With any event that brings about sudden change, humans tend to exhibit a gradual reaction in trying to grasp the situation. Denial usually comes first; then comes shock. During the last three years, independent advisory firms have reacted gradually to the changes brought about by the stock market's decline. In AdvisorBenchmarking.com's upcoming study of the RIA marketplace, we broke down this reaction into four chronological phases: Denial, Panic, Restructuring, and Adapting (see chart 1). The last and most current phase is the culmination of the first three, and it is the critical threshold that some firms may simply fail to cross.
Since 2000, AdvisorBenchmarking.com has conducted confidential online surveys of registered investment advisors to help them benchmark their firms, as well as to determine the best practices of the most successful ones. AdvisorBenchmarking, an affiliate of Rydex Global Advisors, followed up on the surveys with focus group interviews over the past year to accurately assess how advisors were coping with this persistent bear market. This article presents a preview of the complete report on the registered investment advisor marketplace that AdvisorBenchmarking will publish this month.
Phase I: Denial
The first phase began in early 2000. Advisors downplayed the market pullback and the potential that the tech bubble was bursting, and instead calmly waited for imminent recovery. When the S&P 500 finished the year down 9%, advisors re-iterated to their jittery clients the virtue of long-term investing and reminded them of the staggering profits they'd made in the prior nine years. From a firm's profitability standpoint, it was business as usual for most advisors, and, to a certain extent, justifiably so.
At the end of 2000, the financial health of the average RIA firm was relatively intact compared with its state in 1999 (see chart 2, following page). At least that's the case when taking into account the whopping 40% decline in the Nasdaq composite and technology stocks--which comprised a sizable portion of assets managed by advisors. With average profit margins of 30% and net profits of over a quarter million dollars, advisors' bottom lines were fairly unscathed, with revenues falling a mere 2.44% and assets dropping just a little over 8%.
Operationally, the picture didn't change much, either. Client acquisition strategies mirrored those of 1999, where new business came in with moderate effort and at a very low cost. Nearly 70% of new clients originated from unsolicited referrals and less than 4% of total spending was dedicated to marketing.
In addition, competition from wirehouses and other external forces was weak, with the average firm reporting that it was losing a mere 1.25% of its clientele to competition. (Competition data was not surveyed for 1999.)
This attitude of inaction had a significant effect in shaping advisors' perceptions later on in this cycle, as we will demonstrate. "Once bitten, twice shy" would be an accurate description of its impact.
Phase II: Panic
By early 2001, the economic decline --and its massive layoffs and dot-com collapse--were too visible to dismiss. In the span of 12 months, the Nasdaq composite lost 63% of its value from its March 10 high; the broader stock market was down 24% from its peak on March 24. Then just when we thought the worst was over, the tragic events of September 11 took place. Despite their display of resilience, advisors found themselves in a maze of confusion and uncertainty. The second phase, panic, had begun.
At the heart of this phase was a state of extreme ill-preparedness, especially in dealing with clients who were now asking for constant handholding--an essential service many advisors did not choose or need to offer at any great length during the market's heyday. Additionally, many advisors who had never experienced a major market decline or a national disaster simply did not know how to reassure clients.
By the end of 2001, fewer than 32% of advisors reported contacting their clients more frequently than in the prior year. Significantly, more than 50% reported calling clients less frequently than in the previous year. Moreover, comprehensive financial planning as a component of advisory firms' offerings had been in little demand for some years, as the focus was on asset management. Clients were now asking for a much wider array of wealth management services, and for many firms, this was either not an existing element of their offerings nor one that they could incorporate quickly and efficiently.
Despite the growing difficulties in meeting the increased needs of clients, advisors scurried to generate new clients to replace the assets under management lost to the collapsing stock market. Nearly 27% of firms lowered their minimum account size in an effort to cater to investors fleeing from wirehouses as well as former do-it-yourself-investors with now-much-smaller accounts. This hasty decision--not uncommon in a panic mode--later proved to be damaging. Those smaller clients, whose accounts continued to shrink, represented a major drag to the firms' bottom lines, generating meager revenues while demanding the same level of service and time from the advisor as larger clients. Big or small, profitable or not, clients of all shapes demanded more handholding and broader services.
Advisors continued to scramble to accommodate those worrisome clients, only to bump into the Enron collapse in late 2001. This event snowballed to historic levels, bringing down names once revered as pillars of the "New Economy." The stock market finished the year down--despite a short-lived rally following September 21 lows--marking the first two-year decline since the 1973-1974 crash. Advisors' financial health in year-end 2001 was now seriously challenged, as shown in chart 3. Assets dropped nearly 6%, profit margins were under 29%, expenses were rising more than 9%, and competition from wirehouses and CPAs was intensifying. In early 2002, the first round of settlements by Wall Street firms--over their research analysts' conflicts of interest--hardly put the issue to rest. Without a doubt, investors' confidence in Wall Street was now almost nonexistent.
However, because of that mounting mistrust toward Wall Street institutions, investors turned to independent advisory shops seeking objective guidance not influenced by investment banking relations. The average advisory firm saw a net increase in clientele of 8.13% in 2001 from 2000 levels, the only positive change in its year-end financials. This boost in new business significantly mitigated the decline in revenues from existing clients--a drop estimated at 19.87%--to a much smaller overall decline of 5.80% The flourishing new business had a calming effect on advisors and set the tone for the next and more-positive phase in this cycle. For many firms, this was their chance to regroup.
Phase III: Restructuring
On the heels of two years of unprecedented events in the marketplace, a new set of dynamics emerged. Some offered daunting challenges for advisors, others presented opportunities and all played a part in reshaping the way advisors did business.
Here's what triggered the change:
First, the stock market continued to slide. As a result, assets under management were declining and profit margins were shrinking. But new clients poured in--and they demanded more handholding, constant reassurance, and more sophisticated services beyond asset management and basic planning, Meanwhile, wirehouses and CPAs gained traction in the advisory market; because of this competition, fee pressures weighed heavily on advisors.
The new dynamics created by these forces include the following:
- The fee-based revenue model proved inefficient under the dismal stock market conditions and with the mounting pressure on the advisor's time.
- Offering a limited range of wealth management services diluted the advisor's perceived value.
- Finding qualified high-net-worth clients became more difficult in light of the growing competition and investors' hesitancy.
In response to those dynamics, successful firms began revamping their businesses to meet the changing needs of the marketplace. The most notable restructuring action steps taken included:
- Reducing asset-based fees. With clients' investment accounts getting slashed, advisors cut their fees in 2002 by 9.09%, to 110 basis points from 121, in 2001 to appease their clients.
- Instituting retainers. To offset the self-imposed lowered asset management fees, nearly 31% of firms reported implementing a retainer pricing method, up from 24.5% in 2001. This also served to ensure that a minimum amount of revenue was generated from clients with accounts that fell below the minimum account size.
- Boosting the minimum account size. Over 14% of firms increased their minimums to stave off smaller clients, twice as much as the 7% reported in 2001.
- Hiring more client-services staff. To better serve the needs of restless clients and free up the advisor's time, 11.4% of firms hired new or additional client specialists and services staff. In all, the average advisory firm had 8.5 employees in 2002, up from 7.25 in 2001.
- Employing more efficient client-contact methods. To preserve the advisor's time and to reassure clients, firms utilized other methods to enhance communication with clients. More than 70% of firms reported having a client newsletter, up from 63.2% in 2001. Nearly 80% reported having a Web site, up from 67% in 2001.
- Forging partnerships with other professionals. In the face of growing competition and increased difficulty finding qualified clients, 34.2% of firms reported they had a referral arrangement or a partnership with a CPA firm, up from 19.4% in 2001. A smaller number, 28.4%, reported having such an arrangement with an attorney. And 13.8% indicated having a referral arrangement with another advisory firm.
- Pursuing client referrals more aggressively. In the same proactive spirit, more advisors solicited referrals directly from their clients, by virtue of mentioning it in client correspondences and communication. Nearly 70% of firms reported employing such a technique, up from 60.5% in 2001.
- Seeking mergers and acquisitions. To replace lost assets, many firms believed that buying another practice might be a faster, and sometimes, cheaper alternative to finding new clients. Nearly 20% of firms reported looking to acquire another advisory shop and 20.3% reported looking to merge with another RIA firm. The mergers-and-acquisitions appetite wasn't just for similar advisory shops. A combined total of 6.3% firms reported their intention to buy or merge with a CPA firm, while 5.19% reported their plans to buy or merge with a law practice.
- Allocating assets to alternative investments. As the equity market continued to decline and entered a choppy trading period with no consistent trend, advisors turned to alternative investments as a means to enhance returns and manage risk. In 2002, more than 15% of advisors allocated a portion of their clients' assets to hedge funds, up from 10.2% in 2001 and from 4% in 2000.
- Expanding into wealth management. Perhaps the most notable restructuring action of all was the drive toward offering comprehensive wealth management, beyond the asset management and basic financial planning services. Chart 4 (above) shows the firms that reported offering wealth management services in-house or by virtue of outsourcing to a third party--and many firms said they were planning to add them in the near future.
As shown in Chart 4, there has been a growing interest in providing sophisticated wealth management services, such as business advisory services and charitable giving planning. These services, once reserved for the mega-affluent client, are now in demand by smaller HNW clients, and advisors are answering that growing call.
These restructuring efforts led to a new business model, one that is making the average RIA firm look more like an institution rather than a small business. Better yet, if the speed of the restructuring is any indication, advisory firms definitely enjoy more flexibility than a typical large institution, as they are able to quickly revamp their businesses to adapt to the changing market environment.
Looking at Chart 5 (preceding page), we can clearly see some of these restructuring moves at work. A case in point is the decreased reliance on asset-based fees as a source of revenues: AUM fees made up 70.25% of total revenues in 2002, down from 74.25% in 2001, while revenues from retainers comprised 23.34% of total revenues, up from just a little over 10% in 2001. Similarly, the reliance on passive referrals to generate new clients diminished significantly, with a little over 50% of new clients generated that way, down significantly from the 60.25% reported in 2001. Instead, new partnership agreements with CPAs and other professionals yielded more clients than ever before (23.34% of total new clients, up from 17.80% in 2001).
Not surprisingly, assets, revenues, profits and margins all fell, but at considerably slower rates than the prior two years. The number of clients, on the other hand, rose at very strong rates. All in all, advisors' businesses were improved dramatically by the time the restructuring phase had ended.
Phase IV: Adapting
This phase is just getting under way. Its beginning does not necessarily suggest that all advisors are finished restructuring their businesses, or are even planning to do so.
The restructuring phase may very well still be in progress at many firms. But what this new adapting phase means is that for those who are finished revamping their businesses, now is the time to absorb the changes and refine their practices further--by adapting to the new revenue models, the clients' new needs and the competition's new face. For the ones who won't or can't adapt, it's going to be a tougher ride from here. If the last three years have taught us anything, it's that only the most adaptable survive.