Bear and Grin It

The upside to a down market is that clients may re

A distraught couple came into an advisor's office recently. They were referred by Charles Schwab & Company after losing half of the value of their $6 million account by investing in tech stocks in 2000. "They were sick over it," says the advisor who met with them.

The advisor says the couple had stayed out of tech during most of the bull market of the 1990s, but began dabbling in 1998 and 1999. In March 2000, the couple let almost their entire portfolio ride on tech stocks.

"I know that not all advisors are diversified," says the financial planner who picked up this new account. "But I can't imagine any advisor doing something like what this couple did to themselves.

"Just as sure as there are stupid retail investors, there are stupid advisors," says the planner. "But an advisor never would have let this couple put all their money in technology stocks in March 2000.

"The problem wasn't that Schwab gave them advice," says the advisor, who declined to be named because he was uncomfortable about embarrassing Schwab. "The problem was that Schwab did not advise them."

There are many stories like this these days. Independent investment advisors appear to be faring quite well relative to do-it-yourself investors in this bearish environment, and some RIA firms are finding opportunity as well. Many advisors say they are getting new clients as the market has tumbled. Do-it-yourselfers who were burned now realize that maybe they do need help and are turning to advisors.

Quantifying the "advisor advantage" in a bear market is difficult. But numbers gleaned from press releases by Schwab tell an incredible story. To its credit, a Schwab spokesman helped me work through some of the numbers after the pattern became clear.

Retail assets at Schwab in 2000 dro

pped from $512.2 billion to $507.7 billion. Despite the fact that new investors poured $72 billion into the retail side of Schwab, market losses were greater, accounting for the shrinkage.

But what's amazing is that assets held by the RIAs using Schwab Institutional as their custodian rose smartly. Total RIA assets at Schwab Institutional, home to some 6,000 independent RIAs, increased from $213 billion to $234 billion in 2000--a 9.9% jump in a year when the overall stock market declined by 10.1%. This is largely due to the fact that $45 billion in net new assets came into Schwab Institutional.

This is all very good for advisors. Using an average capital base calculation to smooth the difference between the end-of-year and beginning-of-year asset levels, advisor accounts in aggregate fell in value by 10.7% versus a 15% loss on the retail side. That excludes the net new assets that flowed into both sides of Schwab.

"The average advisor account outperformed the average retail account by hundreds of basis points over the course of the year," says John Coghlan, vice-chairman of Charles Schwab Corp. and president of Schwab Institutional, who has the actual figures.

These figures also exclude the assets Schwab added by purchasing U.S. Trust a year ago, but are still not perfect. For instance, it's safe to assume that the retail clients have more in cash because clients don't pay advisors to keep money in cash, so the loss on the retail side must be much steeper if the numbers were to exclude money market account holdings.

This isn't about Schwab, by the way. It's a good bet the retail investors at TD Waterhouse, Ameritrade, E*Trade, and all the other online brokerages have lost just as much or more as Schwab's retail customers. But Schwab happens to be the best gauge I can find to measure the "advisor advantage" because it is the top online brokerage firm catering to retail investors and it is the overwhelmingly dominant firm serving independent RIAs.

Still, the big picture is clear: People are turning to advisors more, and advisors' portfolios are generally performing better than retail client accounts. Advisor losses are about in line with the S&P 500.

"Clearly, advisors with whom we do business had a very successful year last year,"says Coghlan. "2000 was a record year for new assets at Schwab Institutional. In fact, continuing on into January, new assets brought in by advisors increased as a proportion of all net new assets coming into Schwab."

With the S&P 500 crossing the line into bear market territory--declining in value by nearly 20% as of mid-March--many advisor portfolios are probably down as much or more than the large-cap benchmark, but many advisors who have practiced broad diversification are now reaping the benefits.

"People didn't become clients in 1998 and 1999 because they said to themselves, 'Why pay 1% to an advisor when I can just pick stocks on my own and they'll go straight up'" says Harvey Rowen of Starmont Asset Management in San Francisco. "That's all changed now."

There are other benefits to this bear market. "You don't hear clients saying that 25%-per-year returns are not enough," says Rowen. "And you no longer have clients asking whether we really have to put bonds or value stocks into their portfolios."

Tom Connelly of Keats, Connelly & Associates in Phoenix also has found that the bear market has not been all that bad for business. In fact, Connelly says that the bull market of 1997 and 1998 was in some ways tougher to explain to clients. When U.S. large-cap growth stocks were "going great guns," says Connelly, clients would sometimes want to ask why their diversified portfolios were not doing as well.

But Connelly says he is not interested in marketing his firm to new clients on the basis of beating the markets in 2000. "I don't want to be a hired gun based on one-year of decent relative performance, and I don't want clients focusing on quarter-by-quarter or year-by-year results.

Some firms are finding that the bear market has opened up opportunities for mergers. Rowen says his firm is now able to engage in serious dialogue with other advisory firms about merging practices.

"On the investor side, they realize they need help and that managing money isn't as easy as they thought it was," says Rowen. "On the advisor side, they're saying this is a tough business and maybe they need help with research and should consider being part of a larger entity."

Alan Gavornik, CEO of Concord Equity Group in Laurence Harbor, New Jersey, says his broker/dealer firm is close to acquiring a B/D with about 40 reps. "A lot of groups stayed away from being acquired a year ago because of the strong market," says Gavornik. "Now we're seeing a number of new opportunities coming to us."

There are, to be sure, negatives to the market plunge. Advertising budgets are softening, a sign that mutual funds, insurers, and other companies in the industry are tightening their belts. And advisors are looking over their budgets for places to trim--so Web site vendors, software companies, and other firms that support advisors are likely to feel the pinch.

Still, the evidence suggests that advisors have fared far better than retail investors in this downturn. You may want to find a way to communicate this message to prospects and clients. Schwab, Fidelity, and Waterhouse probably won't have enough incentive to tell the world just how well advisors have done versus retail investors, but you may.

Keeping the Light On at Morningstar

There have been changes galore at Morningstar, but Don Phillips keeps the faith. What's his story?

Don Phillips of Morningstar has been a voice of investing reason ever since mutual funds became the investment vehicle of choice during the 1980s and 1990s. Independent investment advisors feel Phillips's presence in their offices every day, thanks to the leading role he's played in the retooling of Morningstar's professional investment analysis products, such as Principia Pro. But in recent months, much has changed. The bull market collapsed, and the SEC released two important rules on fund disclosures. What's more, Morningstar's plans to expand its advisor division ran into serious snags, and Phillips stepped down as CEO to become a managing director. Some advisors have even begun to wonder about the future of the company, so it seemed like a good time to find out what Don's thinking.

How do you size up this stock market? The magnitude of losses has been very steep. But if you told people that in 1999 the market was way up and in 2000 it was way down, they'd probably assume that in 2000 almost all stocks lost money and in 1999 almost all stocks made money. In reality, even in a great bull market year like 1999 half of all stocks lost money. Conversely, in a year like 2000, there were ample opportunities to make money. What this means is that picking winners in the stock market is never that easy.

Any unusual opportunities in the fund universe? Yes, funds with tax-loss carryforwards. A handful of funds that suffered losses and then had to sell stocks to meet redemptions are sitting on large tax-loss carryforwards. If you buy into one of these in a taxable account, your returns for some time in the future will essentially be tax-free.

The SEC recently made final some truth-in-labeling rules. The truth-in-labeling rule requires a fund company to invest at least 80% of its assets in the type of investment suggested by its name. Until now, a fund with the words "U.S. Government" in its name could invest up to 34.9% of its assets in junk bonds and other investments that behave very differently from U.S. Government Bonds. While the rule is an improvement and works fine in some cases, in other instances it doesn't go far enough.

You've been advocating an overhaul of the fund disclosure rules. One very valid approach the SEC could take to is to say, "Let's treat investment companies the same way we treat operating companies. Let's have the same disclosures on funds that we do for common stocks." I think it would be totally appropriate.

The SEC also finalized a rule on requiring after-tax disclosures. They require all funds to disclose after-tax returns in their prospectuses after February 16, 2002. Also, fund advertisements that include performance data as well as ads for funds that claim to be managed for tax-efficiency are required after October 1, 2001 to disclose their after-tax returns.

The new SEC rule requires funds to tell you about their track record over the previous one-, five-, and 10-year period after taxes. A standardized formula will be used for the disclosure. It will assume that you're in 39.6% Federal tax bracket. This is a step in the right direction, but it still misses the fact that ultimately, taxes are an investor issue, not an investment issue. The tax you pay is linked to your personal tax situation and not to the fund. Two people can have different tax ramifications in the same fund. This encourages all managers to manage toward the same tax situation. It would be better to have one fund for taxable accounts and another fund for tax-deferred accounts. In addition, this rule will only help identify funds that have been more tax-efficient in the recent past, which may be inversely correlated with the future.

What's happening at Morningstar? Joe Mansueto, the founder and chairman of the company, made a decision a few months ago to get back involved with the day-to-day business of the company. People are trying to read a lot into why he decided to get back in, but I think the real question is, why did he leave? I was disappointed when he pulled back and am pleased to see him return.

The part of the job I've given up is the part that no rational person would want. It's dealing with HR issues, internal policy statements, trying to reconcile disputes between departments. I'm proud of the work I did as CEO, but if you ask me what I've done best, it would be more along the lines of what I'm doing now and will be doing in the future.

My role will be continuing to work with our core audiences--and no audience is more important or more dear to me than the advisor audience.

Morningstar got about a $90 million investment from Softbank in June 1999. How has Morningstar been using that money? Morningstar has become the dominant and widely recognized source for mutual fund information on the Internet. That's something not to be overlooked. Three years ago, when people started paying attention to the Internet, it was a sea change in the industry. We have over 60,000 people paying $100 a year for access to premium content on sixfold over a year ago. So the notion that people won't pay for information on the Web is categorically untrue. They won't pay for inferior information, but if you have a quality product, people will pay, and Morningstar is evidence of that. The Softbank investment helped us accomplish this.

One of the areas we've invested in was our equity research capability. We write up analyses on 1,000 stocks in our database of 8,000 stocks. We try to give investors the spectrum of debate on a stock. This is a major area we've built up with money from Softbank.

By putting this kind of tool directly into the hands of investors, aren't you undermining the advisor? There's a gap between data and knowledge. Yes, some do-it-yourselfers will subscribe to our Web site, but they are a small sliver of the overall population of investors. One of the things we've learned in this industry is that even with lots of no-load fund offerings pitched directly at individuals, there's still an overwhelming demand for the services of advisors. I don't think things we do at will in any way cannibalize the value the advisor brings to the table. was kicked off a year ago and you hired away two key people from this magazine, Bob Clark and Bob Veres, to run it. Now they're no longer with you. What's happened? The question isn't "What happened?" It's "What's happening?" It's a work in progress. What we've offered so far is the community aspect, but what advisors have said is that while community is great, it's only one piece of the puzzle. What we need to provide to them--and what we intend to provide to them--is tools and resources to help them better manage their practices throughout the day.

The Bobs were part of the community part of this. Bob Veres is continuing with the site in a consulting role and he will continue to have a voice. But there were managerial difficulties. I have the highest respect for both Bobs, and they did great work, but we decided we needed to adjust the mix between community and resources. We needed to make the site more functional and place more emphasis on tools that could materially benefit an advisor's practice.

A lot of money has been spent on over the past year, hasn't it? Clearly, we did spend a significant amount of money, and I hope we'll always be willing to spend a significant amount on what in essence was research and development. When I joined Morningstar in 1986, we had one product, The Mutual Fund Sourcebook. If we'd just rested on our laurels, we wouldn't have amounted to a very important or interesting company. We reinvented ourselves and migrated our business from print to software, then from a DOS product to a Windows product. Our belief is that at some point in the future, the best services for advisors will have a Web component. Of all the information providers advisors consult, has any one more reinvented its business to take advantage of new technology better than Morningstar? Our plan is to introduce [more] advisor tools to this summer.

Of, by, and For Advisors

The Office of Thrift Supervision gives conditional approval to National Advisors Holdings

After nearly three years of talk, the first advisor-owned national trust company may be about to become a reality, creating a consortium of independent advisory firms that can share a technology platform, buy products and services as a group, and offer trust services to clients without fear of losing assets under management in a generational shift of capital.

National Advisors Holdings, Inc. expects to complete its effort to raise $6.5 million by the end of April. By then, 80 to 100 advisory firms are likely to have invested a minimum of $40,000 each to be part of the deal. The average shareholder manages about $225 million in capital, which means, as a group, NAH represents firms managing in aggregate more than $20 billion.

Dave Roberts, NAH president and CEO, says the Office of Thrift Supervision on February 5 gave approval to NAH's charter, making it conditional on raising at least $6.5 million and on OTS approval of the firm's board of directors and executives. Receiving conditional approval from OTS was a major passage for the trust company.

Talk about creating an advisor-owned trust company first surfaced about three years ago. Some investment advisors had been frustrated by the fact that their clients' estate plans often made traditional trust companies a trustee of their assets at death. As a result, the advisory firm would lose the fees on managing those assets when the clients died and their estate plans kicked in.

If a client's estate plan called for leaving assets in a testamentary trust for the benefit of a child, for instance, the assets would be managed by the trust company when the client died and the assets were transferred into the trust. That's not good for business if you're an advisor.

At the same time that advisors began discussing the trust company problem, many advisors were talking about looking for alternatives to Schwab Institutional and more and more questions were arising about Schwab's competing with advisors. Advisors viewed an advisor-owned trust company as a possible custodian for all their assets and not just their trust business. Thus began the long quest to set up NAH.

In May 1999, about 40 advisory firms filed their first application for a trust charter with OTS, but the application was badly flawed. Under the plan, the trust company would receive trustee's fees for its services and hire the investment advisory firm that brought in the trust assets to manage that money. However, since the trust company could hire any firm to manage the assets--and, in fact, as a fiduciary was obliged to shop around the asset management engagement--the OTS would never have approved the original application. In September 1999, the consortium withdrew that application, hired a new law firm, and met with regulators to see how they could structure the advisor-owned trust company.

In February 2000, a new business plan was distributed to interested advisors; changes were made in a new application for a national charter. Since then, it's been a waiting game.

"The regulators wanted to believe that there was a need for this type of organization and that advisory firms would in fact invest in it," says Roberts, who spent almost 25 years at UMB Bank as a trust officer before agreeing to shepherd NAH. "By the same token, as a pre-condition of investing, advisors wanted to see a sound business plan that the regulators would be likely to approve. So it was a chicken or egg issue."

Another complication was that regulators permit only one shareholder class in this type of offering, so separate share classes could not reward early shareholders. What's more, Schwab bought U.S. Trust, and TD Waterhouse struck a deal with The Capital Trust Company of Delaware, which was founded with the express aim of serving advisors.

One big change during this process was that some of the founding participants' idealism gave way to business sense. Originally, the trust company would have been run as a break-even operation. Now, the company will seek to make a profit for shareholders.

"We learned that there was no incentive to invest more than the minimum, and regulators didn't understand a break-even financial institution," says Roberts. One advisory firm, he says, has sent a letter of intent to invest $300,000 in NAH, far more than the minimum required in the offering memorandum.

Roberts says the founders have agreed to run the company using a Sungard Expediter ( technology platform, giving trust companies, advisors, defined contribution plans, and broker/dealers oneinterface to scores of fund families. The Sungard system also allows processing of direct trades of individual equities. That means stockholders in NAH can trade through the system and custody more than just trust assets.

"Our primary competition will be the Schwabs, TD Waterhouses and Fidelitys offering a combination of custody services and trust services to RIAs," says Roberts.

Roberts says the plan is to charge 25 basis points on personal trust account assets where NAH is legally relieved of investment management responsibility, and 15 bps for custody of non-trust assets. Roberts concedes that the 15 bps rate is high, but says NAH will eventually tier its custodial fees based on the size of the accounts.

NAH aims to help advisory firms transitioning to fees by using 12(b)-1 marketing and distribution fees or shareholder accounting to offset client fees.

The founding of the first advisor-owned trust company represents the maturation of the independent advisor business. It gives planners and advisors greater control over the future of their client relationships and the future of their businesses, and fosters cooperation among a group of advisory firms so that they can negotiate as a group to get favorable pricing on goods and services. Still, each firm is able to remain independent. NAH hopes to be in operation by June.

Defined Contribution Confusion

Should your small-business clients get a letter asking them to amend their DC retirement plans, make sure they respond

Sy Goldberg, one of the nation's foremost experts on the technical rules of retirement plan distributions, says hundreds of thousands of small business owners with defined contribution plans are about to experience a period of confusion and a financial threat from the Internal Revenue Service. Which is, of course, an opportunity for a good financial advisor to look smart.

Goldberg says that many of your clients who own small businesses with profit-sharing plans, money purchase plans, and other types of defined contribution retirement plans are about to start receiving notices in the mail to amend their plans from fund companies, brokerages, insurers, banks, and other vendors that wrote their original prototype plan documents. Prototype plans are common and are used by small businesses that want to avoid the expense of hiring lawyers, accountants, and actuaries to create a custom-tailored retirement plan for their companies.

The amendment notices that are about to go out will inform the business owners that their prototype plan documents must be updated. Failure to update a plan could result in serious consequences, such as having the IRS say that all or part of a plan's assets are taxable and all of the deductions taken on contributions to a plan could be retroactively disallowed.

All that the business owners must do to avoid this ugly fate is sign the amendment notice that effectively updates their plan and send it back to the brokerage or fund company. However, based on past experience, Goldberg says about 25% of the business owners who receive these amendments fail to sign them and send them back, meaning that their plans remain out of compliance. Which brings us to the real problem.

Goldberg says that the notices that are about to go out to hundreds of thousands of business owners pertain to changes that must be made to bring plans up to date with tax laws enacted after 1994.

In the mid-1990s, some relatively minor changes in retirement plans were made in a series of tax reform acts passed. For example, one change is in the way plans must treat military leave, and another allows someone who owns less than 5% of a business to defer distributions even after age 70 1/2 if he or she did not retire.

Signing the amendments will let a business owner comply with the post-1994 reforms. Advisors may want to mention to their clients who own small businesses that an amendment notice will be arriving in the mail; you yourself may want to send out an e-mail or letter to your clients reminding them to keep an eye out for the notice.

What is most troubling is that signing the amendments will not put the business owner in compliance with the pre-1995 tax reforms.

When the Tax Reform Act of 1986 was adopted--and that was a sweeping tax law change--the IRS gave business owners until the end of 1994 to update their plans to comply with the changes. Goldberg, editor of, a pension distribution information service for professionals, says an executive at a major brokerage firm told him recently that about 10% of its pre-1995 plans are still out compliance. Goldberg thinks the real number is more like 20% to 30%.

Goldberg, who's a member of the IRS Northeast Area Pension Liaison Group, a group of pension professionals selected by the IRS to help the agency figure out policy and compliance issues, says the IRS audits only about 10,000 pension plans a year. Chances of getting caught are pretty small. But when the IRS does find a small business pension plan that is out of compliance with the pre-1995 changes, things can get ugly.

Plans for many small businesses--doctors, lawyers, accounting firms, and other types of small companies--lose their tax-deferral on the earnings of the contributions, their deductions for the contributions are disallowed for previous years' returns, and penalties can be levied. Goldberg says negotiating with the IRS on these problems is difficult. The IRS has created a procedure where plan sponsors can settle pre-1995 deficiencies for $2000 if they voluntarily notify the agency.

With small business owners about to receive amendment notices that will make them compliant with post-1994 amendments, however, the business owners are unlikely to realize that they may have failed previously to comply with pre-1995 amendments, and that's why this is such a mess.

Advisors may want to be sure that their clients have updated their plans in the past to reflect pre-1995 amendments because the penalties are so steep and can put your clients' tax-deferred retirement plan money in jeopardy if their failure to update their plans is ever uncovered.

As far as the post-1994 changes, you'll also want to make sure your clients respond to the amendment notices that are about to go out. You should know that the IRS has gotten smarter about tracking plans that do not comply, however.

This time around, the IRS is requiring fund companies, brokerages, and other firms that write the prototype documents to keep a registry of the small businesses that do not sign the documents to update their plans. If one of your clients does not amend their plans, the IRS will now be able to track them down and will no longer have to depend on an audit to uncover the deficiency.

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