From the September 2004 issue of Investment Advisor • Subscribe!

September 1, 2004

Adaptation

For many advisors, the good times have returned. Following some fallow times brought on by the three-year bear market, the latest results from the Rydex AdvisorBenchmarking Research Study shows that advisors by the end of 2003 had built their practices back to 1999 levels, with both assets under management and revenues reaching or exceeding five-year highs. Advisors are spending more time building their books of business from existing clientele, a tactic that paid off in increased management fees and revenues. Despite regaining that lost ground, however, not everything is rosy--while revenues and profits have increased, profit margins failed to keep pace with that growth as registered investment advisors increased staff compensation and spent more time and money dealing with compliance issues.

Among the other notable trends revealed by the survey: RIAs are devoting more time to managing existing clients' portfolios and spending less money on marketing; and an increasing number of RIAs have shifted from strategic to tactical asset allocation. In response to the mutual fund stale pricing scandal, almost half the advisors surveyed advised clients to pull money from tainted mutual funds, though most said they will continue to use mutual funds in the future. The RIAs surveyed are paying more attention to transition and succession planning, suggesting there will be a continued focus on mergers and acquisitions.

Following are some specific findings of the fifth annual AdvisorBenchmarking survey, which was conducted online and via telephone surveys with 1,023 RIAs between March 2003 and June 2004.

Assets and Revenues Rebound

Following a three-year decline in which the median assets under management fell from $87 million in 1999 to $71 million in 2002, RIAs saw assets make up the three-year drought in one fell swoop during 2003, with median assets under management returning to $87 million. With assets back to 1999 levels, the gain in AUM actually outpaced the Standard & Poor's 500 Index, which lost ground during the same period (see top chart on page 97). Firms are also charging higher percentage fees to smaller accounts. Accounts with less than $250,000 are being charged a median asset management fee of 1.45%, as compared to the largest accounts, $3 million and more, which are being charged just 0.75% for the same service. This is no doubt due to discounts for larger accounts as well as RIAs' move to elevate minimum account sizes.

Revenues showed the same resiliency. Following three straight years in which they declined from $902,000 in 1999 to $795,000 in 2002, revenues regained ground last year, coming in at a median of $917,000 (see second chart on right). This represents a 15.35% increase in revenue, though it sharply trailed the 22.54% growth in AUM in 2003.

One explanation for the disparity between AUM and revenues is that asset management fees made up a smaller portion of RIAs' total revenue picture. Although more than four percentage points higher than in 2002, the 78.65% of revenues culled from asset management fees was smaller than the three previous years. The increase in assets also did not match the market's upswing in 2003. Financial planning fees comprised 20.15% of revenues, almost double the percentage in 1999, while commissions made up just over 1% of revenues--the smallest percentage since Rydex started conducting this survey five years ago.

Less Bang for the Buck

In the midst of these rising asset levels and revenues, profit margins not only failed to keep pace with such growth, but actually declined. The median 2003 profit margin for advisors in the survey was 25.85%, 55 basis points smaller than in 2002 (see bottom chart at right). This marked the fifth consecutive decrease in the bottom line since 1999, when profit margins were a much healthier 31.6%.

An interesting observation is that the size of the advisor's practice played an important role in profit margins, with the smallest and largest practices performing best. Practices with $500 million or more in assets had a median profit margin of 31.2%, while the profit margin of practices with less than $50 million in assets under management was 28.28%. Faring worst were those in the middle: practices with between $100 million and $200 million in assets reported profit margins of only 21.25%.

One possible explanation for the disparity is each practice's economy of scale. The smallest practices served 122 clients on average with just one principal and two employees. The mid-sized RIAs had two principals and eight employees compared with a median of three principals and 11 employees in the largest practices. While the median numbers of personnel of the larger two groups were similar, the number of clients they served differed dramatically. Mid-sized practices served a median of 198 clients, while the largest firms had almost double the client load. These results indicate that mid-sized practices are either gearing up for an increase in business or may be overstaffed (see top chart on page 98).

More Compliance, Less Marketing

As for advisors' expenses, they have risen every year since 2000, when median expenses were $575,000. In 2003, expenses increased 10.76%, to $710,000. Not surprisingly, compliance and other legal expenses jumped during 2003, increasing a brow-raising 152.92% from 2.4% of every expense dollar to 6.07%. Two other categories--travel and entertainment, and research and publications--also increased substantially, perhaps due to the end of the bear market and a stronger focus on staying abreast of changes in the industry.

One expense that fell dramatically was advertising and marketing, with 2003's totals accounting for less than one-third of 2002's percentage of 9.87%. Also, after the number of clients in 2002 rose to 275 from only 226 the year before, the median number of clients per firm leveled off to 272 last year. This renewed focus on growing from within may have contributed to the drop in advertising and marketing dollars.

Another notable increase in expenses was the 4% average rise of total firm expenses for compensation of staff members. With staff levels remaining constant from the prior year, this increase may reflect RIAs' desire to reward staff following some lean years (see middle chart on page 98).

Money wasn't the only thing that was stretched over the past year. Time spent serving clients and managing their portfolios also increased in 2003. According to the study, RIAs spent 35.5% of their time on client service, up from 30.84% in 2002, while the percentage of time spent on portfolio management increased from 15.87% to 19.2%. Mirroring the drop in expenses, RIAs also spent less time marketing: 16.5% compared to 20.76% in 2002 (see bottom chart on left).

Interestingly, the largest firms dedicated the most time to client service--40.09% for firms with $500 million or more in assets under management compared to only 24.5% for firms with between $50 million and $100 million in assets. Conversely, smaller practices spent more time managing their clients' portfolios. The largest RIAs committed just 10% of their time to portfolio management, compared to 23% for firms with between $50 million and $100 million in assets under management.

More Trades, Bigger Minimums

In 2003, firms made a median of nine trades compared with seven the year before. Larger firms typically made more trades than smaller ones. This increase no doubt contributed to the extra time RIAs reported in managing client portfolios. Of course, the larger firms also employed more people to pick up the load, raising the question of whether smaller firms have the capacity to serve clients and manage their portfolios as thoroughly as they would like to.

An argument can be made that adding personnel can free RIAs from administrative and management duties and enable them to spend more time expanding their businesses by both serving existing clients and by marketing to new prospects. Compared to larger practices, the smallest firms spent an inordinate amount of time-about 50%--on marketing and administrative duties. The largest firms spent only about 25% of their time tending to the same duties.

Another way firms may deal with the time crunch is by raising minimum account standards. About half of all RIAs surveyed have a stated minimum account size requirement and another quarter have a negotiable minimum. The median minimum account size requirement rose dramatically from $225,000 in 2002 to $310,000 last year. The market's performance during 2003 no doubt helped some clients meet these higher minimum requirements.

Again, the bigger firms had larger minimum requirements. Practices with $500 million or more in AUM had the largest minimum account size requirement: $705,000. That amount was almost double that of firms in the $200 million-$500 million asset range and more than five times that of the smallest practices.

With the number of trades and assets under management increasing strongly in 2003, where did that new business come from? According to the study, investment advisors lost fewer clients to both full-service and discount brokers during the past year. In particular, RIAs lost about 25% fewer clients to full-service brokers in 2003 and, not surprisingly, about 30% more clients to other investment advisors. CPAs also provided slightly more competition than during the previous year.

One notable change in the competition portion of the study is the percentage of firms losing clients to discount brokers. In 2002, that number swelled to 13.5% from only 5.2% the year before. In 2003, the percentage of firms losing clients to discount brokers leveled off to 12.42%, indicating an awareness of the need for qualified investment advice in an increasingly complex investment market.

The mutual fund scandals of the past year played a major role in investment advisors' perceptions of investments during 2003, but did little to change their plans to use funds in the future. More than 45% of RIAs surveyed reported that they redeemed clients' money from tainted fund families in 2003. However, more than 58% said that their use of mutual funds in general will not change over the next 12 months.

However, the typical investment mix changed slightly during the past 12 months, perhaps in response to the widely-shared anticipation of rising interest rates and the sideways volatility of the market during the first half of 2004. The percentage of RIAs using hedge funds and private equity vehicles grew during the period--hedge funds by 15.3% and private equity by about 25%. Managed accounts also became a more common component of advisors' investment arsenals, with 50.2% of advisors using them as opposed to 44.4% the year before. The number of RIAs who said they were considering their use also rose during the period, from 26.7% to 39.2%.

No-load mutual funds comprised the majority of investments for smaller firms, but the study reports that larger firms took greater advantage of other products, including individual stocks, bonds, and hedge funds. This may explain a noticeable shift in investment philosophy among survey respondents from strategic to tactical asset allocation. While the majority of investment advisors remained true to a buy-and-hold strategy, 11.38% report that they have shifted to a more tactical approach. Market volatility and the desire to add more alpha to clients' investment portfolios were cited as the top reasons for the shift.

Focus on the Next Step

Despite an increase in the time spent managing portfolios and dealing with compliance, 37.1% of those surveyed reported having a succession plan in place, up from 32.1% the year before. That percentage is dwarfed by other formal plans reported by advisors: 81.47% said they had a compliance manual and 60.80% said they had a written business plan (see middle chart on left).

As for advisors' exit strategies, more than three-quarters of RIAs with succession plans intend to sell their practices to an existing partner or an unidentified third party, split evenly between the two. Another 10% plan to sell their businesses to existing employees, while 7% intend to sell to an identified third party (see bottom chart).

In line with these results, 4.7% cited the purchase of another practice as their top goal, up from 3.8% in 2002, while the number of RIAs who cited "positioning their practice for sale" shot up 20%.

As we predicted last year, 2003 turned out to be a good year for advisors. But even with strong asset and revenue growth, the coming months offer a host of challenges for advisors to meet--an up-and-down economy and stock market, continued geopolitical concerns, particularly events in Iraq, and the November presidential elections. As in years past, advisors need to keep a firmer hand on expenses and better manage profitability. Building on a solid 2003, our research shows that advisors are well equipped to handle the uncertainties and challenges they face in the coming year.

Dawn Kahler is VP, marketing/communications, at Rydex. She can be reached at dkahler@rydexinvestments.com. Maya Ivanova is a research analyst at Rydex AdvisorBenchmarking.com and can be reached at mivanova@advisorbenchmarking.com. Rydex PracticeValue is a free practice management program designed to help RIAs better manage and grow their firms.

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