up a Phone System
9. Technology forever and ever (demo technology solutions including CRMs, financial planning software, rebalancing software, and custodian websites)
10. Write a 90 day transition timeline and set realistic goals for yourself

The Broker Protocol And Other Issues Below the Surface To Consider During Your RIA Transition

Two to Three months from D-Day you will start the due diligence process to develop a structured approach that leaves nothing to chance. In this stage you will develop your firm’s Business Plan, find/identify your niche, and determine the value proposition that will ultimately drive your business going forward. You’ll determine your firm’s name, business entity type (LLC, S-Corp, Etc.). I recommend right from the onset of transition hiring a securities attorney to help review your current business and talk about and legal questions you may have. Make a list of any questions or reservations you have to ask your attorney to be ready for any litigation issues that may arise down the road. Knowing the ins-and-outs of your current employment situation will give you a lot of confidence you can make the transition successfully (and actually keep you out of trouble).

You may have a non-solicitation agreement or a non-compete that you should absolutely review with your attorney, to know how to handle the transition in a legal way. Know whether or not your firm is a member of The Broker Protocol by visiting www.thebrokerprotocol.com. The goal of the protocol is to further the client’s interest of privacy and freedom of choice in connection with the movement of their Financial Advisors. If you are a member of the broker protocol, you are permitted to take the name, address, phone number, email address, and account title for every client that you personally serviced at the firm, subject to certain limitations for partnerships and retirement agreements. You are not permitted to take any other documents or information concerning the accounts of your clients.

Call at least three firms who have successfully transitioned within the last 3-24 months (ideally who actually left your same broker-dealer). I cannot tell you how important it is to get the perspective of others when making this type of business decision. They will likely give insight on what potential issues you will run into. If they are from your broker-dealer in particular, they will know what assets and accounts may be problematic such as proprietary funds held in managed accounts. They may also be able to provide you with best practices to achieve a high conversion ratio. Send them a nice bottle of scotch for their time. Trust me, it will be worth yours.

Lastly and most importantly do lots of homework. You should expect to spend between 1-4 hours a day for 30-60 days to successfully master this process and have a smooth transition. This part involves learning your business inside and out all over again. You should know how many clients, how many accounts and what type of accounts you plan on working with – without even thinking twice. It’s easy to say we have roughly 350 clients and $150 million AUM, but if a third of your clients have annuities and insurance products with your Broker Dealer you are more likely to transfer only $100 Million. Remember, Custodians do not hold your Variable or Insurance Business. So in order to continue servicing these accounts, you may look to a service like Low Load Insurance Services, or becoming a dual-registered RIA by also keeping a separate Broker Dealer relationship, such as with Purshe Kaplan Sterling.

Since we made our transition in 2014, 2 of the original 4 advisors on our team have dropped their Broker Dealer registration and gone solely RIA and “Fee-Only” with their businesses. They found it was a tremendous amount of work getting registered with a broker-dealer, and then learning technology systems to stream accounts into financial planning software for business, yet it only reflected less than 5% of our overall business revenue. Looking back, we wonder whether or not this was the best decision we made setting up a broker-dealer affiliate relationship at all.

Fortunately, most custodians accept all ETFs, and 99% of Mutual Funds. If you have a one-off share class or fund that you use, be sure to check with the custodian in advance to make sure you can hold the asset. If you have Hedge Funds, Alternative REITS, BDCs, or SMAs be sure that you are aware of their transferability and how the accounts will be set up at the new custodian. Some firms require separate accounts for SMAs, where firms like TD Ameritrade may allow you to create models using SMAs. THIS IS AN IMPORTANT STEP NOT TO OVERLOOK.

Identify your clients who will be making the move with you. Use the tiered client segmentation system which you are likely to already have in place for your current clients. A client is either going to be a yes, maybe, or not a good fit for your new firm. Knowing upfront who is and who isn’t will ultimately be how you define your ideal clients in the future. Whether you serve Millennials, retirees, or both, make sure you focus on your ideal clients. This exercise will give you a realistic idea of what assets will likely transfer and help you identify opportunities down the road.

You’re now at the point where you have your firm name, you have a vague idea of how things will work from talking with other firms, you’ve identified your key clients, and it’s time to focus on the more important aspect of running an RIA – selecting your custodian and your technology solutions. The Big Three – TD Ameritrade Institutional, Schwab Advisor Services, and Fidelity Institutional, will all tell you they are the best solution for you. My advice is to really demo all three of these providers, and have a face-to-face meeting with them to address your concerns. Most of them will offer you a dedicated service team to make the transition. This does not mean they will do your paperwork for you, it simply means they will come to your office and ensure you are filling the forms out correctly. They do help you with a lot of the preliminary checklist to make sure you are on pace. From the outside looking in it’s always hard to tell whether or not a firm is properly prepared. Be sure to ask about the transitions that didn’t go so well to get insight and avoid potential known problems. You will have enough unknowns to deal with and the more you know the better off you will be.

My Experience With TD Ameritrade, Schwab, And Fidelity As RIA Custodians

Here is my experience with the various RIA custodians as we investigated during our own transition process. Take this as you wish.

TD Ameritrade is by far the most versatile in terms of Technology. For advisors that enjoy using SMAs and want to construct multiple Manager Models on a platform, they have the market. Schwab and Fidelity still require separate accounts to be opened up for each managed account.

Schwab is a great custodian, and this is who our firm uses as our primary custodian. We have a dedicated service team, as we have AUM greater than $100 million, and although the paperwork is cumbersome, they have a really robust trading platform that we have grown to appreciate. Schwab also recently launched its Institutional Intelligent Portfolios for 10 bps to firms under $100 million and free to firms with more than $100 million AUM, so if you are looking to add the robo-advisor to your platform to attract Millennials this may be a good fit.

Having little experience with Fidelity I cannot give a true perspective on their services. However, if your business is focused on retirement plans they are certainly a leader in this space.

We also use Betterment Institutional for our clients, as the Robo Advisor platform certainly cannot be ruled out. It was pretty easy to set up as a registered firm, didn’t cost anything to do so, and is a great solution for Gen X and Gen Y clients generally in the accumulation phase. Folio Institutionalis also another good solution for these types of clients.

Select a custodian based on your comfort level. Ultimately a custodian is a shell for you to set up accounts for clients to protect them. You are not stuck, your clients are not required to use your custodian, and you can easily add/change Custodians down the road.

Finding a marketing company to design branding material, make general announcements and create letterhead can be easy if you are good at making decisions. I recommend using a company like Web Savvy, Advisor Websites, or Make it a Great Day, Inc to design a website for you. Go toGoDaddy.com and purchase a domain name for your future website. You can expect to spend between $1,000 and $12,000 for a customized website. If you have the time and tech capabilities you can do it for less, but let’s be honest are you a CFP or a Web designer? As a best practice, focus on your strengths and don’t try and add another project to your list. You will have plenty of other decisions to make. Note you should expect spending at minimum 6-10 hours of conference calls and planning to get the content down to brand your new firm if you hire a company to build your website.

Crossing the RIA Setup Compliance Bridge

Compliance is certainly not something we generally get excited about, however it’s a must that should be taken seriously and should be a priority for you as you define your new world.

I thought this was one of the most generic aspects of starting the new firm because it primarily involves filling out a bunch of paperwork. However, it’s actually just as important as your marketing and branding. The forms you fill out will tell clients who you are, where you are, what you do, and how you do it. If you have put in the leg work to define the business with your niche this should be pretty straightforward. Your compliance homework will entail filling out Form ADV Part 1 and Part 2, setting up Personalized Investment Advisory Contracts, Privacy Policy Statements, Code of Ethics and even setting up a Business Continuity plan. Let’s face it these are all very important aspects of your new firm that you likely don’t have a clue on how to set up.

The good news is you will have plenty of options in this department. Whether you join a turnkey group such as the XY Planning Network as a Fee-Only advisor, hire a compliance consulting group such asGS Compliance Consulting, or use a template consulting company such asRIA in a Box, the process is involved. Advisors can expect to pay between $2,400 – $15,000 a year for registration and compliance reporting.

Obtain business, errors and omissions, and cybersecurity insurance. While we hope to never actually use the insurance we purchase, it’s always good to have a layer of protection in your business. There is no regulatory requirement to have it and while you are acting as a Fiduciary, a simple cost-benefit analysis will generally give comfort knowing you are protected. Check with FPA or NAFPA if you need to find a good Insurance Broker to provide this type of coverage. Typically you should expect to pay about $2,000 a year for a $1 Million policy.

With all of the decisions to be made, and work to be done, it’s no wonder why there are not more advisors taking this route of breaking away to an RIA. Of course, there are alternative options such as a Turnkey RIA Solution or even joining an established practice that allows advisors to avoid many of the overwhelming tasks of setting up a new business. Seriously consider calling firms, locally or even nationally, if you think you can find one with a core value alignment. A team-based approach can benefit all advisors. It was estimated by Meridian IQ that there are over 31,000 total RIA firms actively registered today and this number is growing by approximately 2000 per year. Joining an existing firm who has the experience and manpower could lead to a more successful transition as you would be able to focus simply on the transfer of clients vs. the ground laying work in setting up a business. Simply finding the right firm with the same core values and alignment is never easy for a Type-A Financial Advisor but it certainly is a solution that shouldn’t be ruled out when considering leaving your current firm. Most advisory firms are looking to grow and a phone call on your end is certainly worth your time.

Note that most RIA firms are not going to be beating down your door to have you come work with them, nor are they going to offer you upfront money to make the move. Generally you will retain the rights to your clients, and it will be a shared business expense to run the office. Economies of scale are worthwhile to leverage expertise and reduce costs. If it’s not a win for you, a win for the existing firm, and a win for your clients it’s usually not worth pursuing. That’s a lot of preplanning, now you are almost ready to move into your new office or convert your existing office into your new firm. We were lucky we own the building we are in so we just put up a new sign on the conversion date.

Rent can vary by office type but typically you can usually find non-metropolitan commercial office space for $10-$15 per square foot. In metro areas like Chicago you can find pretty decent space for $25-$50 per square foot. Your call where you want to get started. We are lucky to be in a non-metro area where space is affordable. For a 6 unit office, conference room, and reception area we have about 3600 square feet, which would retail at about $14 per square foot. This means our office would lease for about $14 x $3,600 = $50,400 per year. The benefit in this is we can easily accommodate 6 advisors and additional support staff. Look for an office that gives you the ability to grow.

Technology Solutions As An Independent Financial Advisor

Lastly, before you walk out the door on your existing firm, you will need to make some important decisions on what technology solutions your firm will use. Technology and systems are all pretty easy to use once you have had time to really learn the systems. It does take time and the systems are constantly “improving” with updates. We were originally set up with a bundled plan through Schwab Integrated Office. Most custodians or Networking Alliance Groups Such as XY Planning Network have turnkey Technology Bundled Solutions for you to access. These solutions will generally be your best bang for your buck and are a safe place to get started if you want one less thing to do. Stick to their process, don’t rush them, it’s not their first rodeo. Bundling tech will allow you to focus on transitioning your clients. If your goal is to always improve things for clients they will understand that you are testing new solutions to help meet their needs. We use Multiple Financial Planning tools and we are able to provide more solutions in doing so.

I read Alan Moore’s ”Guide to Establishing a Next Generation Financial Planning Firm” and this is a great piece on selecting some best Tech practices. Using his article as a template, here are some of the tools we are currently using and have recently demoed:

FINANCIAL PLANNING SOFTWARE

MoneyGuidePro – $995/year – Currently we use
Emoney Advisor – $3,400/Year – Currently we use

RISK PROFILING SOFTWARE

RiskAlyze– $129/Month – Currently we use

PERFORMANCE REPORTING AND BILLING

Advent Black Diamond – Approximately $20,000 Annually – Cadillac Plan
Junxure – $41/month – Demoed did not sign up

CLIENT REPORT DELIVERY & FILE SHARING

DropBox – Free

REBALANCING

TradeWarrior – $350/month – Demo’ed but did not sign up
Schwab Portfolio Rebalancer – Free currently we use

DATA GATHERING AND AGGREGATORS

PreciseFP – $59.95/month – Demo’ed did not sign up
BlueLeaf – $395/month – Demo’ed did not sign up
EMoney Advisor – Included in Financial Planning
Envestnet – Pricing Determined by AUM and services needed – We were not a good fit for Envestnet with $200 million AUM. They are great for larger firms over $1 billion in AUM. Middle market and smaller firms may not get the best services from my experience.

CLIENT RELATIONSHIP MANAGEMENT (CRM)

Wealthbox– $29/month- Great solutions for start-used – Used briefly
SalesForce – $125/month – Large learning curve – Schwab bundle – Used in past
XLR8 Salesforce – $75/Month per user – Plus upfront training cost ($5,000) – Currently we use
Redtail – $65/Month per user – Used in the past do not currently use
Junxure – $41/Month- Demo’ed but do not use

DOCUMENT MANAGEMENT

Netdocs – $200/Month up to 5 users – Currently we use

E-MAIL AND CALENDAR

Google Apps (Calendar)  – Included in Gmail pricing – Great tool, great value – Currently we do not use
Outlook – $69.99 – Comes with Word/Excel/Powerpoint – Currently we use

ONLINE MEETING SCHEDULING

Bookeo – $14.95/month – Have not used
ScheduleOnce – $19.95/Month – Currently we use

ELECTRONIC DOCUMENT PREP AND SIGNING TOOLS

EchoSign – $19.95/month – Have not used
Docusign – $20/month per user – Free with Schwab – Currently we use
LaserApp – $499/year – Free with Schwab – Currently we use

NEWSLETTER DELIVERY

MailChimp – $11/month – Currently we use

WEBSITE HOSTING

WordPress & GoDaddy – $40/year – Currently we use

PHONE

RingCentral – $114/month  (3 office locations) – Have not used
ATT – $199/Month (4 Lines) – Currently we use
Ruby Receptionist – $229/month – Plan to implement within next 12 months

E-MAIL ARCHIVING

Google Vault – $5/month – Have not used but have heard great reviews.
Smarsh – $40/month – Have not used but have heard mixed reviews
SilverSky – $29.95/Month – Currently we use

ACCOUNTING & PAYROLL

QuickBooks Online – $39.95/month – Excellent (save 30% by paying upfront) – Currently we use

VIRTUAL MEETINGS

Skype – Free – Average – Used in the past
Join.Me – Free – Average – Currently we use occasionally
GoToMeeting – $39/Month – Good – Currently we use
WebEx – $24/Month – Good – Demo’ed

PASSWORD MANAGEMENT

LastPass – Free
iLock – Mac OS Free

Estimated Technology Annual Cost: $12,000-$40,000 annually for office staff of 1-6.

The 90-Day RIA Transition Challenge: Converting 75-100% of your existing clients

Week 1, Day 1, you will be greeted by the conversion team for your RIA. You may have hoped that they will be doing your paperwork for you, but they will not be. You are your own firm and they are an affiliate. They will help ensure you fill out paperwork correctly, and they will probably have by now ordered your client packets that will have new account paperwork, your firm’s client agreements, and firm disclosures. You will be drinking out of a fire house for the next 3 months until you have transferred most of your accounts.

You will be busy moving accounts, setting up clients online to get access to their new accounts, and overwhelmed by the amount of paperwork you will fill out. It will all settle down and then you can begin to integrate your firm’s technology. Don’t rush the implementation of the technology solutions you selected at first, until you move the majority of your accounts over. It’s a mass data export and then when you add new clients it’s a one off to enter new clients into your CRM. Take your time, you’ll have lots of time to focus on your business once you make it through the account conversion.

Note: Our firm transferred 90% of our business, approximately $200 million AUM, nearly 1200 accounts for just over 500 households, in 3 months. We have 5 advisors and 3 support staff. Firms that are setting up new phone systems, office leases, and entirely new business certainly need to make sure they put the prep work into the transition, even more so than we did.

Until next time, keep it moving!

Why RIA Custodians Should Start Charging A Basis Point Custody Fee

EXECUTIVE SUMMARY

A custodian is one of the most crucial vendors for RIAs that manage client assets. From the core custodial services of trading and holding and keeping records of electronically-owned securities, to the ancillary technology that custodians provide to help advisors run their business, a good RIA custodial relationship can help firms attract and retain clients. However, as the advisory industry has shifted from a focus on sales to advice, custodians and the RIAs they serve are increasingly in conflict with one another, as many of the ways in which RIAs can help their clients reduce costs and further grow their wealth (reducing unnecessary trading costs, seeking out the best cash options, etc.) are actually detrimental to the bottom lines of the RIA custodians they use!

In this week’s post, my Tuesday 1PM EST broadcast via Periscope, we discuss why RIA custodians should start charging the RIAs they serve a custody fee, and why a basis-point custody fee would ultimately better align the interests of RIAs and the custodians that serve them, allowing custodians to actually focus on providing the best services and solutions to RIAs, instead of just seeking new ways to make money off of an RIA’s clients instead! 

To better understand why an RIA custody fee would be an improvement relative to the status quo, it is helpful to first look at how RIA custodial platforms actually make their money in the first place. In practice, most RIA custodians make money in three ways: (1) earning money on cash (either through the expense ratio of a proprietary money market fund, or by sweeping the cash to a related bank subsidiary), (2) servicing fees for mutual funds and ETFs, such as sub-TA fees along with 12b-1s via “No Transaction Fee” (NTF) platforms, and (3) ticket charges earned whenever a client makes a trade. In practice, many of these fees may ultimately be trivial to the end consumer (e.g., it’s unlikely a 50 basis point fee on a 1% cash position is going to make or break a client’s retirement), but when companies like Charles Schwab have almost 1.5 trillion dollars on their RIA platform, these expenses result in substantial revenues for RIA platforms when aggregated across all clients… albeit at the direct expense to the client.

And the reason this structure matters is that it means RIA custodians are fundamentally misaligned with the advisors they serve. Because a situation is created where we as RIAs create value for our clients by trying to systematically dismantle the custodian’s revenue and profit lines! Instead of just leaving cash in whatever money market fund is available, we look for ways to reduce cash balances or shift that cash to institutions that best compensate our clients for holding cash. Instead of using an NTF fund with a higher expense ratio, we’ll shift our client’s assets to a non-NTF fund when the ticket charge will reduce costs for them (or vice-versa). And unlike broker-dealers who stand to profit from increased trading (by marking up the ticket charges for themselves), RIAs try to reduce trading costs by helping clients avoid unnecessary trading. In short, the problem is that as RIAs, custodians have put us in the position where we look better by sticking it to the custodian… and the more we manage to ‘play the game’ and dismantle the custodian’s profit centers, the more money we save our clients, and the better we look to our clients!

And this is why the future of the RIA custody business will eventually be RIAs simply paying a basis point custody fee to the RIA custodian instead. Which is a huge leap relative to the “free” that we as RIAs currently enjoy with our custodians… but basis point custodial fees would actually be better for all of us in the long run! Suppose RIA custodians charged 10 basis points, tiering down to 7, 5, and then 3 basis points for large firms (intended to simply approximate what they already make off of RIA clients on average). If custodians did this in lieu of making money off of our clients, now their incentive is not to try and figure out how they can make more money off of our clients, but instead to truly create the best RIA custody platform out there for gathering client assets! With a custody fee in place, RIA custodians could then pay better rates on money market funds, eliminate ticket charges that annoy our clients (and time spent by advisors devising ways around ticket charges for our clients), and eliminate both 12b-1 fees and sub-TA fees, instead providing a new version of truly “clean shares” that strip out all back-end fees (regardless of what fund company is used). In other words, once the RIA custodian gets an RIA custody fee, the custodian is freed up toactually give us as advisors the best possible solutions for our clients!

Of course, there may be some challenges in getting RIAs to adopt such a model, particularly given that a subset of RIAs – namely those that use buy and hold portfolios for clients and actively seek ways to get clients the best deal on cash holdings – are already paying less (as they’re effectively subsidized by the RIAs that do not use such strategies!).

But the bottom line is just to recognize that, in the long-run, both RIAs and the custodial platforms they use would be better off with custodians charging a basis point custody fee, rather than just looking for ways to make money off of our clients. Even though it may feel really awkward to us when we’re not using to paying that custody fee, it will ultimately be better, both for the custodian and for the RIA itself, by properly aligning their interests… which means, in the end, it’s better for the client, too!

How RIA Custodians Are Misaligned With The RIA Advisors They Serve

And the reason this structure matters as a problem is that it means RIA custodians are fundamentally misaligned with all of us the advisors that they serve. Because it’s now created a situation where we as RIAs can create value for our clients by trying to systematically dismantle the custodian’s revenue and profit lines, right? The custodian makes most of their money off the money market and bank sweep that pays ultra-low interest rates so the custodian can profit, great, then either we userebalancing software to always keep clients fully invested so they don’t have more than, like, a 1% allocation they have to, or we buy ultra-short-term bond funds just so that we don’t have to keep anything in actual cash, or we tell our clients to keep their cash somewhere else that gives them better yields if they’re not about to invest it anyways.

There’s even a service now called MaxMyInterest, which will helpautomate the process of taking client cash away from custodians and send it to third-party banks that pay drastically higher yields, boosting client cash returns by as much as 1% to 1.5% a year.

Similarly, if RIA custodians make money off sub-TA fees, we choose mutual funds or ETFs that don’t pay sub-TA fees. That’s the major reason why Vanguard and DFA funds have lower expense ratios than most of their competitors offering similar solutions, because their expense ratios don’t include all the back-end payments to the custodians. So we seek out the lowest cost funds for our clients and we dismantle the custodian sub-TA fee line.

The same thing happens with 12b-1 fees in NTF platforms. It’s usually not a good deal for most clients of advisors to use mutual funds in those NTF platforms because they have higher expense ratios because they use the share class with the 12b-1 fee, which still indirectly comes out of the client’s pocket and goes to the custodian. So what do we do as advisors? When clients have sizable assets, we skip the NTF platform, pay the ticket charges instead because it’s cheaper for our clients at the expense of the custodian losing revenue. The only clients we put in NTF funds, clients whose accounts are small, where 12b-1 fee is cheaper than paying the ticket charge. Which means we’re simply making sure as advisors that it’s lose-lose for the custodian.

And then, of course, there’s the ticket trading charges themselves which are completely commoditized, getting pressured lower and lower, for which we as advisors then regularly ask for more concessions. “New clients coming on board with a whole bunch of trades, can we have a break so we can get the client?” Using rebalancing software to ensure we’re trading efficiently. Maybe just if we do a lot of trading, negotiating a fee-based wrap account arrangement anyways for the client or that particular investment strategy with the high-volume trading to bring the total cost down. Basically, it’s another lose-lose situation for the custodian.

Because again, the problem is that as RIAs, custodians have put us in the position now where we look better by sticking it to the custodian. The more we play the game and dismantle the custodian’s profit centers, the more money we save our clients, and the better we look in front of our clients. And ironically, that means the more fee pressure there is on us as advisors, the more incentivized we are to put pressure on the custodians to reduce their profits, because it reduces the client’s costs and that makes our fee look more manageable when we could say, “Look at how much money I’m saving you by helping you avoid all these direct and indirect investment expenses,” many of which are coming from the custodial platform and used to be the revenue of the custodial platform.

This is the problem when RIA custodians operate a business model that’s infundamental conflict with the advisors they serve.

The Future Of RIA Custody Is Paying A Basis Point Custody Fee

And this is why I think the future of the RIA custody business will eventually be, as RIAs, we will simply pay a basis point custody fee to the custodian instead.

I realize that this is a huge leap relative to the “free” that we are used to getting as RIAs with our custodians, but hear me out on why I think this is actually better for all of us in the long run.

Imagine for a moment that an RIA custodian charged us a custody fee to use their platform, all their tools, all their technology and then all the actual brokerage platform stuff itself and the funds and the ETFs and the stocks and the bonds, we get all of that, and instead of getting it for “free”, where they try to extract the value from our clients, we pay for it directly, maybe for something like 10 basis points, tearing down to 7 and 5 and 3 basis points as your assets grow.

Which is simply meant to be an approximation of how much the RIA custodian already makes off the typical RIA, but instead of making a basis point or 2 on average in ticket charges and a few basis points off the sliver of client assets and NTF funds and then the 50 to 100 basis points that they make off a few percent of cash that we hold, they just charge us one uniform custody fee on everything with breakpoints at higher asset thresholds.

If all the RIA custodians it was our custody fee, we would rightly be pissed off as RIAs because now they’re double-dipping, right? They’re charging us to use the platform and they’re still making money off our clients. But the point here is not to charge us custody fee and to make money off our clients, the point is to charge us a custody fee in lieu of making money off our clients and simply charging a custody fee that averages out to the same dollars they were already making from us anyways when you calculate it as a percentage of the revenue based on the total assets of their platform.

But here’s why it matters. Because once the RIA custodian switches their model to a custody fee, now their incentive is not to try to figure out how to gauge more money indirectly from our clients and playing that game with us, now their incentive is actually just to make it the best darn RIA custody platform out there for gathering client assets.

So imagine an RIA custodian that because they don’t need to make money off their money market funds because it already earns the uniform custody fee, they pay 1.5% to 2% yields on their money market like other leading online banks, how much more can we attract in clients by having the best money market rates out there? And because the RIA custodian would be making their custody fee, there’d be no ticket charges at all. They’re just wrap-trading to the custody fee at that point. Wouldn’t it be nice to be able to stop whacking clients with all those ticket charges, which even though they’re pretty small, a couple bucks a trade, is still a big nuisance for clients? Now we don’t have to decide whether they’re going to pay for it or we’re going to pay for it, it just vanishes into a custody fee.

And because the RIA custodian will be making their custody fee, I would expect they then go back to all the fund providers and renegotiate new versions of true, clean shares. No 12b-1 fees, no sub-TA fees, no nothing, a special version of advisor class shares where no back-end fees are needed because the custodian is earning their custody fee, which means you get the cheapest funds that exist of any fund company at any time. You don’t just have to go to Vanguard or DFA to find the cheapest funds, you can go anywhere because the costs will come down for all of them because we’ve stripped out the sub-TA fees and the 12b-1 fees because we’re simply paying a custody fee.

In other words, once the RIA custodian gets a custody fee, they’re free to actually try to give us the best solutions for our clients. The best cash returns, the zero trading costs, the true lowest cost funds. And the custodian doesn’t have to care now whether we use Vanguard or whether we use American Funds. And if we do which F class share we use and the one that is the sub-TA fee or not, because all of them would just be uniform low-cost share classes and the fund companies could be urged to make them just to get out of the hot, new RIA custodial platform.

Because what this does in the aggregate is that now instead of us being incentivized to game the system, minimize cash, create workflows and processes to reduce ticket charges, swap it in and out of NTF platforms against the size the client, avoid share classes with sub-TA fees in order to minimize custodial revenues, now we as advisors would actually be incentivized to consolidate client’s assets into a common platform that clients would want to use because they have the best solutions, not the ones that make the custodian the most money. We would legitimately be able to have the best solutions in the marketplace. And why wouldn’t clients want to consolidate at that point if you actually have the lowest cost options in each category of what you’re doing, or the best yield or the lowest rate, the lowest charging rate in a good way?

It helps us as advisors validate our fees for providing that value. And the more we consolidate, the bigger the RIA custodian gets as well because they earn the custody fee on all the assets regardless of the type. That’s what happens when the models get aligned. And it also helps the RIA custodian that just won’t have to struggle any longer with the fact that passive RIAs are less profitable than active ones that generate more ticket charges. And firms that use rebalancing software are less profitable than those that don’t manage the portfolio as well and carry excess cash balances because all the RIAs would be consistently profitable with the platform based on their uniform custody fee. And there wouldn’t be incentives to try to game the system anymore. The only incentive we’d have is to grow, which makes everybody win.

The Challenge Of Pivoting To Paid RIA Custody Arrangements

Ironically, though, the fact that not all RIAs are equally profitable right now will actually be one of the biggest blocking points for reinventing the RIA custody model. Because those of us who are already good at playing the game essentially get a below average fee and won’t want to switch. We are being subsidized by the subset of firms that are the most profitable because they do a lot of trading or they’re not careful with their cash balances. Which means from the RIA custodian’s end, the firms gaming the system will want to keep gaming the system by not switching to a custody fee, and the firms that were previously profitable will want to go to the custody fee because they get a price cut, which unfortunately is something the RIA custodians have brought on themselves by misaligning their models with the RIAs they serve.

This was never an issue in the broker-dealer world because broker-dealers are a transactional business and they just got a slice of those transactions. If a custodian charges 5 bucks or 10 bucks a trade, broker-dealer charges 15 bucks and takes the markup. If the custodian makes 50 basis points on cash, the broker-dealer gets another 10, and so on down the line. This was never a necessary shift in the broker-dealer world. The RIA custody model ironically is actually more aligned to broker-dealers, though. It’s not aligned to the RIAs they’re serving now. This is just what happens when you have a transactional broker-dealer model and you apply it to a relationship-oriented AUM/RIA model.

That’s why I think it ultimately has to shift. Because it lets RIAs avoid this constant conflict with their custodial platforms, and it lets custodial platforms grow without being gamed by their RIAs. A true alignment of business model is a powerful thing. I mean, arguably, the alignments to the RIA model is why it’s grown so well itself because it better aligns the advisor and the client’s interest in an ongoing relationship rather than being transactional. And the same is possible for the RIA custodian and the firms they serve, by making one simple, clean, well-aligned custody fee.

Not blended with having minimums for cash or minimums for trades or other requirements, just one that simply says, “Hey, advisor, you want to break on your fees? Grow bigger and hit the next asset break point.” And rather than begging us as advisors to make our clients more profitable for them by trading more or holding more cash or using more expensive funds.

And well, we’ll see who makes the shift first. My gut is that some RIA custodian is going to offer this soon, perhaps because of just the competition. As RIAs get better and better at gaming the system, we’re bringing all the revenue lines lower and lower for the custodians as a percentage of assets. We may force it at some point anyways. Especially as we get more efficient cash management tools and we start moving cash off custody platforms, it’s actually a very material threat to the entire custody business model. Or perhaps some RIA custodian will just do it to be the“disruptive innovator” that challenges the rest of the custodians…

But this is the opportunity for us to actually have the best custody platform we’ve ever seen with the best fund solutions, the lowest ticket charges, real high yielding money markets along with whatever else they can throw in, lower margin loan rates, lower rates on securities-based lending. Because again, the whole point is that once you price the RIA relationship with a basis point fee, you don’t have to nickel and dime the clients to profit on each product line. Instead, the custodians make this product compelling to use with clients and attract RIAs and client assets instead.

I hope this is helpful as just some food for thought about why I think the future of the RIA custodian model is to charge a custody fee, and why even though it’s going to feel really awkward for us when we’re not used to paying their custody fee, it will ultimately be better in the long run, both for the custodian and for the RIA itself (that gets better than ever solutions to offer their clients), which means, in the end, it’s better for the client too.

This is Office Hours with Holman Skinner We’re normally 1 p.m. East Coast time on Tuesdays. Obviously a little bit off today, but thanks for joining us here on Wednesday. Have a great day!

So what do you think? Should RIA custodians start charging a basis point custody fee? Would this business model allow custodians to provide better resources to RIAs? Would a basis point custody fee ultimately be better for clients as well? Please share your thoughts in the comments below!

The Favorable Tax Treatment Of Financial Advisor Commissions Over Fees After TCJA

EXECUTIVE SUMMARY

The annual requirement of all Americans to pay taxes on their income requires first calculating what their “income” is in the first place. In the context of businesses, the equation of “revenue minus expenses” is fairly straightforward, but for individuals – who are not allowed to deduct “personal” expenses – the process of determining what is, and is not, a deductible expense is more complex.

Fortunately, the basic principle that income should be reduced by expenses associated with that income continues to hold true, and is codified in the form of Internal Revenue Code Section 212, that permits individuals to deduct any expenses associated with the production of income, or the management of such property – including fees for investment advice.

However, the recent Tax Cuts and Jobs Act (TCJA) of 2017 eliminated the ability of individuals to deduct Section 212 expenses, as a part of “temporarily” suspending all miscellaneous itemized deductions through 2025. Even though the reality is that investment expenses subtracted directly from an investment holding – such as the expense ratio of a mutual fund or ETF – remain implicitly a pre-tax payment (as it’s subtracted directly from income before the remainder is distributed to shareholders in the first place).

The end result is that under current law, payments to advisors who are compensated via commissions can be made on a pre-tax basis, but paying advisory fees to clients are not tax deductible… which is especially awkward and ironic given the current legislative and regulatory pushtowards more fee-based advice!

Fortunately, to the extent this is an “unintended consequence” of the TCJA legislation – in which Section 212 deductions for advisory fees were simply caught up amidst dozens of other miscellaneous itemized deductions that were suspended – it’s possible that Congress will ultimately intervene to restore the deduction (and more generally, to restore parity between commission- and fee-based compensation models for advisors).

In the meantime, though, some advisors may even consider switching clients to commission-based accounts for more favorable tax treatment, and larger firms may want to explore institutionalizing their investment models and strategies into a proprietary mutual fund or ETF to preserve pre-tax treatment for clients (by collecting the firm’s advisory fee on a pre-tax basis via the expense ratio of the fund, rather than billed to clients directly). And at a minimum, advisory firms will likely want to maximize billing traditional IRA advisory fees directly to those accounts, where feasible, as a payment from an IRA (or other traditional employer retirement plan) is implicitly “tax-deductible” when it is made from a pre-tax account in the first place.

The bottom line, though, is simply to recognize that, while unintended, the tax treatment of advisory fees is now substantially different than it is for advisors compensated via commissions. And while some workarounds do remain, at least in limited situations, the irony is that tax planning for advisory fees has itself become a compelling tax planning strategy for financial advisors!

Deducting Financial Advisor Fees As Section 212 Expenses

It’s a long-recognized principle of tax law that in the process of taxing income, it’s appropriate to first reduce that income by any expenses that were necessary to produce it. Thus businesses only pay taxes on their “net” income after expenses under IRC Section 162. And the rule applies for individuals as well – while “personal” expenditures are not deductible, IRC Section 212 does allow any individual to deduct expenses not associated with a business as long as they are still directly associated with the production of income.

Specifically, IRC Section 212 states that for individuals:

“There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year:

• for the production or collection of income;
• for the management, conservation, or maintenance of property held for the production of income; or
• in connection with the determination, collection, or refund of any tax.”

Thus, investment management fees charged by an RIA (i.e., the classic AUM fee) are deductible as a Section 212 expense (along with subscriptions to investment newsletters and similar publications), along with any service charges for investment platforms (e.g., custodial fees, dividend reinvestment plan fees, under subsection (1) or (2) above), or any other form of “investment counsel” under Treasury Regulation 1.212-1(g). Similarly, tax preparation fees are deductible (under subsection (3)), along with any income tax or estate tax planning advice (as they’re associated with the determination or collection of a tax).

On the other hand, not any/all fees to financial advisors are tax-deductible under IRC Section 212. Because deductions are permitted only for expenses directly associated with the production of income, financial planning fees (outside of the investment management or tax planning components) are not deductible. Similarly, while tax planning advice is deductible (including income and estate tax planning), and tax preparationfees are deductible, the preparation of estate planning documents thatimplement tax strategies (e.g., creating a Will or revocable living trust with a Bypass Trust, or a GST trust) are not deductible (at best, only the “planning” portion of the attorney’s fee would be).

The caveat to deducting Section 212 expenses in recent years, though, washow they are deducted. Specifically, IRC Section 67 required that Section 212 expenses could only be deducted to the extent they, along with any/all other “miscellaneous itemized deductions”, exceed 2% of Adjusted Gross Income (AGI). In turn, IRC Section 55(b)(1)(A)(i) didn’t allow miscellaneous itemized deductions to be deducted, at all, for AMT purposes.

Thus, in practice, Section 212 expenses – including fees for financial advisors – were only deductible to the extent they exceeded 2% of AGI (andthe individual was not subject to AMT). Fortunately, though, given that financial advisors tend to work with fairly “sizable” portfolios, and the median AUM fee on a $1M portfolio is 1%, in practice the 2%-of-AGI threshold was often feasible to achieve, and thus many/most clients wereable to deduct their advisory fees (at least up until they were impacted by AMT).

TCJA 2017 Ends The Deductibility Of Financial Advisor Fees

As a part of the Tax Cuts and Jobs Act (TCJA) of 2017, Congress substantially increased the Standard Deduction, and curtailed a number of itemized deductions… including the elimination of the entire category of miscellaneous itemized deductions subject to the 2%-of-AGI floor. Technically, Section 67 expenses are just “suspended” for 8 years (from 2018 through the end of 2025, when TCJA sunsets) under the new IRC Section 67(g).

Nonetheless, the point remains: with no deduction for any miscellaneous itemized deductions under IRC Section 67 starting in 2018, no Section 212 expenses can be deducted at all… which means individuals lose the ability to deduct any form of financial advisor fees under TCJA (regardless of whether they are subject to the AMT or not!), and all financial advisor fees will be paid with after-tax dollars.

The Tax Cuts and Jobs Act of 2017 has eliminated the deductibility of financial advisor fees!

CLICK TO TWEET

Notably, though, a retirement account can still pay its own advisory fees. Under Treasury Regulation 1.404(a)-3(d), a retirement plan can pay its ownSection 212 expenses without the cost being a deemed contribution to (or taxable distribution from) the retirement account. And since a traditional IRA (or other traditional employer retirement plan) is a pre-tax account, by definition the payment of the advisory fee directly from the account is a pre-tax payment of the financial advisor’s fee!

Example 1. Charlie has a $250,000 traditional IRA that is subject to a 1.2% advisory fee, for a total fee of $3,000 this year. His advisor can either bill the IRA directly to pay the IRA’s advisory fee, or from Charlie’s separate/outside taxable account (which under PLR 201104061 is permissible and will not be treated as a constructive contribution to the account).

Given the tax law changes under TCJA, if Charlie pays the $3,000 advisory fee from his outside account, it will be an entirely after-tax payment, as no portion of the Section 212 expense will be deductible in 2018 and beyond. By contrast, if he pays the fee from his traditional IRA, his $250,000 taxable-in-the-future account will be reduced to $247,000, implicitly reducing his future taxable income by $3,000 and saving $750 in future taxes (assuming a 25% tax rate).

Simply put, the virtue of allowing the traditional IRA to “pay its own way” and cover its traditional IRA advisory fees directly from the account is the ability to pay the advisory fee with pre-tax dollars. Or viewed another way, if Charlie in the above example had waited to spend the $3,000 from the IRA in the future, he would have owed $750 in taxes and only been able to spend $2,250; by paying the advisory fee directly from the IRA, though, he satisfied the entire $3,000 bill with “only” $2,250 of after-tax dollars (whereas it would have cost him all $3,000 if he paid from his taxable account!)!

However, the reality is that IRAs are not the only type of investment vehicle that is able to implicitly pay its own expenses on a pre-tax basis!

The Pre-Tax Payment Of Investment Commissions And Fund Expenses STOP!!

Mutual funds (including Exchange-Traded Funds) are pooled investment vehicles that collectively manage assets in a single pot, gathering up the interest and dividend income of the assets, and granting shares to those who invest into the fund to track their proportional ownership of the income and assets in the fund that are passed through to them, from which expenses of the fund are collectively paid.

The virtue of this arrangement – and the original underpinning of the entire Registered Investment Company structure – is that by pooling dollars together, investors in the fund can more rapidly gain economies of scale in the trading and execution of its investment assets (more so than they could as individual investors trying to buy the same stocks and bonds themselves), even as their proportionate share ownership ensures that they still participate in their respective share of the fund’s returns.

From the tax perspective, though, the additional “good news” about this pooled pass-through arrangement is that mechanically, any internal expenses of the pooled vehicle are subtracted from the income of the fund, before the remainder is distributed through to the underlying shareholders on a pro-rata basis.

Example 2. Jessica invests $1M into a $99M mutual fund that invests in large-cap stocks, in which she now owns 1% of the total $100M of value. Over the next year, the fund generates a 2.5% dividend from its underlying stock holdings (a total of $2.5M in dividends), which at the end of the year will be distributed to shareholders – of which Jessica will receive $25,000 as the holder of 1% of the outstanding mutual fund shares.

However, the direct-to-consumer mutual fund has an internal expense ratio of 0.60%, which amounts to $600,000 in fees. Accordingly, of the $2.5M of accumulated dividends in the fund, $600,000 will be used to pay the expenses of the fund, and only the remaining $1.9M will be distributed to shareholders, which means Jessica will only actually receive a dividend distribution of $19,000 (having been reduced by her 1% x $600,000 = $6,000 share of the fund’s expenses). Or stated more simply, Jessica’s net distribution is 2.5% (dividend) – 0.6% (expense ratio) = 1.9% (net dividend that is taxable).

The end result of the above example is that while Jessica’s investments produced $25,000 of actual dividend income, the fund distributed only $19,000 of those dividends – as the rest were used to pay the expenses of the fund – which means Jessica only ever pays taxes on the net $19,000 of income. Or viewed another way, Jessica managed to pay the entire $6,000 expense ratio with pre-tax dollars – literally, $6,000 of dividend income that she was never taxed on.

Which is significant, because if Jessica had simply owned those same $1M of stocks directly, earned the same $25,000 of dividends herself, and paid a $6,000 management fee to a financial advisor to manage the same portfolio… Jessica would have to pay taxes on all $25,000 of dividends, and would be unable to deduct the $6,000 of financial advisor fees, given that Section 212 expenses are no longer deductible for individuals! In other words, the mutual fund (or ETF) structure actually turns non-deductible investment management fees into pre-tax payments via the expense ratio of the fund!

In addition, the reality is that a commission payment to a broker who sells a mutual fund is treated as a “distribution charge” of the fund (i.e., an expense of the fund itself, to sell its shares to investors) that is included in the expense ratio. Which means a mutual fund commission itself is effectively treated as a pre-tax expense for the investor!

Example 2a. Continuing the prior example, assume instead that Jessica purchased the mutual fund investment through her broker, who recommended a C-share class that had an expense ratio of 1.6% (including an additional 1%/year trail expense that will be paid to her broker for the upfront and ongoing service).

In this case, the total expenses of her $1M investment into the fund will be 1.6%, or $16,000, which will be subtracted from her $25,000 share of the dividend income. As a result, her end-of-year dividend distribution will be only $9,000, effectively allowing her to avoid ever paying income taxes on the $16,000 of dividends that were used to pay the fund’s expenses (including compensation to the broker).

Ironically, the end result is that Jessica’s broker is paid a 1%/year fee that is paid entirely pre-tax, even though if Jessica hired an RIA to manage the portfolio directly, with the same investment strategy and the same portfolio and the same 1% fee, the RIA’s 1%/year fee would not be deductible anymore! And this result occurs as long as the fund has any level of income to distribute (which may be dividends as shown in the earlier example, or interest, or capital gains).

Under TCJA, a 1%/yr commission can be paid pre-tax, but not a 1%/yr investment advisory fee!

CLICK TO TWEET

Notably, it does not appear that the new less favorable treatment for advisory fees compared to commissions was directly intended, nor did it have any relationship to the Department of Labor’s fiduciary rule; instead, it was simply a byproduct of the removal of IRC Section 67’s miscellaneous itemized deductions, which impacted dozens of individual deductions… albeit including the deduction for investment advisory fees!

Tax Strategies For Deducting Financial Advisor Fees After TCJA

Given the current regulatory environment, with both the Department of Labor (and various states) rolling out fiduciary rules that are expected to reduce commissions and accelerate the shift towards advisory fees instead, along with a potential SEC fiduciary rule proposal in the coming year, the sudden differential between the tax treatment of advisory fees versus commissions raises substantial questions for financial advisors.

Of course, the reality is that not all advisory fees were actually deductible in the past (due to both the 2%-of-AGI threshold for miscellaneous itemized deductions, and the impact of AMT), and advisory fees are still implicitly “deductible” if paid directly from a pre-tax retirement account. Nonetheless, for a wide swath of clients, investment management fees that were previously paid pre-tax will no longer be pre-tax if actually paid as a fee rather than a commission.

In addition, given that the now-disparate treatment between fees and commissions appears to be an indirect by-product of simply suspending allmiscellaneous itemized deductions, it’s entirely possible that subsequent legislation from Congress will “fix” the change and reinstate the deduction. After all, investment interest expenses remain deductible under IRC Section 163(d) to the extent that it exceeds net investment income; accordingly, the investment advisory fee (and other Section 212 expenses) might similarly be reinstated as a similar deduction (to the extent it exceeds net investment income). At least for those whose itemized deductions in total can still exceed the new, higher Standard Deduction that was implemented under TCJA (at $12,000 for individuals and $24,000 for married couples).

Unfortunately, one of the most straightforward ways to at least partially preserve favorable tax treatment of advisory fees – to simply add them to the basis of the investment, akin to how transaction costs like trading charges can be added to basis – is not permitted. Under Chief Counsel Memorandum 200721015, the IRS definitively declared that investment advisory fees could not be treated as carrying charges that add to basis under Treasury Regulation 1.266-1(b)(1). Which means advisory fees may be deducted, or not, but cannot be capitalized by adding them to basis as a means to reduce capital gains taxes in the future (although notably, CCM 200721015 did not address whether a wrap fee, which supplants individual trading costs that are normally added to basis, could itself be capitalized into basis, as long as the fee is not actually for investment advice!).

Nonetheless, the good news is that there are at least a few options available to financial advisors – particularly those who do charge now-less-favorable advisory fees – who want to maximize the favorable tax treatment of their costs to clients, including:

– Switching from fees to commissions

– Converting from separately managed accounts to pooled investment vehicles

– Allocating fees to pre-tax accounts (e.g., IRAs) where feasible

SWITCHING FROM ADVISORY FEES TO COMMISSIONS

For the past decade, financial advisors from all channels have been converging on a price point of 1%/year as compensation (to the advisor themselves) for ongoing financial advice, regardless of whether it is paid in the form of a 1% AUM fee for an RIA, or a 1% commission trail (e.g., via a C-share mutual fund) for a registered representative of a broker-dealer.

Of course, the caveat is that once a broker actually gives ongoing financial advice that is more than solely incidental to the sale of brokerage services, and/or receives “special compensation” (a fee for their advice), the broker must register as an investment adviser and collect their compensation as an advisory fee anyway. Which is why the industry shift to 1%/year compensation for ongoing advice (and not just the sale of products) has led to an explosion of broker-dealers launching corporate RIAs, so their brokers can switch from commissions to advisory fees.

Given these regulatory constraints, it may not often be feasible anymore for those who are dual-registered or hybrid advisors to switch their current clients from advisory fee accounts back to commission-based accounts – especially for those who have left the broker-dealer world entirely and are solely independent RIAs (with no access to commission-based products at all!).

Still, for those who are still in a hybrid or dual-registered status, there is at least some potential appeal now to shift tax-sensitive clients into C-share commission-based funds, rather than using institutional share classes (or ETFs) in an advisory account.

Of course, it’s also important to bear in mind that many broker-dealers have a lower payout on mutual funds than what an advisor keeps of their RIA advisory fees, and it’s not always possible to find a mutual fund that isexactly 1% more expensive solely to convert the advisor’s compensation from an advisory fee to a trail commission. And some clients may already have embedded capital gains in their current investments and not be interested in switching. And there’s a risk that Congress could reinstate the investment advisory fee deduction in the future (introducing additional costs for clients who want to switch back).

Nonetheless, at the margin, for dual-registered or hybrid advisors who dohave a choice about whether to be compensated from clients by advisory fees versus commissions, there is some incentive for tax-sensitive clients to use commission-based trail products (at least in taxable accounts where the distinction matters, as within an IRA even traditional advisory fees are being paid from pre-tax funds anyway!).

Creating A Firm’s Own Proprietary Mutual Fund Or ETF

For very large advisory firms, another option to consider is actually turning their investment strategies for clients into a pooled mutual fund or ETF, such that clients of the firm will be invested not via separate individual accounts that the firm manages, but instead into a single (or series of) mutual fund(s) that the firm creates for its clients. The appeal of this approach: the firm’s 1% advisory fee may not be deductible, but its 1% investment management fee to operate the mutual fund would be!

Unfortunately, in practice there are a number of significant caveats to this approach, including that the client psychology of holding “one mutual fund” is not the same as seeing the individual investments in their account, the firm loses its ability to customize client portfolios beyond standardized models being used for each of their new mutual funds, the approach necessitates a purely model-based implementation of the firm’s investment strategies in the first place, it’s no longer feasible to implementcross-account asset location strategies, and there are non-trivial costs to creating a mutual fund or ETF in the first place. For which the proprietary-fund-for-tax-savings strategy is again only relevant for taxable accounts (and not IRAs, not tax-exempt institutions) in the first place.

Nonetheless, for the largest independent advisory firms, creating a mutual fund or ETF version of their investment offering, if only to be made available for the subset of clients who are most tax-sensitive, and have large holdings in taxable accounts (where the difference in tax treatment matters), may find the strategy appealing.

Notably, for this approach, the firm wouldn’t even necessarily need to pay itself a “commission”, per se, but simply be the RIA that is hired by the mutual fund to manage the assets of the fund, and simply be paid its similar/same advisory fee to manage the portfolio (albeit in mutual fund or ETF format, to allow the investment management fee to become part of the expense ratio that is subtracted from fund income on a pre-tax basis).

Paying Financial Advisory Fees From Traditional IRAs (To The Extent Permissible)

For those who don’t want to (or can’t feasibly) revert clients to commission-based accounts, or launch their own proprietary funds, the most straightforward way to handle the loss of tax deductibility for financial advisor fees is simply pay them from retirement accounts where possible to maximize the still-available pre-tax treatment. As again, while the TCJA’s removal of IRC Section 67 means that Section 212 expenses aren’t deductible anymore, advisory fees are still Section 212 expenses… which means IRAs (and other retirement accounts) can still pay their ownfees on their own behalf. On a pre-tax basis, since the account itself is pre-tax.

In practice, this means that advisory firms will need to bill each account for its pro-rata share of the total advisory fees, given that IRAs should only pay advisory fees for their own account holdings and not for other/outside accounts (which can be deemed a prohibited transaction that disqualifies the entire IRA!). In addition, an IRA can only pay an investment managementfee from the account, and not financial planning fees (for anything beyond the investment-advice-on-the-IRA portion), which limits the ability to bill financial planning fees to IRAs, and even raises concerns for “bundled” AUM fees that include a significant financial planning component. And of course, it’s only desirable to bill pre-tax traditional IRAs, and not Roth-style accounts (which are entirely tax-free); Roth fees should still be paid from outside accounts instead.

The one caveat to this approach worth recognizing, though, is that while paying an advisory fee from an IRA is pre-tax (i.e., deductible), while paying from an outside taxable account is not, in the long run the IRA would have grown tax-deferred, while a taxable brokerage account is subject to ongoing taxation on interest, dividends, and capital gains. Which means eventually, “giving up” tax-deferred growth in the IRA on the advisory fee may cost more than trying to preserve the pre-tax treatment of the fee in the first place.

However, in reality, the breakeven periods for it to be superior to pay an advisory fee with outside dollars are very long, especially in a high-valuation (i.e., low-return) and low-yield environment. Accordingly, the chart below shows how many years an IRA would have to grow on a tax-deferred basis without being liquidated, to overcome the loss of the tax deduction that comes from paying the advisory fee on a non-deductible basis in the first place. (Assuming growth in the taxable account is turned over every year at the applicable tax rate.)

As the results reveal, at modest growth rates it is a multi-decade time horizon, at best, to recover the “lost” tax value of paying for an advisory fee with pre-tax dollars. And the higher the income level of the client, the morevaluable it is to pay the advisory fee from the IRA (as the implicit value of the tax deduction becomes even higher). Nonetheless, at least some clients – especially those at lower income levels, with more optimistic growth rates, and very long time horizons – may at least consider paying advisory fees with outside dollars and simply eschewing the tax benefits of paying directly from the IRA.

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In the end, the reality is that when the typical advisory fee is “just” 1%, the ability to deduct the advisory fee only saves a portion of the fee, and the alternatives to preserve the pre-tax treatment of the fee have other costs (from the expense of using a broker-dealer, to the cost of creating a proprietary mutual fund or ETF, or the loss of long-term tax-deferred growth inside of an IRA), which means in many or even most cases, clients may simply continue to pay their fees with their available dollars. Especially since the increasingly-relevant “financial planning” portion of the fee isn’t deductible anyway.

Nonetheless, for more affluent clients (in higher tax brackets), the ability to deduct advisory fees can save 1/4^th to 1/3^rd of the total fee of the advisor, or even more for those in high-tax-rate states, which is a non-trivial total cost savings. Hopefully, Congress will eventually intervene and restore the tax parity between financial advisors who are paid via commission, versus those who are paid advisory fees. For the time being, though, the disparity remains, which ironically has made tax planning for advisory fees itself a compelling tax planning strategy for financial advisors!

So what do you think? Are you maximizing billing traditional IRA advisory fees directly to those accounts after the TCJA? Will larger firms creating proprietary mutual funds or ETFs to preserve pre-tax treatment for clients? Will Congress ultimately intervene and restore parity between commission- and fee-based compensation models for advisors?  Please share your thoughts in the comments below!

What This Week’s Market Volatility Teaches About Making Customized Portfolios For Every Client

EXECUTIVE SUMMARY

The big news this week was the “record-breaking” drop (at least in absolute point decline) in the stock market on Monday, the incredible blow-out of the VIX, and the challenge that inevitable comes when market volatility rises: the need to check in with clients, talk them through what’s happening in the markets, evaluate whether it’s necessary to make any portfolio changes, and try to talk them off a ledge if they’re really freaking out. But the reality is that being able to proactive communicate with clients, and have effective client meetings, during times of market volatility, is actually heavily impacted by how youconstruct your client portfolios in the first place, and the extent to which you customize those portfolios for each client.

In this week’s discussion, we examine the problem with financial advisors customizing every client portfolio, particularly once we experience volatile markets, and how financial advisors (and asset managers) should look at “customization” going forward!

In a world where advisors are trying to become less product-centric and add more value to clients, there does appear to be a nascent trend of advisors trying to create more customized portfolios for clients. Though this idea isn’t exactly new (it has occurred for decades in the form of selecting stocks and mutual funds for clients and adapting at every client review meeting), the rise of rebalancing software (or “model management” software tools more broadly), has made it easier to systematize the process of customizing individual client portfolios, while still being able to monitor and manage them centrally.

But I think this week’s market volatility is actually a really good example of the problem that arises with trying to create drastically customized and different portfolios for every client: if every client has their own “customized” portfolio, then it is really hard to keep track of all of your different clients and their portfolios. And so, instead of being able to easily send out broadly applicable communication to your client base, you’ll end up spending an hour to prep for every meeting and write every personalized client email during volatile market times. Simply put, customizing every client portfolio isn’t scalable for the client relationship itself (regardless of the scalable back-office technology to support it).

The challenges of the trend towards customization is notable with respect to asset managers as well. Because asset managers are – justifiably, I think – afraid of their future in a world where advisors are less product-centric, and looking to retool their own businesses. And the discussion I’m hearing more and more from those asset managers is “if advisors don’t want to use standard mutual fund products anymore, then we have to pivot and go the other direction. From products to customization instead!” But here’s the problem: when we look at the advisory firms adopting ETFs and eliminating mutual fund products, they’re not really customizing that much anyway. Even advisory firms that have dropped mutual funds and are building model ETF portfolios, not customized ETF portfolio (allowing them to keep charging their 1% fee while disintermediating the cost of the mutual fund manager, and effectively turning themselves into portfolio managers). So the real shift is that the client buys the investment “product” from the advisor and the advisor’s firm, not from the mutual fund company or other asset managers. The opposite of product isn’t customization. The opposite of product is advisor. When our value proposition is based on what we do, we don’t want to sell a third-party product, of any type. We want to sellourselves!

So where does all of this leave us? From the advisor’s perspective, and particularly for those of you who are now struggling to figure out how to assess the damage of this week’s market volatility because all of your clients have “customized” portfolios… let this be a call-to-action for you of how not scalable you’re making the client relationship management needs of your business. There are a lot of firms that are growing just finewithout customizing every single portfolio differently for every client. There may be times when some customization is still needed, but it is better to customize from a planning perspective (e.g., for tax purposes) rather than an investment perspective.

And for Asset Managers, particularly mutual fund managers, trying to figure out how to reach advisors and stay relevant… I can only caution you that the push towards making more customized solutions is not likely to work out well for you. If you want to stay relevant as financial advisors transition from salespeople to actual advisors, figure out how to make better products that cost less and are truly best in class at what they do. Because as advisors, if you can pass our screens and get to the top of the list, you get all of our money in that fund or category. And if you can’t, you’re never going to get in the door in the first place anymore.

The bottom line, though, is just to recognize that customizing portfolios for every client is simply not a scalable model, not because of technology limitations but in light of the stress and communication challenges that come with trying to help our clients through volatile markets. Which means this may be a great opportunity to begin the process of standardizing your investment process (if you haven’t already) so that you can actually be more proactive with clients, when you’re not spending all that time re-analyzing every client’s portfolio one at a time!

 

The Problem With Customizing Every Client Portfolio

In a world where we as advisors are becoming less product-centric and trying to add more value to clients, I’ve observed that there does appear to be this kind of nascent emerging trend of advisors trying to create more customized portfolios for each and every client. To be fair, the idea of customized portfolios isn’t exactly new. It’s effectively occurred for decades as we crafted mutual fund portfolios and before that stock portfolios for clients, which was some combination of investments we were recommending at the time, ones that the client was interested in, ones that fit their investment needs.

And because we didn’t have any technology tools to manage all this, historically, over time, our practice would become a bit of a mess because every client ended out with a different portfolio customized to whatever stocks or funds were being recommended the last time they came in for a client meeting, and then usually didn’t get changed until the next time they came in for a client review. We would print our Principia Pro reports from Morningstar and try to evaluate whether to make any changes.

In recent years, we have the rise of rebalancing software (or really what probably should more broadly at this point be called model management software tools), and they’ve made it easier to systematize the process of creating models for clients, including customized models for each individual client, and then being able to monitor and manage them more centrally. So everything from existing rebalancing software tools like iRebaland Tamarac or even newer players like Capitect that are building software to facilitate the creation of customized model portfolios for each client. And so, customized portfolios are becoming less of a technology barrier issue than they were in the past.

But I think this week’s market volatility is actually a really good example of the problem that crops up when trying to create drastically customized, different portfolios for every single client. And it’s the stress that it introduces into our advisor-client relationship. Because the truth is that when every client has their own customized portfolio, your brain just can’t keep track of all the different clients and all the different stuff that’s in all their different portfolios. If you have half a dozen standard model portfolios that you use for clients with, you know, varying levels of risk, it probably took you about 5 minutes this morning to figure out what the damage was from yesterday’s market volatility even if you’ve got 100-plus clients. I know some advisory firms that even yesterday were already sending out messages to all their clients communicating their thoughts, putting the market decline in context of how their clients are invested. More advisors are sending messages out today and queuing them up for the week.

Unless, of course, all your clients have individually customized portfolios, in which case it’s probably going to take you days or even weeks just to evaluate the damage, analyze one security at a time for one custom portfolio at a time to figure out what if anything you’re going to do or not do and then communicate with the clients, which you have to do one at a time because each client’s portfolio is different. And heaven forbid all the client review meetings you already had this week you’re probably scrambling right now just trying to figure out what your talking points are in all those client review meetings because every review meeting is different when every client portfolio is different, when, you know, markets do crazy things and some clients are more impacted than others just based on whatever it is that they happen to own.

 

Simply put, customizing every client portfolio this way just isn’t scalable… and certainly not if you’re serving dozens or 100-plus clients at a time. And not because we don’t have the technology tools to manage so many different models, which it really is getting better with all the model management software, it’s because of the client communication and client meetings. The process of talking clients off a ledge isn’t scalable when your brain has to try to relearn and keep track of a conversation for every single client in every single meeting, all of which are different because every client’s portfolio is different.

The Opposite Of Product Isn’t Customization

Part of the reason that I point this out is that it’s actually also an interesting trend towards customization that’s coming down from a lot of asset managers as well. Because a lot of asset managers, and mutual fund companies, in particular, are justifiably quite afraid of their future in a world where advisors are becoming less product-centric. You only have to look at the nearly $1 trillion of outflows from mutual funds over the past decade since the financial crisis to see this trend unwrapping. And the discussion I’m hearing more and more from asset managers is something to the effect of, “If advisors don’t want to use standard mutual fund products anymore, then we have to pivot and go the other direction for products to customize solutions instead.” You know, this idea that if they can better customize their asset management strategies for our clients and then maybe use technology to distribute them, they can regain their market share.

But here’s the problem: When we look at advisory firms even today adopting ETF’s, eliminating mutual fund products, they’re not really actually customizing that much. Most advisory firms I see that drop mutual funds that are building model ETF portfolios are building model ETF portfolios. Typically, you know, maybe half a dozen different options from very conservative, very aggressive on the risk spectrum because they’re…but they’re not building different customized portfolios for every client because it’s not scalable for us, because it’s not scalable for the advisor-client relationship to do so.

Instead, as I’ve discussed on this blog in the past, I think the real reason we’re seeing so many advisors shift away from mutual funds and ETFs in the first place is that effectively, we’re disintermediating mutual fund managers. We’re cutting out their fees and their layer and then trying to earn it ourselves. After all, if I’m an advisor who charges my 1% advisory fee and then I have to stack it on top of a mutual fund manager’s fee, if I can shift to a strategy where I manage low-cost ETFs instead, I save my clients the difference in fees between the fund manager and the low-cost ETF, I use technology to manage it efficiently for myself, I get to keep my whole 1% AUM fee, and the client’s cost go down, right? Who doesn’t want that? I’ve got a solution where your portfolio gets cheaper and I add the value directly. Of course, that’s why we’re seeing such a shift. You know, in essence, we’re making ourselves into the portfolio managers, but since we typically don’t have time to do individual stock analysis and are more focused on the asset-allocated portfolios these days, we use the easiest building blocks for asset-allocated portfolios, which are ETFs.

But again, when you look at the kinds of ETF portfolios that most advisors seem to be building, especially the largest firms that are fastest growing and the ones that care the most about the scale, I find they’re the ones least likely to be customizing portfolios for every client. Most aren’t even trying to, they’re trying to instead develop a centralized investment team to make the best possible models that their advisors can use with all of their clients.

In essence, the large advisory firm is making its own in-house managed account products. Larger RIAs are doing it, increasingly broker-dealers are doing it as well with their own shift to in-house accounts. If they’re not comfortable with their in-house capabilities, they sub-advise out to a TAMP if they don’t have the time or the inclination to do it internally. But in all these scenarios, the client is still essentially buying an investment product if you want to call it that, it’s just the product is a managed strategy from the advisor in their firm, not from a third-party mutual fund company or other asset manager. That’s the real shift here.

You know, it isn’t a shift from product to customization, it’s a shift from product to advisor. When our value proposition is based on what we do, we don’t want to sell a third-party product of any type. We want to sell ourselves. Otherwise, we fear that at some point the client will say, “Why am I paying you for a product that I could just get directly online for myself?” That I think is the reason why we’re seeing ETFs grow so rapidly but actively managed ETFs are not, because advisors don’t want to use actively managed ETFs, we want to actively manage the ETFs ourselves because then the client perceives us as bringing the value to the table, not selling a third-party product.

The opposite of product isn’t customization. The opposite of product is advisor!

CLICK TO TWEET

And frankly, I think the situation is probably only exacerbated by the fact that in the real world clients often have a behavioral bias that just leaves them towards, let’s call it, the disaggregated solution. So some people call this the naive diversification bias. It’s the phenomenon that if you show a client a portfolio of 500 stocks, they believe they’re very diversified. If you show them a portfolio that has a 100% in the S&P 500, they feel concentrated and risky. Same 500 stocks, same allocations, but if you put 1 line item on that statement instead of 500 of them, it feels less diversified.

Now granted we don’t do this much as advisors with individual stocks, but I think this is another reason why there’s so much pressure on mutual funds, especially fund-to-fund strategies because not only is there an extra layer of cost, but clients like to see all those line items. And even the trading and rebalancing that occurs, that shows them, you know, the advisor is doing something and being engaged.

Now, I realize not all this is rational, and it’s not even always good activity because of a lot of bad overmanagement and overtrading that could come from this phenomenon, but you can’t ignore the power of behavioral biases that are there and the perceptions of what happens when you don’t just roll everything up into one solution. The advisor, you know, owns the line items because they own the ETFs or they own the components, rather than just letting the third-party manager do it all in mutual fund format.

The Path Forward For Advisors (And Asset Managers) [Time – 10:48]

So where does this leave us? From the advisor’s perspective, particularly for those of you who are now maybe struggling a little to figure out how to get a handle on what’s going on on all your clients’ portfolios, figuring out if you’re going to make any changes and then how to communicate them or you’re waiting for each client review now to do it because you couldn’t even possibly reach out to all your clients at once, you have to wait for each client review, which means now you’re just not communicating with your clients, it’s because your clients have all these different customized portfolios. And let this be maybe a little bit of a call to action to you about how not scalable you’re making your business. If you’ve wondered why are other advisors getting messages out to clients same day or within 24 hours and you’re going to stagger it over the next 3 to 6 months of client review meetings, this is why.

There are a lot of firms that are growing just fine without customizing every single portfolio differently for every client. You know, if you’re not sure that your client will buy a standardized portfolio that you create, or to be fair, you know, a range of them, at a minimum you’re still going to have something that goes from very conservative to very aggressive just to cover the normal range of risk, don’t try to do more customization, just spend more time and resources trying to make better, more compelling portfolios. Or maybe just spending a little bit more time on your marketing materials so you can better explain the value you are creating for your clients with that standardized portfolio, and then figure out what your talking points will be for clients about why you’re not customizing. It doesn’t even have to be all that complex.

I’ll tell you how we typically handle it when you come up for prospects because we run standardized models for clients. Range of risk, but here’s our portfolio. So what do I say when a potential client asks, “Why aren’t you customizing this more for me?” You know we say, “This is the risk you need and want to take to achieve your goals. And we have a dedicated investment team that spends all their time researching to find the highest quality and the lowest cost ETFs to get market exposure in all the areas that we want to invest for our client portfolios. So if you really want to, I’ll go through all the recommendations that we’re making to you, and you can tell me which lower quality higher cost ETFs you want us to substitute in instead of the ones that we’re recommending. But I can assure you we don’t have a super-secret list of extra-special higher quality investment ideas that we hold back for certain clients and give everyone else something inferior. This is the list of the best portfolios we believe we can construct. And we spend all of our time focused on these portfolios, and once we find something that we think is the best, we implement it for all of our clients. Does that seem reasonable to you?” We don’t get a lot of objections after that.

Now to be fair, there are some circumstances where even our firm does customize, but it’s not from an investment perspective, it’s from a planning perspective. It’s the clients that have unusual embedded capital gains circumstances or portfolios that we need to transition over time. Our firm is based in the Washington, D.C. metro area so we have a lot of government employees and various agencies where sometimes we have to work around their industries. Some people at certain levels of Department of Defense can’t own defense stocks… some people tied to senior levels at NIH (National Institutes of Health), can’t own medical company stocks or biotech stocks… so those are planning situations and we’ll adapt as necessary. There’s some good technology in the rebalancing software these days to handle that. But that’s a matter of planning customization, not investment customization.

And for asset managers (and particularly mutual fund managers) trying to figure out how to reach advisors and stay relevant, I can only caution you that the push towards making more customized solutions is not likely to work out well for you. Because the truth is, even in the mutual fund age, advisors already had a ton of choices of different mutual funds to customize for each individual client account, and usually what ended up happening, most of us would end up using a small subset of mutual funds that we were comfortable with, learn the stories of those funds, you know, American Funds and The Growth Fund of America story or PIMCO Total Return in the days of Bill Gross, and then we tended to recommend the same common set of mutual funds for every client.

Not because technology was the limiting factor (although it wasn’t great at the time), but because when you’re sitting across from clients, you have to know what you’re talking about and you have to be able to convey confidence to clients. And if you can’t even keep track of all the stuff that you own, which you can’t if you’ve got dozens or 100-plus clients who all have different customized portfolios, it is a surefire path to losing client confidence and eventually getting fired.

Simply put for asset managers, if you want to stay relevant as advisors switch from product salespeople to actual financial advisors, figure out how to just make better products that cost less and truly are the best at what they do, because as advisors, if you can pass our screen to get to the top of our list, you get all of our money in that funding category because that’s what happens when we standardize and don’t customize. And if you can’t get to the top of that list, you’re never going to get your foot in the door in the first place.

But this isn’t about product versus customization, this is about whether we create as advisors our value through your products or create the value ourselves. And selling your product, which is what we did historically but now is something that any client can buy from any online brokerage account anyways, doesn’t reflect well on our value and that’s what’s driving the shift.

I hope this is some helpful food for thought. Maybe a fresh opportunity for some of you to use the pain of this week’s market volatility and the stress of trying to figure out how you’re going to communicate with all of your clients on all their customized portfolios, in order to begin the process of not customizing so much in the future and standardizing more of your investment process. And you can actually be more proactive with clients, rather than needing to spend all this time reanalyzing every client’s portfolio, and actually just spend your limited investment resources, whatever you’ve got, focusing on one set of the best investment opportunities you can find for clients and not trying to relearn and reinvent every portfolio every single time.

This is Office Hours with Michael Kitces, normally 1 p.m. East Coast time on Tuesdays. Got a slightly late start today, but thank you for joining us and hanging out, everyone, and have a great day.

So what do you think? Have you used a TAMP? Have you thought about outsourcing your investment management? What types of services would you like to see TAMPs provide going forward? Please share your thoughts in the comments below!

You Need To Do What Others Don’t

The hardest part of achieving 10-20+ baggers is having the patience and conviction to hold through multi-year periods of under performance. Patience is your biggest asset when investing in a great business. Time always pushes out the weakly convicted and creates opportunities for those with a long-term perspective. The greatest flaw in the short-term investor is they think great business performance is always linear. The truth is that even great businesses suffer growing pains, and so do their stocks.

The investor that always worries about “next quarter” will sell at any sign of imperfection. Since no company is perfect, this means they will always sell too soon. Short-term investors will accept a 20% gain because they didn’t spend the time to develop the conviction and foresight to see the next 500%.

The second hardest part of achieving 10-20+ baggers is holding stocks that sometimes look expensive by traditional metrics. If your aim to is hold a great business for a long time, you are going to have to get used to holding a business that isn’t always “cheap”. This is a topic that David Gardner talks about in this Invest Like the Best podcast.

Whether it’s holding a great business whose stock doesn’t move for months or years, or holding one that doesn’t look “statistically cheap”, there is an art to holding. The simple answer is you focus on the business, not the stock.

A successful long-term investor today needs to be incredibly focused on knowing what they own better than others. This means they cannot depend on others for their due diligence. You need to do the work. You can borrow someone else’s stock ideas but you can’t borrow their conviction. A multi-baggers journey is filled with the corpses of highly intelligent-articulate naysayers. There isn’t one great stock or company that wasn’t credibly doubted all the way up (H/T @EdBorgato). Put on your armor of diligence and conviction so you can hold a great company when you find one.

Thirty years ago the best investors had the biggest funnels of information. Today the best investors have the best filters of information. They know what is important and knowable, and they don’t become distracted by the noise around them. Sometimes important information comes from sources that aren’t obvious.

I recently dug into a CEO’s past so deep that I ended up networking my way back twenty years to his college roommate. The key takeaway from the college roommate was that the now CEO was always incredibly honest and had high integrity. This is from a roommate that likely saw him in many different forms (studying, dating, sports, drunk, etc). The college roommate told me a story from twenty years prior about how he and the now CEO broke a chair at a college party. The following morning the now CEO walked a mile to the person’s house and paid them for the damage. He didn’t have to. No one knew he broke the chair. Now this type of conversation might seem insane to most investors. But is it insane to do a background check on the integrity of the leader you’ve invested 5-10-20% of your net worth? I don’t think so. Do you think that uncovering such a nugget or differential insight, albeit from 20 years prior, gives me an edge? Yes, I believe so.

If you want above average returns, you need to do what average investors aren’t willing to do. You need to gain perspectives that average investors aren’t willing to gain because it’s just too hard, too uncomfortable, and takes too much time. It’s easier to sit in an office and crunch numbers than it is to get on a phone or plane and talk to people. If you aren’t willing to do so, then don’t complain about being average.

In Ron Baron’s Q2 Letter at Baron Funds, he talks about going the extra mile for research:

As part of our ongoing effort to gain further insight into Tesla’s prospects, we recently met with Dr. Ion Yadigaroglu, a venture capitalist. Ion is an engineer with a doctorate in physics from Stanford. Ion has been programming since he was eight years old! Ion’s dad is a prominent nuclear scientist. So much for Ion’s creds. When Ion studied at Stanford graduate school, his roommate founded eBay. Ion’s $1,300 investment in the eBay startup became worth millions. In 1992, at the dawn of the Internet, Ion met Elon Musk. Elon had come to Palo Alto to research battery technologies in Stanford’s labs. Elon dropped out after only six days! Further, while at Stanford, Ion was the teaching instructor for JB Straubel, Tesla’s CTO and chief engineer. Ion believes JB and his team are better at battery technology than anyone else. It was lucky for Ion that he met both Elon and JB. Ion invested in Tesla when it was just beginning, and so far has made a lot more than he did in eBay. After meeting Ion, we concluded it was lucky for Elon and JB they met Ion as well.

Our meeting with Dr. Yadigaroglu is one example of Baron Funds’ differentiated primary research approach. Few institutional investors have met with Elon and JB. Fewer still, we’re guessing, have met with the co-founder’s teaching instructor at Stanford. We believe fewer and fewer in the investment industry are performing even the most basic research on businesses. There is a reason for this. During the past 15 years, boosted by virtually instantaneous communications, computer algorithms, and the increasing popularity of ETFs, securities trading volumes have multiplied exponentially. As computers and software have replaced traders and marketplaces, brokerage commission revenues have fallen dramatically. Brokerage commissions historically have been used to pay for investment research. Ergo, investment research budgets have been cut significantly; there are now far fewer financial analysts; and “price discovery” and markets have become less efficient.

We believe the fewer people who do research, the more valuable the fundamental research we conduct and the more likely it is that we will continue to outperform. This is although we cannot guarantee that we will. One Tesla executive with whom I speak regularly recently remarked to me, “It is amazing to me how little most people know about Tesla.”

One of my golf friends recently remarked, “I love to play poker with people who think the game is all about luck.” My friend wins so often and so much, he thought he was going to be asked to leave his game. One of our mutual friends who plays in that game marvels how this individual “knows” what cards are in his hand without seeing them. “It’s about mathematics and ‘reading the table,’ studying how your opponents bet their hands,” my friend explained to me. Which is just like world championship bridge. Teams that compete in bridge study books several inches thick on “conventions” and practice diligently. Based on my observation, people who earn lots of “masters points” don’t earn them because they are lucky.

Just like anything else, the harder you “work,” the “luckier” you get. We think the same goes for investors who earn returns significantly greater than those of the market over the long term.

TD Ameritrade Sells Out NextGen Advisor-Client Platform By Replacing 84% Of Its NTF ETF Lineup

The big news amongst RIAs this week was the announcement on Monday that TD Ameritrade was making major changes to its no-commission ETF Market Center platform, expanding from 100 to 296 available ETFs, including the launch of new ultra-low-cost SPDR Portfolio ETFs (that provide exposure to most “core” asset classes for just 3-7bps, even as its other ETFs remain higher, apparently adopting Blackrock’s “pricing for the future” strategy). However, in the process of making the change, TD Ameritrade also eliminated 84% of its current ETF line-up, including all of its Vanguard ETFs and most of its lowest-cost iShares Core ETFs as well, effective November 20th. Which is a substantial problem to existing RIAs using the platform, that must now decide – in barely 30 days – whether to change all of their existing clients from iShares and Vanguard ETFs to the new SPDR Portfolio ETFs (which can have substantial capital gains implications given the multi-year bull market), or to keep the “old” ETFs for existing funds but allocate all new contributions to new clients (which introduces substantial operational challenges, especially for advisors who don’t already use iRebal and its “proxy purchase” system of alternative security purchases, and especially given many of the new ETFs in the lineup also have ultra-low-volume that introduces execution risks), or to just keep using the existing Vanguard and iShares Core ETFs and pay the $6.95/trade fee going forward (which is fine for “larger” clients but untenable for younger/smaller clients, especially those making ongoing savings contributions). Which means, ironically, that the change is the most disruptive for the most loyal TD Ameritrade RIAs (that had the most already invested into the platform), and those serving next generation clients (whose modest ongoing purchases necessitate switching to the new NTF ETF lineup). Perhaps the biggest frustration, though, was that TD Ameritrade Institutional completely blind-sided its advisors with the announcement, which is likely driven by the recent Scottrade acquisition and growth potential of the ETF Market Center to those new retail clients, and there doesn’t appear to be any advisor- or client-centric reason for the change on the TD Ameritrade Institutional side, beyond that State Street was apparently willing to pay more to get into ETF Market Center than what Vanguard and Blackrock were willing to pay to keep their ETFs there – and that TD Ameritrade simply sold out its existing advisors and clients to the highest asset management bidder. Of course, no one can begrudge TD Ameritrade for trying to get paid for what it does… but the question arises as to why TD Ameritrade Institutional had to let the Retail division take the lead on the change (perhaps not coincidentally just a month after RIA champion Tom Bradley departed), and whether it’s time to just let advisors and their clients pay a reasonable asset-based trading fee and have access to 100% of all available ETFs, as RIA custodian disruptor Apex Clearing has been positioning itself to do. Will TD Ameritrade be willing to make right its mistake, after taking the most non-fiduciary action possible for its RIA advisors and clients, especially since it has spent years trying to stand as an advocate for fiduciary RIAs and next generation clients?

5 Bold Predictions For Asset Managers Product Shelf In 2027

The trend of robo-advisors and technology in financial services isn’t just proving disruptive to parts of the financial advisory community; it’s actually disrupting trends in asset management as well, especially when paired with ongoing regulatory changes. In fact,while financial advisor fees have remained remarkably stable and resisted any technology-driven fee compression so far, it’s been the asset management industry that has borne the burnt of the fee compression, as advisors themselves use technology to select lower-cost investments and try to add value in other ways. And the situation is made even more complicated by the fact that advisors are increasingly trying to get paid for the value of their advice, even as broker-dealers often still treat them as being paid primarily to sell products… such that Cetera President Adam Antoniades has stated he’s banning the word “broker-dealer” within his own company, in an effort to transition the firm from being product-centric to advice- and advisory-centric. Other notable trends in the coming decade include: the shift to “passive management” with ETFs doesn’t appear to be passive at all, given ETF turnover is 880%/year (compared to “just” 120% for individual stocks), and instead implies that advisors are simply using ETFs as trading instruments for active asset allocation; the processing and trading value-proposition for custodians is quickly grinding towards zero (just witness the recent round of cuts in ticket charges from major RIA custodians), as the firms shift their own models to focus more on asset management and lending instead (and more generally, custodians split their offerings into low-cost commoditized processing, and higher-margin servicing); the debate still rages about whether asset managers can and will embrace goals-based reporting, or whether it’s still just a smokescreen for those who aren’t actually beating their benchmarks and will persist (because consumers still have a right to verify that their managers are adding value at the manager level, or not); and the shift of advisors and reps serving as investment managers is creating its own due diligence problem, as when the advisor is the manager and the fiduciary for the client… does that mean the advisor may have to fire themselves for bad performance someday?

Launching An ESG Shareholder Engagement Initiative As An Advisory Firm Value-Add

EXECUTIVE SUMMARY

Historically, socially responsible investing (SRI) has been about a fundamental decision: whether to hold a “traditional” diversified portfolio, or to screen out companies for various environmental, social, or governance (ESG) criteria in order to meet an SRI mandate. The end result has been an endless debate about whether a portfolio that used ESG screens will subsequently produce returns that are better, worse, or the same as the traditional portfolio.

Yet the reality is that an SRI approach doesn’t have to be a choice between traditional portfolio investing or using ESG screens. An alternative approach is to try to shape the stocks in a traditional portfolio to better adhere to an SRI mandate, by leveraging the proxy voting and shareholder engagement process to steer the company’s management itself in a more SRI-focused direction.

The end result of their ESG shareholder engagement initiative was a deeper engagement with clients themselves, for what was ultimately a fairly modest financial and logistical cost for the firm. However, because there are specific requirements that must be met for clients to vote proxies, including owning individual securities directly, affirming their ownership, and delegating proxy voting authority to a third party, advisory firms must be certain to implement a proper process to ensure their shareholder engagement efforts with clients are successful!

 

The Rise of Environmental, Social and Governance Initiatives in Shareholder Engagement

Shareholders of publicly traded companies – particularly long-term investors – have a powerful opportunity to represent material interests to corporate management. Through active shareholder engagement, investors can encourage management action on critical issues that could impact a company’s long-term financial performance.

Accordingly, environmental, social and governance (ESG) initiatives are growing in prominence, as the business case for these practices continues to build. In their 2016 report, The Forum for Sustainable and Responsible Investment estimates that $2.56 trillion in US-domiciled assets were engaged in filing shareholder resolutions on ESG issues. This year, even the index behemoth Vanguard took a stance on climate risk disclosures at ExxonMobil’s annual meeting, joining a monumental shareholder turnout of nearly 70% of votes in favor of better transparency about the financial risks of climate change. Glenn Booraem, Vanguard’s investment stewardship officer, said recently, “Our support for these proposals is not a matter of ideology, it’s a matter of economics. To the extent there are significant risks to a company’s long-term value proposition, we want to make sure there is long-term disclosure of those risks to the market.”

Effective shareholder engagement does require substantial resources and expertise. First, a solution must be identified that, should it be implemented, could result in material benefits to the company. Next, a strategy must be developed to approach the company. This strategy may include letter writing, meeting participation, coalition building, as well as resolution filing and proxy voting at annual meetings (Figure 1). Campaigns may range from complex, multi-year engagements, to succinct conversations with more immediate results. Done well, the process can be collaborative and productive, as corporate management can gain insights on critical and emerging risks and opportunities by incorporating input from a broad range of stakeholders.

The Spectrum Of Effective Shareholder Engagement Strategies

Historically, non-profit organizations have played a critical role in advocating for social, environmental and governance initiatives through shareholder engagement. More recently, large institutional investors have dominated the shareholder engagement arena, particularly following a 1988 DOL interpretation requiring proxy voting from ERISA fiduciaries. These stakeholders have often developed sophisticated internal resources to orchestrate engagement approaches and build productive relationships with the companies they seek to influence. They can also mobilize substantial assets. CalPERS, who declared that diversity, proxy access and climate risk reporting topped their 2016 engagement agenda, manages over $270 billion in assets.

And as the field continues to mature, the opportunity for shareholder engagement is expanding to new groups of “smaller” investors (e.g., small-to-mid-sized foundations and endowments), thanks to a growing group of non-profit organizations providing support. For example, the non-profit As You Sow works directly with foundations, endowments and even individual shareholders to mobilize shareholder resolutions to support their engagement campaigns. Proxy Impact provides foundations and socially responsible investors with ESG proxy voting guidelines and voting support services, as well as customized shareholder engagement services. Ceres’ Investor Network on Climate Risk and Sustainability serves more than 130 institutional investors in building corporate engagement strategies and policy solutions.

With the growth of such support organizations, though, the expanding reach of shareholder engagement isn’t just about institutional investors. Now, financial advisors can also find expert support and access to campaigns, without the need to employ substantial internal resources, and help their clients engage directly in shareholder activism efforts.

The Opportunity for Individual Investors (And Advisory Firms) in Shareholder Engagement

Simply put, shareholder engagement strategies no longer need to be limited to institutional investors; there is active interest, ability and demand among individual investors, including existing and prospective investment advisory clients.

The key is to recognize that in addition to just “growth” and investment returns, many individuals seek intangible value from their wealth, hoping to make a positive impact using their assets. This is especially true for both Millennials, and many high net worth individuals. The 2017 U.S. Trust Insights on Wealth and Worth survey found that 45% of high net worth individuals surveyed either own impact investments, or are interested in adding them to their portfolios, with Millennials leading in interest. 52% of these individuals think corporations must be held accountable for their actions. Shareholder engagement can offer a productive outlet for those clients who hold individual stock positions, allowing them to be responsible stewards of their assets (with the support of their advisors) while advocating for positive change.

So how can one shareholder make a difference? There are a few key areas within larger shareholder engagement campaigns in which an investor that holds individual stock positions can have the greatest impact.

For instance, with as little as $2,000 worth of shares, held for at least a year prior to and leading up to the company’s annual meeting, individual shareholders can file a resolution suggesting a change in corporate practices. Listed on the company’s proxy statement, these brief, 500-word proposals are then formally presented and voted on by shareholders at the company’s annual meeting. To be included, resolutions must address a material concern for the company and meet certain guidelines set by the U.S. Securities and Exchange Commission (SEC).

Although nearly always non-binding, shareholder resolutions represent a powerful public platform to voice concern and propose changes to both management and other investors. The results are publicly reported, with outcomes calculated as favorable votes divided by the total votes cast for and against the proposal (abstentions are not counted). Typically, outcomes around or over 10% send a clear signal of shareholder support to a management team, but even limited voter support can still lead to adoption of thoughtful proposals. For example, a 2015 resolution for Abbot Laboratories encouraging them to avoid genetically modified organisms in baby formula was successfully implemented with only 6% of voting shares. In addition, subject to certain conditions, resolutions may be re-filed and voted on in subsequent years, allowing shareholder awareness of the issue to build over time.

Of course, not all proposed resolutions make it to the annual meeting. In some cases, companies are motivated to satisfy a resolution in advance of the proxy vote, based on the merit of the proposal and the desire to avoid public exposure on poor practices. In other cases, companies may challenge a proposal based on SEC standards to disqualify it from inclusion on the proxy statement. Sophisticated shareholder engagement programs maintain a continuous and constructive dialogue to reach consensus between investors and management on their shared interest: improving the long-term financial performance of the company.

Some recent success stories of individual investor impact from our own offering include:

Antibiotics & Factory Farms: Overuse and misuse of antibiotics in the meat industry is contributing to the rise of antibiotic resistance globally; antibiotic-resistant infections cause over two million illnesses and 23,000 deaths each year in the US, costing $55-$70 billion. In 2015, McDonald’s adopted a policy to source chicken raised without antibiotics important to human medicine in the US, but did not create a similar policy for pork, beef or chicken sourced outside the US. This year, an individual investor supported a larger shareholder engagement campaign by acting as lead filer for a resolution requesting McDonald’s extend this policy throughout the global supply chain, enabling the resolution to be listed on the annual proxy statement. 30% of shares voted favored the resolution, representing approximately $30 billion of shareholder support.

Carbon Asset Risk & Climate Change: Developing high-cost, high-carbon reserves demands intensive capital expenditures for a resource that may never be economical to extract, potentially wasting investor capital. Individual investors joined a larger shareholder engagement campaign with Southern Company to directly support a resolution requesting better reporting on stranded asset risks related to climate change and associated coal demand reductions. Rather than put the resolution to a vote at the annual meeting, Southern Company agreed to report on their distributed energy resources, modernization of technology, and coal reduction efforts, and the resolution was withdrawn.

Challenges for Individual Investor Involvement

Given this opportunity to hold corporations accountable, what is limiting individual investors from getting involved in shareholder engagement, and how can the investment advisory industry help to address these needs? Some potential limitations to individual involvement may include:

LACK OF AWARENESS

Challenge for individual: Many individual investors remain unaware of their leverage as shareholders, and the role they can play in the responsible stewardship of their assets.

How advisors can help: Advisors are in a key position to understand client values, educate clients about the various opportunities available to them, and provide encouragement about how individuals can and have made a difference in this space.

LIMITED RESOURCES TO ENGAGE

Challenge for individual: Given the substantial resources and expertise required to initiate even a single campaign with a single company, many individual investors are unlikely to pursue this avenue on their own.

How advisors can help: Expert organizations run multiple shareholder engagement campaigns and seek additional shareholder support for their efforts. Sometimes, an individual’s support can directly impact these larger strategies. Advisors are in a key position to facilitate access to existing campaigns and connect clients with diverse opportunities.

PERCEIVED INSIGNIFICANCE

Challenge for individual: Individuals may feel that lower commitment opportunities, such as simply voting their shares, may seem insignificant when compared to the total market capitalization of a company.

How advisors can help: Advisors and their expert partners can assist individuals in accessing campaigns at strategic points – such as filing a shareholder resolution – where an individual’s contribution can be most impactful.

LIMITED ACCESS TO INDIVIDUAL STOCK POSITIONS

Challenge for individual: Opportunities within shareholder engagement, such as proxy voting, are limited to direct shareholders of that company.

How advisors can help: Individuals who do not directly own a stock position in the company in question can find alternate methods of advocacy. For example, if the individual owns a mutual fund or ETF, they may choose to express their interest to the fund manager. Advisors can also educate individuals on the shareholder engagement activities and proxy voting guidelines of various funds.

The Opportunity for Financial Advisors on Client Shareholder Engagement
Financial advisors can and should support our clients through many of these limitations. A well-designed program can not only protect the value of client assets and strengthen client-advisor relationships, but can also enable clients to derive personal and financial value from the investments they hold.

Responsible shareholder engagement can also be a good and proper exercise of fiduciary duty, especially as parts of the process, such as proxy voting, are specifically required by the SEC for other fiduciaries in our industry. Registered investment advisors may also choose to exercise proxy voting authority on behalf of their clients, following the guidelines set by SEC’s Rule 206(4)-6 on Proxy Voting. Votes must reflect the client’s best interest and the process must be open and transparent.

(Note: Rule 206(4)6 requires registered investment advisors with voting authority to do so in the client’s best interest, adopt written policies and procedures specifically addressing potential conflicts of interest, make available to clients their policies, procedures and voting results, and keep certain records related to voting client securities.)

Shareholder proposal filings require that investors have direct ownership of individual stock positions. Thus, prior to creating a shareholder engagement program, an advisory firm should assess their investment composition and determine if their clients hold sufficient individual stock positions to justify enhancing their service offering. Nearly all external organizations draft resolutions based on pressing social and environmental corporate concerns, rather than the reach of client portfolios, so you may find such services to be of greater value if you have a diverse set of positions throughout your managed holdings. With that said, many external organizations are still in the process of developing their offerings and, as such, may have the ability to tailor their services to more concentrated positions or portfolios. Advisors who compose portfolios predominately from funds can still play a key role by evaluating the shareholder engagement programs of fund managers and encouraging additional accountability on ESG measures.

Filing resolutions is only one part of the process. While not required, you can further support these shareholder engagement efforts by voting a client’s shares in favor of the resolutions s/he supported as a lead or co-filer. As discussed earlier, proxy voting is regulated by the SEC; as such, your practice must have certain policies and procedures in place. Wetherby has long voted proxies on behalf of clients; as such, we have established policies and procedures to ensure that we represent our clients’ best interests and comply with these SEC requirements. Many investment advisors choose to follow independent proxy voting guidelines; most third-party proxy advisory firms offer socially responsible proxy voting policies and guidelines which align with resolutions related to ESG issues in most, if not all, cases.

Developing an ESG Shareholder Engagement Service Offering
By working with expert organizations, Wetherby Asset Management has enhanced our offering to include ESG-related shareholder engagement initiatives – without adding significant internal resources. Our firm’s strategy is to work with third-party organizations and initiatives that are running their own shareholder engagement campaigns. We can thus develop a diverse assortment of initiatives aligned with individual stock positions held by our clients and facilitate the client’s involvement in them. Clients need not be explicit impact investors to benefit. Instead, each individual or family can curate their own approach from their existing investment positions, based on their personal motivations and values.

When working with external organizations, it is crucial to find a credible organization that can provide expert capacity that will resonate with your client interests, as well as a streamlined process that will align with your operations. Some important qualities we seek in and questions we ask of external firms include:

Approach – What is the organization’s approach to engagement? How do they define, plan and measure a campaign? How does the organization select engagement topics/sectors/companies? How does the organization integrate and adapt with additional information gathered through engagement process? Does the organization have escalation strategies for when an engagement is unsuccessful?

Expertise – Does the organization have the expertise to suggest compelling and sound business initiatives? What resources and staff does the organization have to support its research? What is their track record in campaigning, engaging collaborators and building interest in an initiative?

Facilitation – How much effort is required on the part of the financial advisors in your firm? Will this collaboration require substantial resources from your team? Has the organization worked previously with advisors and does it understand your needs?

Diversity of Initiatives – Does the organization offer a sufficient range of initiatives that can accommodate your clients’ individual stock positions and represent their interests? (Especially for advisory firms that primarily use mutual funds and ETFs and only have a subset of clients that hold individual stock positions.)

Education and Reporting – Does the organization offer timely and easy-to-access education and reporting? Are your clients able to engage with material prior to their decision to authorize, as well as throughout the campaign?

For example, our firm relies primarily on As You Sow to enable us to offer impact shareholder resolution opportunities to our clients. As You Sow is a non-profit organization that promotes corporate responsibility through shareholder advocacy, coalition building, and innovative legal strategies. Their expert team explores solutions across multiple themes, including energy, environmental health, waste, human rights, and executive compensation issues. As You Sow then launches customized engagement approaches for each company and initiative. Should they choose to draft a resolution as part of their campaign, they look for interested shareholders – such as our clients – to authorize them to submit the resolution on their behalf. For example, in 2017, As You Sow connected with investors to file over 50 resolutions across various themes and companies.

As You Sow has greatly simplified involvement for financial advisors by sourcing resolutions, filing resolutions on behalf of interested clients, and maintaining communication and status updates at key points throughout the process. They charge an annual fee based on the size of the firm’s assets under management, ranging from $5,000 to $15,000 per year. These fees include options for your clients to file or co-file on the available resolutions, access to their content and education, up to three hours of the CEO’s time, and up to three hours of staff time for expert briefings.

The majority of resolutions are filed in November and December, and As You Sow will notify advisors with resolution opportunities prior to these filing dates. While firms may differ in their level of involvement, our firm pursues the following process:
Sample Letter of Authorization
1. As You Sow notifies our firm with a list of resolutions and brief descriptions for each topic and resolution. They provide pre-drafted letters of authorization (see sample) and proof of ownership (see sample) letters to facilitate the advisor-client experience and maintain consistency for their own records.

2. Upon notification, our firm’s Chief Compliance Officer will review the resolution opportunities to ensure that they do not represent a conflict of interest for our clients. This includes verifying that none of our clients hold board or executive positions in the companies represented in the resolution notifications. Should there be any real or perceived potential for conflict, our firm chooses not to present the resolution opportunity to any of our clients.

3. Once reviewed, one Wetherby employee researches the holdings across all client accounts to determine which clients hold individual stock positions that satisfy the eligibility requirements to file a resolution. She then aggregates the available resolutions and eligible clients into an Excel dashboard that is shared with our client service team.
4. Our advisors can then proactively reach out to these eligible clients with the opportunity. Depending on their relationships, this can be as simple as an email, or a larger discussion over the phone or at one of our regular in-person client meetings. The advisors confirm if a client wants to support a resolution, or take no action. Clients may choose to support individual resolutions as a lead filer, where their involvement and name may be featured in the proxy statement, or as a co-filer, where their support is critical but their name is never listed on the proxy statement. Advisors will coordinate with the client in obtaining a physical signature on the letter of authorization.

5. The advisor then sends the pre-drafted proof of ownership letter to the appropriate custodian holding the client’s position for them to complete and return. Next, the advisor ensures that a “do not trade” restriction is placed on the client’s investment position to ensure that at least $2,000 of shares continues to be held through to the annual meeting to satisfy the eligibility requirements. Once complete, the advisor sends the two documents (the client-signed Letter of Authorization and custodian-verified Proof of Ownership) back to As You Sow, who then files the resolution on the client’s behalf.

6. As You Sow follows up with updates throughout the campaign. Advisors can choose to send the communications directly to clients, or repurpose the materials into meeting reports or custom decks. Our firm also produces an annual report on the outcome of all shareholder resolutions that were supported by our clients. Clients can engage with the content according to their level of interest; through As You Sow’s public resources, clients can become deeply knowledgeable on their own time, or they can await periodic updates from their Wetherby team.

 

Insights From Our Firm’s Experience

Enhancing our services with a Shareholder Engagement process has resonated with clients, and has been well worth the limited procedural effort and costs necessary to establish and implement the program. In fact, for an annual cost of $5,000 to $15,000 for a service like As You Sow, the cost of establishing a partnership with an external partner to support shareholder engagement, is actually less than the cost of what many advisory firms spend on far-less-impactful initiatives! And the process itself is highly conducive to being systematized, once initially rolled out and formalized.

In addition, by formalizing our program two years ago, we have increased participation substantially – both in terms of the number of clients supporting resolutions as well as the number of resolutions supported by each individual client. Armed with a simple solution for interested clients, our wealth mangers have found it easy to proactively broach the topic with clients. What was previously an ad hoc activity for a small number of clients of a single wealth manager has grown to include over a dozen clients of more than half of our advisors and we expect that group to continue to expand as we approach our third season of filings. While initial adoption has been driven by our impact clients, a more diverse set of clients has expressed interest in becoming involved. In fact, for some clients, experience with shareholder resolutions has sparked an interest in some of our other services and related fields, including both impact investing and strategic philanthropy, further deepening the client-advisor relationship.

Many aspects of the program appeal to our clients. By focusing on a single initiative, clients can better understand their potentially catalytic role in the process, and witness the amplification of their impact as other shareholders vote in favor of their sponsored resolutions. Clients can also customize their involvement, and engage deeply with the content and follow the campaign in the news, or simply receive updates from our team. Many clients enjoy seeing how solutions can scale across companies within an industry, or are empowered by watching support for their resolution build over multiple years. Clients that participate in a filing in one year are often eager to support a resolution in following years.

In building out a collaborative shareholder engagement service offering, we identified some important themes that could be helpful for firms considering a similar program:

Third-party expertise is key: Managing a shareholder engagement initiative is no small task. Experts must adeptly build productive relationships between the two parties, and be both sensitive and strategic with how they approach companies. Realistically, most independent advisory firms will lack this internal capacity and expertise, which makes trusted third parties invaluable as an effective alternative to support interested clients with high-quality initiatives backed by research and led by experts. While As You Sow is our primary and longest-standing relationship, we have also worked with other experts including Proxy Impact and the Thirty Percent Coalition.

Keep it simple: Our clients are often pleasantly surprised by how easy it is to become involved in shareholder resolution initiatives. By focusing on the resolution filing process, our clients can follow a few relatively simple steps at a key point in the process where their engagement is the most impactful. Clients new to the process often choose one campaign initially, and then seek additional opportunities after realizing how effortless and enriching this facilitated process can be.

Education and communication enrich the process: Periodic reporting and communications can maintain client interest and support, or help build confidence for clients who are interested but want to learn more prior to participating. The education component truly enriches the client experience, building awareness and empowering clients to generate greater impact.

Manage expectations: Shareholder engagement initiatives are not always successful, and some take years to produce material results. Maintaining open communication with clients and supporting them through both the highs and lows of the proxy process is an important part of delivering a positive and sustainable shareholder engagement experience. Transparency and education help maintain the authenticity of the process.

Be intentional: An offering like this can be highly flexible. At a minimum, advisors may utilize the offering to accommodate interested clients in an ad-hoc manner. However, we believe that advisors can and should be intentional with shareholder engagement opportunities and understand how this type of offering can enhance your client satisfaction and financial stewardship. This type of offering can be scaled up as firms work with additional partners to source more initiatives depending on the capacity of the firm and the interests of the clients.

As shareholders, our clients occupy a powerful position to effect positive change in corporate practices that can improve long-term financial performance. We are in a unique position to facilitate client involvement in shareholder engagement initiatives by enabling and simplifying the process. By working with external parties to enhance our shareholder engagement program with impact offerings, our staff and clients can work together to curate a truly customized engagement strategy, allowing clients to participate in initiatives that address social and environmental challenges that are most important to them.

So what do you think? Would you consider launching a Shareholder Engagement problem to your clients as a value-add? I’m soon going to make a webinar from this topic soon.  Please share your thoughts in the comments below!

Financial Advisor Fees Comparison – All-In Costs For The Typical Financial Advisor?

Executive Summary

While the standard rule-of-thumb is that financial advisors charge 1% AUM fees, the reality is that as with most of the investment management industry, financial advisor fee schedules have graduated rates and breakpoints that reduce AUM fees for larger account sizes, such that the median advisory fee for high-net-worth clients is actually closer to 0.50% than 1%.

Yet at the same time, the total all-in cost to manage a portfolio is typically more than “just” the advisor’s AUM fee, given the underlying product costs of ETFs and mutual funds that most financial advisors still use, not to mention transaction costs, and various platform fees. Accordingly, a recent financial advisor fee study from Bob Veres’ Inside Information reveals that the true all-in cost for financial advisors averages about 1.65%, not “just” 1%!

On the other hand, with growing competitive pressures, financial advisors are increasingly compelled to do more to justify their fees than just assemble and oversee a diversified asset allocated portfolio. Instead, the standard investment management fee is increasingly a financial planning fee as well, and the typical advisor allocates nearly half of their bundled AUM fee to financial planning services (or otherwise charges separately for financial planning).

The end result is that comparing the cost of financial advice requires looking at more than “just” a single advisory fee. Instead, costs vary by the size of the client’s accounts, the nature of the advisor’s services, and the way portfolios are implemented, such that advisory fees must really be broken into their component parts: investment management fees, financial planning fees, product fees, and platform fee.

From this perspective, the reality is that the portion of a financial advisor’s fees allocable to investment management is actually not that different from robo-advisors now, suggesting there may not be much investment management fee compression on the horizon. At the same time, though, financial advisors themselves appear to be trying to defend their own fees by driving down their all-in costs, putting pressure on product manufacturers and platforms to reduce their own costs. Yet throughout it all, the Veres research concerningly suggests that even as financial advisors increasingly shift more of their advisory fee value proposition to financial planning and wealth management services, advisors are still struggling to demonstrate why financial planning services should command a pricing premium in the marketplace.

How Much Do Financial Advisors Charge As Portfolios Grow?

One of the biggest criticisms of the AUM business model is that when financial advisor fees are 1% (or some other percentage) of the portfolio, that the advisor will get paid twice as much money to manage a $2M portfolio than a $1M portfolio. Despite the reality that it won’t likely take twice as much time and effort and work to serve the $2M client compared to the $1M client. To some extent, there may be a little more complexity involved for the more affluent client, and it may be a little harder to market and get the $2M client, and there may be some greater liability exposure (given the larger dollar amounts involved if something goes wrong), but not necessarily at a 2:1 ratio for the client with double the account size.

Yet traditionally, the AUM business has long been a “volume-based” business, where larger portfolios reach “breakpoints” where the marginal fees get lower as the dollar amounts get bigger. For instance, the advisor who charges 1% on the first $1M, but “only” 0.50% on the next $1M, such that the with double the assets does pay 50% more (in recognition of the costs to market, additional service complexity, and the liability exposure), but not double.

However, this means that the “typical financial advisor fee” of 1% is somewhat misleading, as while it may be true that the average financial advisory fee is 1% for a particular portfolio size, the fact that fees tend to decline as account balances grow (and may be higher for smaller accounts) means the commonly cited 1% fee fails to convey the true sense of the typical graduated fee schedule of a financial advisor.

Fortunately, though, recent research by Bob Veres’ Inside Information, in a survey of nearly 1,000 advisors, shines a fresh light on how financial advisors typically set their AUM fee schedules, not just at the mid-point, but up and down the scale for both smaller and larger account balances.  And as Veres’ research finds, the median advisory fee up to $1M of assets under management really is 1%. However, many advisors charge more than 1% (especially on “smaller” account balances), and often substantially less for larger dollar amounts, with most advisors incrementing fees by 0.25% at a time (e.g., 1.25%, 1.00%, 0.75%, and 0.50%), as shown in the chart below.

More generally, though, Veres’ research affirms that the median AUM fee really does decline as assets rise. At the lower end of the spectrum, the typical financial advisory fee is 1% all the way up to $1M (although notably, a substantial number of advisors charge more than 1%, particularly for clients with portfolios of less than $250k, where the median fee is almost 1.25%). However, the median fee drops to 0.85% for those with portfolios over $

1M. And as the dollar amounts rise further, the median investment management fee declines further, to 0.75% over $2M, 0.65% over $3M, and 0.50% for over $5M (with more than 10% of advisors charging just 0.25% or less).

The typical financial advisor reduces AUM fees for clients with larger account sizes!

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Notably, because these are the stated advisory fees at specific breakpoints, the blended fees of financial advisors at these dollar amounts would still be slightly higher. For instance, the median advisory fee at $2M might be 0.85%, but if the advisor really charged 1.25% on the first $250k, 1% on the next $750k, and 0.85% on the next $1M after that, the blended fee on a $2M portfolio would actually be 0.96% at $2M.

Nonetheless, the point remains: as portfolio account balances grow, advisory fees decline, and the “typical” 1% AUM fee is really just a typical (marginal) fee for portfolios around a size of $1M. Those who work with smaller clients tend to charge more, and those who work with larger clients tend to charge less.

How Much Do Financial Advisors Cost In All-In Fees?

The caveat to this analysis, though, is that it doesn’t actually include the underlying expense ratios of the investment vehicles being purchased by financial advisors on behalf of their clients.

Of course, for those who purchase individual stocks and bonds, there are no underlying wrapper fees for the underlying investments. However, the recent FPA 2017 Trends In Investments Survey of Financial Advisors finds that the overwhelming majority of financial advisors use at least some mutual funds or ETFs in their client portfolios (at 88% and 80%, respectively), which would entail additional costs beyond just the advisory fee itself.

Fortunately, though, the Veres study did survey not only advisors’ own AUM fee schedules, but also the expense ratios of the underlying investments they used to construct their portfolios. And as the results reveal, the underlying expense ratios add a non-trivial total all-in cost to the typical financial advisory fee, with the bulk of blended expense ratios coming in between 0.20% and 0.75% (and a median of 0.50%).

Of course, when it comes to ETFs, as well as the advisors who trade individual stocks and bonds, there are also underlying transaction costs to consider. Fortunately, given the size of typical advisor portfolios, and the ever-declining ticket charges for stock and ETF trades, the cumulative impact is fairly modest. Still, while most advisors estimated their trading costs at just 0.05%/year or so, with almost 15% at 0.02% or less, there were another 18% of advisors with trading costs of 0.10%/year, almost 10% up to 0.20%/year, and 6% that trade more actively (or have smaller typical client account sizes where fixed ticket charges consume a larger portion of the account) and estimate cumulative transaction costs even higher than 0.20%/year.

In addition, the reality is that a number of financial advisors work with advisory platforms that separately charge a platform fee, which in some cases covers both technology and platform services and also an all-in wrap fee on trading costs (and/or access to a No-Transaction-Fee [NTF] platform with a platform wrapper cost). Amongst the more-than-20% of advisors who reported paying such fees (either directly or charged to their clients), the median fee was 0.20%/year.

Accordingly, once all of these various underlying costs are packaged together, it turns out that the all-in costs for financial advisors – even and including fee-only advisors, which comprised the majority of Veres’ data set – including the total cost of AUM fees, plus underlying expense ratios, plus trading and/or platform fees, are a good bit higher than the commonly reported 1% fee.

For instance, the median all-in cost of a financial advisor serving under-$250k portfolios was actually 1.85%, dropping to 1.75% for portfolios up to $500k, 1.65% up to $1M, and 1.5% for portfolios over $1M, dropping to $1.4% over $2M, 1.3% over $3M, and 1.2% over $5M.

The typical advisor’s all-in costs are more than 1.5%/year, even for millionaires!

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Notably, though, the decline in all-in costs as assets rise moves remarkably in-line with the advisor’s underlying fee schedule, suggesting that the advisor’s “underlying” investments and platform fee are actually remarkably stable across the spectrum.

For instance, the median all-in cost for “small” clients was 1.85% versus an AUM fee of 1% (although the median fee was “almost” 1.25% in Veres’ data) for a difference of 0.60% – 0.85%, larger clients over $1M face an all-in cost of 1.5% versus an AUM fee of 0.85% (a difference of 0.65%), and even for $5M+ the typical total all-in cost was 1.2% versus a median AUM fee of 0.5% (a difference of 0.70%). Which means the total cost of underlying – trading fees, expense ratios, and the rest – is relatively static, at around 0.60% to 0.70% for advisors across the spectrum!

On the one hand, it’s somewhat surprising that as client account sizes grow, advisors reduce their fees, but platform fees and underlying expense ratios do not decrease. On the other hand, it is perhaps not so surprising given that most mutual funds and ETFs don’t actually have expense ratio breakpoints based on the amount invested, especially as an increasing number of low-cost no-load and institutional-class shares are available to RIAs (and soon, “clean shares” for broker-dealers) regardless of asset size.

It’s also notable that at least some advisor platforms do indirectly “rebate” back a portion of platform and underlying fees, in the form of better payouts (for broker-dealers), soft dollar concessions (for RIAs), and other indirect financial benefits (e.g., discounted or free software, higher tier service teams, access to conferences, etc.) that reduces the advisor’s costs and allows the advisor to reduce their AUM fees. Which means indirectly, platforms fees likely do get at least a little cheaper as account sizes rise (or at least, as the overall size of the advisory firm rises). It’s simply expressed as a full platform charge, with a portion of the cost rebated to the advisor, which in turn allows the advisor to pass through the discount by reducing their own AUM fee successfully.

Financial Advisor Fee Schedules: Investment Management Fees Or Financial Planning Fees?

One of the other notable trends of financial advisory fees in recent years is that financial advisors have been compelled to do more and more to justify their fees, resulting in a deepening in the amount of financial planning services provided to clients for that same AUM fee, and a concomitant decline in the profit margins of advisory firms.

To clarify how financial advisors position their AUM fees, the Veres study also surveyed how advisors allocate their own AUM fees between investment management and non-investment-management (i.e., financial planning, wealth management, and other) services.

Not surprisingly, barely 5% of financial advisors reported that their entire AUM fee is really just an investment management fee for the portfolio, and 80% of advisors who reported that at least 90% of their AUM fee was “only” for investment management stated it was simply because they were charging a separate financial planning fee anyway.

For most advisors who do bundle together financial planning and investment management, though, the Veres study found that most commonly advisors claim their AUM fee is an even split between investment management services, and non-investment services that are simply paid for via an AUM fee. In other words, the typical 1% AUM fee is really more of a 0.50% investment management fee, plus a 0.50% financial planning fee.

Perhaps most striking, though, is that there’s almost no common consensus or industry standard about how much of an advisor’s AUM fee should really be an investment management fee versus not, despite the common use of a wide range of labels like “financial advisor”, “financial planner”, “wealth manager”, etc.

As noted earlier, in part this may be because a subset of those advisors in the Veres study are simply charging separately for financial planning, which increases the percentage-of-AUM-fee-for-just-investment-management allocation (since the planning is covered by the planning fee). Nonetheless, the fact that 90% of advisors still claim their AUM fees are no-more-than-90% allocable to investment management services suggests the majority of advisors package at least some non-investment value-adds into their investment management fee. Yet how much is packaged in and bundled together varies tremendously!

Most financial advisors do more than just investment management for their AUM fees!

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More broadly, though, this ambiguity about whether or how much value financial advisors provide, beyond investment management, for a single AUM fee, is not unique to the Veres study. For instance, last year’s 2016 Fidelity RIA Benchmarking Study found that there is virtually no relationship between an advisor’s fees for a $1M client, and the breadth of services the advisor actually offers to that client! In theory, as the breadth of services to the client rises, the advisory fee should rise as well to support those additional value-adds. Instead, though, the Fidelity study found that the median advisory fee of 1% remains throughout, regardless of whether the advisor just offers wealth management, or bundles together 5 or even 9 other supporting services!

The Future Of Financial Advisor Fee Compression: Investment Management, Financial Planning, Products, And Platforms

Overall, what the Veres study suggests is that the typical all-in AUM fee to work with a financial advisor is actually broken up into several component parts. For a total-cost AUM fee of 1.65% for a portfolio up to $1M, this includes an advisory fee of 1% (which in turn is split between financial planning and investment management), plus another 0.65% of underlying expenses (which is split between the underlying investment products and platform). Which means a financial advisor’s all-in costs really need to be considered across all four domains: investment management, financial planning, products, and platform fees.

Notably, how the underlying costs come together may vary significantly from one advisor to the next. Some may use lower-cost ETFs, but have slightly higher trading fees (given ETF ticket charges) from their platforms. Others may use mutual funds that have no transaction costs, but indirectly pay a 0.25% platform fee (in the form of 12b-1 fees paid to the platform). Some may use more expensive mutual funds, but trim their own advisory fees. Others may manage individual stocks and bonds, but charge more for their investment management services. A TAMP may combine together the platform and product fees.

Overall, though, the Veres data reveals that the breadth of all-in costs is even wider than the breadth of AUM fees, suggesting that financial advisors are finding more consumer sensitivity to their advisory fees, and less sensitivity to the underlying platform and product costs. On the other hand, the rising trend of financial advisors using ETFs to actively manage portfolios suggests that advisors are trying to combat any sensitivity to their advisory fees by squeezing the costs out of their underlying portfolios instead (i.e., by using lower-cost ETFs instead of actively managed mutual funds, and taking over the investment management fee of the mutual fund manager themselves).

Consumers are more sensitive to advisory fees, forcing advisors to squeeze costs of their providers!

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In turn, we can consider the potential implications of fee compression by looking across each of the core domains: investment management, financial planning, and what is typically a combination of products and platform fees.

When it comes to investment management fees, the fact that the typical financial advisor already allocates only half of their advisory fee to investment management (albeit with a wide variance), suggests that there may actually not be much fee compression looming for financial advisors. After all, if the advisor’s typical AUM fee is 1% but only half of that – or 0.50% – is for investment management, then the fee isn’t that far off from many of the recently launched robo-advisors, including TD Ameritrade Essential Portfolios (0.30% AUM fee), Fidelity Go (0.35% AUM fee), and Merrill Lynch Guided Edge (0.45% AUM fee). At worst, the fee compression risk for pure investment management services may “only” be 20 basis points anyway. And for larger clients – where the fee schedule is falling to 0.50% anyway, and the investment management portion would be only 0.25% – financial advisors have already converged on “robo” pricing.

On the other hand, with the financial planning portion of fees, there appears to be little fee compression at all. In fact, as the Fidelity benchmarking study shows, consumers (and advisors) appear to be struggling greatly to assign a clear value to financial planning services at all. Not to say that financial planning services aren’t valuable, but that there’s no clear consensus on how to value them effectively, such that firms provide a wildly different range of supporting financial planning services for substantially similar fees. Until consumers can more clearly identify and understand the differences in financial planning services between advisors, and then “comparison shop” those prices, it’s difficult for financial planning fee compression to take hold.

By contrast, fee compression for the combination of platforms and the underlying product expenses appears to be most ripe for disruption. And arguably, the ongoing shift of financial advisors towards lower cost product solutions suggests that this trend is already well underway, such that even as advisory firms continue to grow, the asset management industry in the aggregate saw a decline in both revenues and profits in 2016. And the trend may only accelerate if increasingly sophisticated rebalancing and model management software begins to create “Indexing 2.0” solutions that make it feasible to eliminate the ETF and mutual fund fee layer altogether. Similarly, the trend of financial advisors from broker-dealers to RIAs suggests that the total cost layer of broker-dealer platforms is also under pressure. And TAMPs that can’t get their all-in pricing below the 0.65% platform-plus-product fee will likely also face growing pressure.

Notably, though, these trends also help to reveal the growing pressure for fiduciary regulation of financial advisors – because as the investment management and product/platform fees continue to shrink, and the relative contribution of financial planning services grow, the core of what a financial advisor “does” to earn their fees is changing. Despite the fact that our financial advisor regulation is based primarily on the underlying investment products and services (and not fee-for-service financial planning advice).

Nonetheless, the point remains that financial advisor fee compression is at best a more nuanced story than is commonly told in the media today. To the extent financial advisors are feeling fee pressure, it appears to be resulting in a shift in the advisor value proposition to earn their 1% fee, and a drive to bring down the underlying costs of products and platforms to defend the advisor’s fee by trimming (other) components of the all-in cost instead. Though at the same time, the data suggests that consumers are less sensitive to all-in costs than “just” the advisor’s fee… raising the question of whether analyzing all-in costs for financial advice may become the next battleground issue for financial advisors that seek to differentiate their costs and value.

In the meantime, for any financial advisors who want to access a copy of Veres’ White Paper on Advisory Fees and survey results, you can sign up here to order a copy.

So what do you think? Do you think financial advisors’ investment management fees are pretty much in line with robo advisors already? Is fee compression more nuanced than typically believed? Please share your thoughts in the comments below!

Switching From Wirehouse To RIA – AUM And Revenue Requirements To Break Away

Executive Summary

The breakaway broker trend, which gained momentum in the aftermath of the financial crisis, has been underway for several years now. And in an environment where many 7- to 9-year post-crisis retention deals are expiring at the same time that wirehouses are reigning in their signing bonuses, there is a fresh wave of interest in potentially breaking away from wirehouses and transitioning to the independent RIA channel for the potential of greater income. However, there are many motivations which may lead to a desire to break away, and pursuing a greater “payout” alone is actually not the best reason to break away.

In this week’s discussion, we discuss different motivations for breaking away from a wirehouse to become an independent RIA, as well as the team characteristics – including revenue, AUM, and desire for independence – that tend to lead to better break away outcomes for advisors!

First and foremost, it is important to recognize the different ways that “take-home pay” are calculated in a wirehouse versus an independent RIA. In the wirehouse environment, brokers at the low end might take home 35% of GDC, while the biggest producers and teams may get to 50% to 55% in some circumstances. By contrast, independent advisory firms typically follow a “40, 35, 25 rule”, that 40% of gross revenue goes towards paying advisors and the investment team, 35% goes towards overhead and administrative staff, and 25% is the profit margin left over. For a solo advisor, this may effectively equate to a 65% payout, by paying themselves both the “employee advisor” compensation and the profit margin. For a larger team, the calculation is messier, but in the end advisors are often able to keep 10% to 20% more of their gross revenue after making the switch.

That being said, there’s a really important caveat to the comparison between wirehouses and an independent RIA. When you’re at a wirehouse, a lot of those cost decisions – about staffing, overhead, compliance, office leases, technology, etc. – are made for you. At an independent RIA, though, the responsibility is on you, as the owner-advisor. The flexibility of being able to make those decisions is what gives advisors some more operational leverage as an independent RIA, but it is also a lot of additional work – or at least responsibility – for you as the advisor. That’s the double-edged sword of going independent, and it’s the reason why most advisors who break away don’t do it for the money.

However, if they are independently minded, want to control their own destiny, want to be the owner of their business, and want to make all the decisions that go along with that… then breaking away may just be a small sacrifice to make for the long run. But if you’re happy to have a firm make those decisions for you, then you’re not going to be happier getting a few more points of take-home on your GDC but being required to shoulder the burden of all the responsibilities and decisions.

It’s also worth noting that there are more and more options today for brokers who are breaking away and want assistance with the transition, to reduce the burden of responsibility. From platforms like HigherTower Advisors and Dynasty Financial – who can recreate a lot of the infrastructure advisors are used to from their wirehouse – to consulting firms like Matt Sonnen at PFI Advisors that help with the transition, to technology benchmarking studies and compliance firms to help guide advisors, there are a lot of resources available. And the truth is that larger firms with higher levels of revenue (e.g., $5 million) can afford to hire staff to handle much of the responsibility, while solo brokers can also be successful in the transition, particularly those around the $50M to $100M of AUM level where brokers may be getting a 40% payout whereas successful solo RIAs are taking home 65% to 85% of their revenue (providing ample revenue to cover some additional expenses as an independent).

The key point in all of this, though, is simply to recognize that if you’re considering whether to break away from a wirehouse to an independent RIA, have a clear picture in your head of why you’re breaking away before you do so. And just trying to make a few more points on your revenue is not the best reason. It may work out okay, but the biggest success stories amongst brokers who go to the independent RIA channel are the ones who want to be independent. In other words, ultimately it’s not really a revenue or a size consideration that drives success during a breakaway – as it’s viable at almost any AUM or revenue level – but rather, an advisor’s desire for independence, with the burdens of responsibility and upside opportunity that comes with it!

Wirehouse GDC Payouts Vs RIA Profit Margins

Let’s start by looking at take home pay at a wirehouse versus an independent RIA. Now, at a wirehouse, brokers at the low end may be taking home something like 35% of your GDC. As your production grows, you may get up to 40-something percent. If you’re a big producer or on a big producing team, maybe you can get 50 to 55% at at least some wirehouses, depending which one you’re at, years of service to the firm, production bonuses, and so forth. Now, coming out of that, you have some miscellaneous fees and costs that go to the wirehouse, but the firm does absorb compliance costs, it gives you a platform, and it usually provides you office space. Basically, it absorbs a lot of the overhead you otherwise have to deal with as an independent.

If we look at this from the independent RIA side, it looks a little different. The good news is, you keep 100% of your revenue. Whatever is at that top line, that’s all yours. The bad news is, you have to pay all of your own expenses out of that 100% off the top line. We have a lot of benchmarking sites at this point that tell us what advisory firms typically spend in various categories (i.e., what their costs are and what their take home pay is across the board). And what you find for independent advisory firms is that they typically follow what’s called the 40-35-25 rule. That means out of their gross revenue, typically, 40% is to paying advisors and investment team in the firm. 35% is for overhead and administrative staff. And that leaves a 25% profit margin left over. So, 100% of your gross revenue minus 40% that’s paid to advisors and investment team, 35% for overhead and staff. Do the math. That leaves you with a 25% profit margin remaining at the end.

Now, if you’re a solo advisor, you usually actually take the pay of the advisor part and the profit part at the bottom, which means when you blend them together, you’re taking home about $0.65 cents on the dollar. Or in wirehouse terms, basically, it’s a 65% payout rate by the time you actually replace all the costs that the broker dealer platform is giving you. Now, if you’re a larger team, it’s a bit messier to reconstruct your income. You’re probably doing a lot of business under split rep codes, with split payouts, so you don’t necessarily get the full payouts and all revenue for your team. And so, if you’re trying to compare that to an independent RIA, frankly, you have to go a little bit deeper to allocate some of the revenue to the other advisors, some of the revenue to you for what you’re actually handling, what your income would be, what you’d recently pay yourself versus the other advisors, and then figure out what your profit margin is that comes down to the bottom line.

Broadly speaking though, what I find for a lot of advisors I’ve seen that go through this comparison is that, they end up keeping somewhere between about 10 to 20% more of their gross revenue after they make the switch. So, if you were walking away with 40 or 45%, you may see yourself walking away with closer to 60 to 65%. Although if you’re further down the grid, if you’re solo and you’re only getting 35 to 40% payouts in the wirehouse, you might see as much as a 30% lift in the amount of gross revenue that you get to keep.

Breaking Away Is About Independence And Control

That being said, there’s a really important caveat with this comparison. When you’re at a wirehouse, a lot of those cost decisions, staffing, overhead, compliance, office leases, technology tools, on and on and on, are made for you. The bad news with this is that sometimes when they decide, they don’t actually pick something that’s a great match for you. That waste, that not everything that’s in the wirehouse platform is necessarily used by every wirehouse broker, is part of what creates that gap as to why you can sometimes generate a little more take home compensation on the independent side. But they make those decisions for you, and if you become an independent RIA, those are your decisions to make.

Now, the flexibility of being able to make those decisions, again, is part of what lets you get a little more operational leverage from your revenue. You can have the office space that’s right for you, maybe you prefer a little bit of a less expensive space than the premier location that a lot of wirehouses tend to rent. You only need to hire the staff you need for your business. It’s a little bit more lean. You don’t need as much overhead infrastructure some times. You can choose the right technology for you, skip what you don’t need. But it’s on your shoulders, and that’s really the double edged sword of going independent. The good news is, you have more control over your destiny; but the bad news is, you have more control over your destiny. And because of that, the truth is that most advisors who break away from wirehouses in the end, don’t do it for the money. They don’t do it because, “Maybe I can take home 10 or 15% more of my revenue”, because it’s a lot of work.

You can try to get your clients to come with you by following the broker protocol, but at best, it’s a huge distraction for months leading up in preparation. A lot of stress when you tender your resignation and immediately start making 100 – 200 phone calls in about 48 hours, to try to reach all of your clients to start the switchover process, before the broker dealer sends other brokers to calling your clients.

Now, if you’re independently minded, you want to control your own destiny, you want to be the owner of your own business, and you want to make all the decisions about the office space, the staff, technology, and the marketing… as well as own your own brand and not be part of the wirehouse’s brand and all the rest, then that transition is usually a small sacrifice to make in the long run. But if you’re happy to have the firm make those decisions and handle that stuff for you, so you can just focus on your clients and growing your revenue, then honestly, I’m not sure you’re going to be that much happier in your business by going through all that effort to make a switch, just to try to get a few more points of take home off your GDC.

Breaking Away – Large Teams Vs Solo Advisors

That being said, it’s worth noting that there are more and more options these days for brokers who are breaking away and want some transition assistance for this. There are platforms like HighTower Advisors and Dynasty Financial, who can actually recreate a lot of the structure you’re used to for the wirehouse, but ultimately, still have the flexibility of being an independent RIA. So, they will provide a lot of guidance about your infrastructure, even provide some of the technology platform and the back office support. You don’t have to make as many of those decisions. And while they do have a cost that’s not trivial, it’s still less than the slice of GDC your wirehouse is taking off your grid. Now, for larger teams that want to break away and really want to control their destiny from the start, there are also standalone consulting firms. Folks like Matt Sonnen at PFI Advisors that work with breakaways and help you to get your office set up and handle the transition directly.

And the truth is, if you’re a larger team (e.g., $5 million or more in revenue) then you have the dollars to hire the depth of staff and infrastructure around you. You can spend on the compliance consultants, the operations manager (or a full on COO), and the management team infrastructure that you need to execute successfully as an independent.

Because again, bear in mind that the typical independent RIA is spending about 35% of its revenue on overhead. So, if you’re a team with $5 million of production and you spend $1.5 million to rent your office, buy the furniture, get the technology, and hire the staff that you need to support you, run the firm, and replace what the wirehouse did – you are actually incredibly profitable. Because spending $1.5 million for that stuff on $5 million of revenue is only 30% of your revenue and cost, and the typical firm is close to 35%. Even as a $2 million team, where you’re probably lucky to keep 50% of your current payout, if you “just” spend $700,000 hiring multiple operations staff members, compliance, consulting, technology, office space, and all the rest of your overhead, you’re still coming out well ahead and probably keeping another 15 to 20% of your revenue, with an actual business entity that you own and that you can sell some day.

And it’s worth noting, because overhead costs scale down the line, breakaways really are not unique to the large team environment. So, Keith had asked as well about solos breaking away, and I actually find that a lot of solo brokers are some of the most successful in making the transition to break away, especially those folks that are sitting around maybe 50 or 100 million of AUM or even a little bit lower. You’re probably getting maybe a 40% payout on your revenue, when successful solo RIAs are taking home 65% of revenue, and the top solo RIAs are taking home as much as 85% of their revenue. There really are solo RIAs out there that are bringing in more than $500,000 of revenue and they keep more than 400 of it.

Power of #FinTech: Successful solo RIAs take home as much as 85% of their revenue!

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Because the technology and the platforms, the RIA custodians, frankly have gotten pretty competitive with the wirehouses, particularly if you’re simply doing managed portfolios with what I’ll call traditional investments, mutual funds, ETFs, stocks, and bonds. Because on the independent side, you may not quite have the same kind of access to lending products, company proprietary products, private fund offerings that you had at the wirehouse. But if you’re simply doing fairly traditional market traded portfolios, you can leverage the technology and independent platforms, be incredibly efficient as a solo in offering up a portfolio and then providing the financial planning advice and the wisdom that’s the value add on top.

And it’s worth noting, another option for solo advisors or teams even up to about a million or two in revenue, is to do what’s called a tuck in, where you join an existing RIA that already has the staff, infrastructure, management, and the operations in place, and you tuck into their platform and you get to leverage their platform. But you don’t do it for a grid payout. In most tuck ins, you bring the revenue and you get some equity. So, you’re a partner now in an independent firm. You’ll get paid something for your client revenue and you’ll participate in the profits, the bottom line of the firm, and own some equity some day that you can sell. And so, it’s different than just moving to join another team where someone else takes a slice of your revenue, it’s moving into an independent world where you’re tucking into a firm, but actually taking equity to be part of something larger.

Or alternatively, there are solos that break away and just go entirely on their own, particularly those that want to form what are often called lifestyle practices. Because one of the other benefits to being independent and being your own boss is that, you get to decide what you’re building toward. So, if you’re happy with your income, especially if you could keep 65 or 75% of your gross revenue, and you don’t want to grow anymore and you’d rather just gain more efficiency so that you can take more vacation, you can do that. There’s no sales manager grieving you for not growing or hitting bigger numbers. Your numbers are whatever you want them to be, including not growing if you’re happy with your income where it is.

Why Do You Want To Break Away, Really?

But again, if there’s one thing that you take away from this discussion it’s just that you need a clear picture in your head of why you’re breaking away and just trying to make a few points on your revenue is honestly not the best reason. It may work out okay for you, especially if you tuck in or look at platforms like HighTower and Dynasty that you can just keep serving your clients, maybe bring your cost structure down a little while you clear a couple more points in the future. But the biggest success stories I see amongst the breakaways who do go to the independent channel are the ones who want to be independent. They want to make those decisions. They want to control their destiny. The fact that can also be more profitable is a wonderful perk and a benefit, and part of the excitement of being an entrepreneur is that, you actually truly own your advisory business.

But if all that sounds scary to you, then you may just want to stick it out where you are, where you don’t have to deal with the responsibility of all those decisions, and you can focus on serving your clients and going to get more. But at the same time, I do think it’s crucial to recognize that breaking away isn’t really just like a revenue requirement or AUM requirement thing. Large teams do it because they want to build their own structure. Medium sized teams do it, and maybe they want to build their own or maybe they want to tuck in. Small solos do it, and sometimes they just want to take home more pay, sometimes they want to go lifestyle, or sometimes they want to tuck into a larger firm. Lots of different reasons and the economics are a little bit different for each, but any of them can do it up and down the line because overhead and cost scale to the size of a business. It’s a question of whether you want the weight of the responsibility and the upside opportunity of doing so.

The decision to break away is based on revenue or AUM requirements, but a desire for independence!

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But the good news is there are a lot more support services out there now. The technology in the independent channel has gotten very strong. There are a lot of benchmarking studies to help guide you on what to spend and consultants to help. Plenty of compliance consulting firms that will help you do the transition and comply with broker protocol.

It does take time to do the transition and a big burst of energy and focus during the transition itself and to get your new firm set up on the other side, but don’t make the decision just based on the fear of the time it will take or the few points you could try to make on the other side. Make the decision based on what you want to do you as an advisor and a business owner. How you want to build a career, what kind of control you want, and whether you want the responsibility that comes with the control of independence. And if not, hang on where you are, keep serving your clients well because the truth is that’s still what most advisors do. As much as we talk about the breakaway broker trend, most estimates are that, it’s still maybe 1% or 2% of brokers that are making a transition to an RIA. That’s not about the math of take home pay. That’s about the subset of advisors that are driven towards independence.

I hope that helps a little as food for thought.

So what do you think? Are breakaway brokers driven by a desire to keep more of their GDC? Do they breakaway over something else? Will we see an uptick in breakaways as post-financial crisis retention deals expire? Please share your thoughts in the comments below!