I was all geared up to lambaste Mark Hurley for subjecting the independent advisory community to another round of shoddy research, weak analysis, and unfounded conclusions, this time in his recent report, Back to the Future: The Continuing Evolution of the Advisory Business, sponsored by JP Morgan Asset Management. Then, at the urging of Mark Tibergien, I talked to Sharon Weinberg, managing director of Asset Management and the report's current co-author.
To say that she's one of the most intelligent, articulate, thoughtful, and intellectually honest people I've met in financial services would be an understatement. Suffice it to say that she was compelling enough to make me want to wade deeper into Back to the Future to find some of the non-Hurleyesque nuggets that she suggested were in there. I was not disappointed. Indeed, there are valuable messages lurking between those lines.
First, let's work through the fa?ade of disinformation that first captured my attention. The basis for this white paper is to assess the predictions about the future of independent advisors made in a similar report in 1999 by Hurley, then CEO of Undiscovered Managers Funds, now owned by JP Morgan. The thrust of that first paper was that the joyride of bountiful clients and growing profits enjoyed by advisors from 1980 to 1999 was coming to a close.
Hurley's first paper went on to predict that economic reality would "force the industry to rationalize over the next decade." That rationalization would include the consolidation of the "fragmented" advisory industry into 40 to 50 dominant firms, each with $15 billion to $20 billion in AUM, and that while thousands of other small firms would continue to exist, a number of factors then in play had "obliterated the current and future economics of about 94% of advisory firms and has consigned their owners to a grim future of having to work harder for less money, while owning enterprises that have little or no economic value." As a result, he argued, only a small number of mid-sized "niche" competitors would "flourish."
Even in 1999 I thought Hurley's predictions were based on a rather embarrassing misunderstanding of the business of independent advice, combined with an ignorance of the powerful trends within financial services that independent advisors were best positioned to take advantage of. The intervening years make me even more convinced of this today.
Undeterred by such considerations, however, Hurley and his new partners seem to see only confirmation of these predictions as they survey today's world: "Our research found that the industry experienced a mini-rationalization since 1999 [that] reshaped the industry into a structure that is consistent with the earlier paper's predictions." Is it just me, or is this hauntingly reminiscent of the Nixonian strategy of declaring victory and quickly moving on?
The only "evidence" cited for this "mini-rationalization" is a rather simplistic pyramid that Cerulli gleaned from RIA filings in 2004 that showed there were about 1,100 firms with over $1 million in revenue, 2,700 with less than $1 million in revenue but with more than $25 million in AUM, and 16,000 firms with less than $25 million under management. Curiously, no comparative data from 1999 is offered in the report. To my eye, with a few more RIAs and some inflation in revenues and AUM, this pyramid--with 5.5% of firms at the top, 13.4% in the middle, and 81.1% at the bottom--looks suspiciously as it would have in 1999.
As for the predictions of massive industry consolidation, five years into Hurley's 10-year "rationalization" he found 124 firms that generate more than $8 million in revenue. Assuming an average fee of 50 bps, these firms have more than $1.6 billion in AUM. Yet the paper goes on to disclose that most of these firms are not independent RIAs: they are money management firms that also offer "financial advice." When it comes to citing any evidence of even one of Hurley's mega-advisory firms with "$15 billion to $20 billion in AUM," the new report is suspiciously silent.
The Niche Advisors
What about the emergence of niche firms and the 94% struggling at the bottom? First, let me point out that virtually all independent advisory firms are "niche" firms, providing solutions to complex financial problems of specific client segments. That's what comprehensive advisors do. What's more, by all accounts the vast majority of independent advisors are doing very well these days. Sure, there are workload challenges and pressure on the bottom line. But I'd suggest these are the result of normal market cycles and business models that continue to evolve to accommodate greater, not less, growth and success. I see no evidence, nor does this paper cite any, of independent advisors "earning far less than they did in 1999."
How did Hurley get it so wrong? Well, for one, his data sampling is troubling. Both papers purport to study the independent advisor industry. Yet their numerical data comes largely from RIA filings with the SEC. The other 130,000 or so independent advisors have escaped the authors' notice.
Further, culling the SEC's database to identify only comprehensive independent advisors is notoriously difficult, as anyone who markets to advisors can tell you. After reading this paper, it's not clear to me that the authors either understand who comprehensive independent advisors are, or have studied them.
But more troubling than the questionable data is Hurley et al.'s ignorance or indifference to larger trends in financial services upon which the independent advice movement is riding. I'll cite just two.
First, financial consumers these days are somewhere in a long learning curve regarding advice. For instance, during the corporate failures of recent years, many were still shocked to learn that stock analysts at brokerage firms were influenced by underwriting considerations. I'm convinced that most people still don't realize that their stockbrokers or insurance agents have no duty to place their client's interests ahead of their own or their firms'. Yet we are still seeing considerable demand for independent financial advice, which will grow exponentially as the public gains a better understanding of the financial world.
Then there's the fact that financial advice is delivered much more efficiently by independent advisors. Entrepreneurial advisors have a great advantage over their captive counterparts in controlling expenses, adapting new strategies, utilizing the latest products, services, and technologies, and even changing business models. When an advisor finds her offices are too small or too extravagant, she moves. What does a bank do with the building it owns? Insurance companies have already figured this out, and brokerage firms are early in the learning curve (Banks? Fahggedaboudit). Providing financial advice through employees in expensive offices only made sense with profits from proprietary products. Those days are over, and so are captive advisors.
In fact, much of the problem with Hurley's analysis of practice economics comes from inadequately valuing the role of the owner of an independent practice. The authors believe that practices will be consolidated by institutions that have profits valued at a higher multiple. Yet this math only works by the accounting sleight of hand by which the independent advisor's compensation is divided into owner's comp and job comp. The consolidator then takes the owner's portion, replacing an advisor making, say, $400,000 a year with an employee making $200,000. I'd suggest the only way an independent practice will work is if you have an owner/advisor(s) with at least the potential to make $400,000 running it.
The Report's Insights
So much for the study's flaws. It also contained a number of valuable insights that Ms. Weinberg pointed out. The great bull market of the '80s and '90s did mask inefficiencies in many advisory practices. Growing numbers of clients with rapidly growing portfolios put a premium on revenues rather than profit margins. But rather than a structural flaw, this seems rather typical of most industries during boom years. Now advisors are in a leaner part of the cycle, which calls for more fiscal responsibility. While not much fun, most practices can be brought into line with this new reality, certainly without an industry shakeup.
One trend that the paper didn't mention regarding rising costs (but which Ms. Weinberg assured me was underlying their thinking) is increased regulatory compliance. If anything could bring about a massive consolidation of independent advisors, it's the skyrocketing price of compliance.
The factor identified by the report that could be viewed as a consolidation of sorts is the increased demand for well-trained, entry-level advisors. Today's practice economics suggest that rather than leaving to start their own firms as did previous generations, new advisors largely will be absorbed into existing practices, to leverage principals and increase economies of scale. This is already happening, and we are indeed beginning to see entry-level salaries rise. I suspect, though, that rather than creating a crisis of overhead, once a reasonable career track complete with ownership equity emerges in the advisory industry, these new advisors will contribute far more than their costs to the revenues and profits of their firms.
The Back to the Future paper paints a bleak future of consolidation with the remaining independent firms struggling for survival. But to me the same "evidence" and broader experience suggests a brighter outcome. I take heart in the droves of brokers who are deserting wirehouses for the better economics and client service offered by the independent practice model. The relatively high values paid for advisory practices by advisors themselves on the independent market that has emerged in recent years is reassuring as well.
The biggest disappointment of this study is to find yet another authoritative source willing to write off 94% or so of independent advisors--rather than to provide smaller firms with useful information and resources to effectively deal with the financial challenges they face. As an industry, our challenge is to ensure that independent financial advice remains economically viable, not to morph it into something more profitable, and less beneficial to the clients. At least that's my vision.
Bob Clark, a former editor-in-chief of this magazine, sagely surveys the advisory landscape from his home in Santa Fe, New Mexico. He can be reached at firstname.lastname@example.org.