In Part Two of this two-part series, Andrew Fairweather explains how financial planners can benefit from adopting an institutional mindset to portfolio construction.
Implementing an institutional mindset to managing wealth should result in enormous cost and compliance savings in an adviser’s business, in addition to increased client satisfaction, because the approach is defendable and robust and likely to lead to improved investment performance over time.
The first step for dealer groups and advisers is to recognise that investment management, when done correctly, can add substantial value to their businesses in addition to increasing client satisfaction. However, in accepting this, they should also recognise that it is very difficult to do well.
The second point to recognise is that investment management is a key driver of adviser and dealer group value – look at the share prices of listed advisory groups whose client portfolios would generally resemble a growth portfolio in terms of asset allocation. Those portfolios have fallen hard as traditional equities, which make up a large part of any growth portfolio, have been hammered. This has shown the other side of the fixed operating leverage equation, as moving fixed costs out of a business can take time, while the hit to revenue is immediate. If advisers and dealer groups are not adjusting down their expectations on what their businesses are worth, they should be.
This further highlights the volatility in dealer group and advisory earnings when linked mainly to traditional growth assets. In recognising these two points, it is our proposition that advisers are better off and better qualified to manage client strategies, communication, plans and goals than they are at investing their clients’ wealth. This is, of course, a general statement, as there are some first class advisory practices that have defendable investment strategies and proven track records. However, these dealer groups are few and far between, and the successful ones have invested heavily in the area knowing that not doing so would be risky to their businesses and their clients.
More importantly – no client, no business. These dealer groups and advisers also recognise that the choices they make in relation to their approach to investment management manufacturing will absolutely impact the volatility of their own earnings and the level of client satisfaction and retention.
In implementing a new approach to investment management, we suggest that advisers start to think like institutions by creating wholesale relationships with multi-manager investment manufacturers, by becoming “virtually” integrated with an outsourced portfolio management capability. The advantages of this approach are numerous and include: zero fee rebate leakage and at higher rates (wholesale versus retail); a dealer group could brand the portfolio in their own name that would extend their brand proposition and hence value creation to another part of the industry value chain; there would be more time for client-facing activities for advisers; compliance risk would reduce substantially; the dealer group and adviser would capture many of the benefits of vertical integration without the associated costs or risks; there would be no gap between research and implementation as a multi-manager is able to see an underlying manager in the afternoon and be completely out by the next day in many circumstances, with the adviser not having to be involved in terminating that manager.
Importantly, dealer groups and advisers would also have access to investment managers that are not accessible to typical retail investors, and at lower fees, as the benefits of scale captured by the multi-manager are passed on to investors.
The ultimate bottom line for dealer groups and advisers in adopting this institutional mindset is the simplification and scalability of their businesses, which becomes easier to manage and far easier to sell (this should also result in lower professional indemnity (PI) premiums).
Complex businesses that have key person dependency, as suggested by the “Planner as CIO” model, should and do trade at lower multiples than those that are institutional and simple. Importantly, it is our proposition that the client would also be better off by having a truly diversified portfolio that they understand, that is robust and dynamic, and that is absolutely aligned to their wealth creation needs.
CHOOSING A FUND MANAGER
The next choice for dealer groups and advisers is whether to choose an absolute return multi-manager or a traditional one. There will be no surprises in terms of SELECT’s view, but some of our thoughts are presented below.
By way of example, consider the following two dealer groups: one which adopts a traditional approach and one with an absolute return approach as their overarching philosophy.
The first group starts the period with $3 billion of funds under advice and, because of the traditional approach they have adopted, their group-wide assets fall by 10 per cent during a bear market. Assuming a 0.75 per cent fee and a 50 per cent cost-to-income ratio, this would result in a $1.125 million reduction in profit, which at a 15 times earnings multiple would result in $16.9 million of total shareholder value destroyed across the dealer group.
The second dealer group starts with the same funds under advice but only suffers a 3 per cent fall in value in the same market as a result of the different approach adopted. On the same assumptions as above, dealer two would suffer a reduction of profit of $337,000, which at 15 times is about $5 million in shareholder wealth destroyed or $11.9 million less than the first dealer group. Which dealer group shares would you rather own, remembering the research from Kahneman cited in Part One of this series?
In adopting the institutional approach, dealer groups and advisers should spend a lot more time undertaking due diligence so that they can position the final portfolio(s) in the right way for their clients. Once the selection has been made though, advisers should get on with managing the client value proposition and monitor the multi-manager through regular communication and investment committee meetings. This is far easier and less risky than the Financial Services Review Act and Australian Financial Services Licence requirement of advisers having to do their own due diligence on each fund that they might use under their current business model, rather than just relying on the dealer group’s recommended list as defence for any inappropriate advice, should that occur.
Focusing on one multi-manager will free up an enormous amount of time in the long run and should reduce compliance risk substantially.
We recognise that adopting this outsource approach will be challenging for most dealer groups and advisers, given the way in which they have presented themselves to clients in the past, their systems, and their mindset; but now is a good time to seriously consider making this change, given recent difficult markets and the expected volatile conditions ahead.
The old model of “Planner as CIO” is unlikely to be sustainable, nor the quasi middle ground of model portfolios which generally only work well in bull markets.
In terms of the stakeholders, there are multiple benefits:
- Dealer groups get less fee leakage (and higher fees), and lower compliance risk, which should flow through to lower PI costs and lower earnings volatility.
- Advisers get a defendable, robust and dynamic portfolio service that will reduce key person risk, lower earnings volatility, introduce business simplicity and hence higher value, and increased customer satisfaction.
- Clients get a robust and dynamic multi-manager portfolio that is well managed and in line with their investment objectives. They should also get more time with their advisers on value-creating activities.