From the October 2010 issue of Investment Advisor • Subscribe!

A Decade of Evolution

Advisory practices make gains, but still face challenges

The RIA business has evolved significantly over the past decade. Many important influences are re-shaping the advisory business, even beyond the industry's response to the recent recession. Advisors are finding new ways to increase efficiency, spend more time with clients and address investment challenges through a broader product mix, though they still face challenges in strategy development and business management. This article is the first in a two-part series that explores key evolutionary trends of the past decade, based on historical data from one of the industry's longest-running advisor surveys.

As we have examined financial results over the last year, we have observed the toll that the economic downturn has taken on advisory firms. Revenues and assets are down from 2007 highs, and many firms responded with significant cutbacks. Layoffs were a first line of defense for firm profitability in 2008. Then in 2009, with staffing levels already cut back, 31% of firms resorted to reducing principals' compensation in order to stabilize firm finances.

In addition, 2009 saw a slight shift from strategic to tactical management of client portfolios, as advisors tried to cope with extreme market volatility and a very uncertain economic climate.

Broadening the Product and Service Mix

But even as RIA firms were dealing with near-term market dislocations, other longer-term trends were continuing to take shape, some of which are helping build and sustain advisors' businesses.

For several years, advisors have been diversifying away from traditional mutual fund choices (Exhibit 1). In their place, we have seen steady growth in the use of ETFs, alternative-style mutual funds and alternative assets. In 2008, we also saw a spike in the use of money market funds, as advisors parked clients' money in cash--a trend that nearly fully reversed in 2009.

What these trends suggest, especially in light of the shift toward tactical investing, is that advisors are searching for new solutions to address market volatility, risk, and cost. ETFs and alternative-style mutual funds can offer lower investment cost compared to traditional products. They may also improve liquidity and flexibility to support a more opportunistic approach to investing.

We have also identified a steady trend in advisors' service mix over the past seven years. It appears as though advisors are honing their offering to leverage their core skill set and add value for clients. For example, tax planning dropped precipitously and is now only offered by a very small minority of advisors. At the same time, financial planning and charitable planning have steadily increased year after year.

There could be any number of reasons for this shift. Early on in the history of the RIA industry, advisors came from a wide range of backgrounds, including tax and accountancy. That mix has changed over the years as breakaway advisors have driven growth in the profession. It could reflect a shift toward outsourcing specialized work (e.g., tax), or creating referral relationships with other professionals. The increase in high-touch planning services could reflect a changing client mix, one in which wealthy clients are increasingly a primary or ideal target.

But the result is more important than the cause: As the industry grows, and the trend toward independence continues, the "table stakes" for successful advisory firms will likely include a range of value-added planning services.

A Changing Revenue Mix

As the product and service mix has been changing over the years, so, too, has the revenue mix for the average firm. Asset-based fees have been the predominant source of revenue for the past decade, but there has been a slow, steady shift toward a more diversified revenue mix, particularly in the latter half of the last decade.

AUM-based fees consistently declined as a share of revenue. Planning and consulting fees increased steadily before shrinking significantly last year with commissions showing a sudden rise just in the past two years. And as the mix diversified, average fees trended downward for several years before showing a slight uptick in the 2006-2007 period, and then another decline in 2008-2009 to 92 basis points.

It appears that advisors are trying to rationalize their pricing and revenue structures around a new product and service mix, optimizing pricing for the "investment" portion of the offering, and adding incremental revenue for other planning-type services that complement pure investment management. Among those 25% of advisors who charge a separate fee for planning and asset management, more than half charge fees on a project basis (61%) or an hourly rate (54%). The addition of fee-based products (e.g., alternative assets), could also be having an effect on the revenue mix by adding commission revenue.

But again, regardless of the cause, the result is striking. Today, one-quarter of a firm's revenue comes from fees and commissions, suggesting that firms will have much more flexibility in pricing structure in the future. These changes to the industry's traditional all-inclusive AUM fee, and retail investor focus, may also allow for better management of profitability.

Key Responsibilities & Time Allocation

Not only has the industry seen steady changes in product, service, and revenue mix, advisors have been shifting their time allocation for a range of key activities, as well. Exhibit 11 shows year-on-year changes in the amount of time dedicated to specific activities between 2003 and 2009. The trend is quite obvious: more time for clients, less time for marketing and business management.

This is something of a double-edged sword for advisors. Spending more time with clients is critical as high-quality client service is an important element of retention. And business development time with prospects (also included in the "client service" number) is critical to growth.

But as advisors have shifted time away from business management, they have left themselves vulnerable to the vagaries of the market. Undisciplined management led to inefficiencies that became painfully clear during the market retrenchment of 2008, leading to staffing cuts and reduced owner compensation.

Marketing, business administration, and business strategy all received short shrift during the boom years from 2003 to 2007, with steady declines in time commitment from the average advisor. A rising market was lifting all boats, and it appeared that was the overall health and trajectory of the business. Not so. The industry was in part sowing the seeds of its own slowdown by ignoring essential management tasks.

The only other bright spot in this picture appears on the investment side of the business. Advisors are spending significantly less time on portfolio management, and seem to have reached an equilibrium point with research and trading. This is most likely the result of implementing model portfolios, which help advisors gain greater leverage over their portfolio management, and research and trading activities.

The improvement in operating efficiency on the investment side may also reflect a trend toward hiring technical specialists to handle labor-intensive tasks, such as rebalancing. And more managers are outsourcing parts of their investment management needs--nearly one-fourth (22%) of advisors now offer investment management services to other advisors. But the overall shift, which should continue to benefit the industry, is toward greater efficiency in how firms manufacture and deliver their investment offering.

Strengths Abound, but Challenges Remain

Aside from a near-term focus on tactical challenges, RIAs have been slowly making many positive changes. A diversified product and service mix may allow them to better meet the needs of a diverse client base. And a diverse revenue mix--supported by a rational pricing structure--may help them manage revenue and profitability in the future. Emerging management practices may also benefit advisors and their clients by enhancing flexibility, liquidity and cost control--all while potentially helping manage market volatility.

But advisors can no longer compromise on professional business management activities. They need to get a handle on marketing, administration, and strategy development if they are to take full advantage of any recovery and avoid similar setbacks in the event of another market dislocation.


Maya Ivanova is senior market research manager for Rydex|SGI AdvisorBenchmarking. E-mail her at mivanova@advisorbenchmarking.com. Results are from the 2010 online AdvisorBenchmarking survey of more than 400 advisory firms.

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