I was recently accused by one of my friends of being a “numbers guy,” which, as a former philosophy major and professional journalist, I found quite amusing. What she probably meant—and it’s undoubtedly true—is that I tend to be a “facts guy.” That is, I agree with the late professor of philosophy A.J. Ayer of the University College, London and other logical positivists, that without tangible verification, all theories are just stories.
Consequently, when confronted with theories from man-made global warming to trickle-down economics to the history of the Exodus, I tend to look for existing evidence either pro or con, across as many disciplines as possible. That’s not to say that the “known” facts can’t be wrong; in fact, it is the veracity of those “facts,” rather than popular opinions about them, by which any theory in question should prove persuasive or not.
As 2011 is winding to a close, it seems an appropriate time to consider the available evidence for the various explanations we currently have floating about for the dramatic changes we are witnessing within the retail advisory industry. I recently attended a presentation by a real numbers guy, Bing Waldert, director of RIA services at Cerulli Associates in Boston, who offered reams of interesting data under the title “The State of the RIA Marketplace.” It was a valuable reality check, in light of the disinformation, misinformation and just plain horse-hockey that’s been published during the past couple of years, to help “clarify” the debate over the Dodd-Frank advisor regulation and fiduciary standard for retail brokers. Data is, of course, open to interpretation, but Waldert offered a macro view of the longer term trends in our industry that often get lost amid the specifics of the current issues.
Over the years, I’ve usually found the data put out by Kurt Cerulli and his team to be both interesting and insightful. Yet, Kurt’s wirehouse background occasionally shows though as a tendency to characterize the financial services industry as a product distribution system rather than providing a valuable service to retail investors. So, when I read the title of Bing’s talk, I have to admit that I inwardly groaned at the notion of an RIA “marketplace.” But while his data certainly contained elements of a business assessment, Waldert’s presentation clearly demonstrated an understanding of—and even a sensitivity to—the subtle differences between securities sales and providing advice.
The upshot of Cerulli’s assessment of the “marketplace” is that, despite regular reports in the trade media to the contrary, the 2007–2008 market meltdown and its aftermath have benefited independent advisors at the expense of the wirehouses. In fact, if anything, the downturn served to accelerate the long-term trend toward independent advice. In 2007, according to the Cerulli data, the wirehouses managed 50% of retail investment assets compared with just 29% managed in the independent channels including independent broker-dealers, dually registered advisors and independent RIAs. Today, the wirehouse share of the $11.2 trillion in retail investments is down to 43%, while the independent channels have increased to 35% market share of assets—closing the gap by 13 percentage points, or 67%, in just three years.
What’s more, Cerulli projects this trend will continue for at least the next two years: By 2013, their data predicts the wirehouse position will fall to just 35% of retail assets, while the independent channel will overtake them with a 39% share. “Our data shows that wirehouses continue [to] not participate in the industry growth during the recovery,” Waldert said. “While they are still the largest and best capitalized channel, it’s not clear that they can, or will even want to, recapture their former market share. It’s entirely possible that as a result of the realignment within the brokerage industry, the wirehouses will alter their business model to focus on the more profitable high-net-worth market.”
As you might expect, on the productivity side, the wirehouse brokers do have a substantial advantage, at least for the present. While RIAs have steadily increased their productivity to $70 million in client AUM per advisor (compared to $61 million for dually registered advisors and only $18 million for independent BD reps), the wirehouse brokers average some $94 million in AUM each, fully 34% more client assets. And it’s more than even odds that their management fees are higher, too, generating significantly more revenue per advisor. Even though their market share of assets is falling precipitously, we also read media reports almost daily of wirehouse brokers who are breaking away to go independent or of mass layoffs at one firm or another. The net result of this corporate belt tightening may be that broker ranks will fall faster than the share of retail AUM, enabling some firms to maintain their high advisor productivity levels.
Yet, here’s a classic example of where the figures don’t tell the whole story. With their massive overheads, expensive regulatory compliance and top-heavy management structures, wirehouses need that high productivity to generate even mediocre profit margins on the retail side of their business. And with proprietary product sales not nearly what they were in the old days, the profitability of retail brokerage has become increasingly important.
Conversely, independent advice is a much more efficient business model. Advisors who own their own businesses have considerable incentives to manage their overhead and maximize productivity. While they don’t manage as much client AUM per advisor as their brokerage counterparts, they don’t have to in order to generate substantial free cash flow margins. The relatively high profitability of an independent firm is often hidden from the naked eye and from business consultants, as privately held businesses have no incentive to carry their revenues all the way through to their bottom lines. But as far as doing more with less, all one has to do is a quick visual inspection of a large brokerage office in a downtown high-rise versus a modest independent firm in a suburban office park.
Then, of course, there’s the cost of regulatory compliance. Despite the increase in SEC actions against RIAs in the past two years (in part, to offset its bad PR for having muffed the Madoff situation on seven separate occasions and to bolster its request for more funding to increase RIA regulation), the incidence of RIA malfeasance is miniscule compared to investor complaints against brokers. That’s because holding advisors to the standard of simply acting in their clients’ best interests is far more compelling than the rules-based suitability standard for brokers that is often more bureaucratic than client-oriented. Consequently, brokerage firms have massively expensive compliance departments to create defensive paper trails.
The net result is that brokers are far more costly to house, equip and supervise, which is why the brokerage industry—largely through SIFMA—is working so hard to “level the playing field” by dramatically increasing the regulatory burden on independent RIAs, both at the SEC and, if they have their way, through a FINRA takeover of regulation. It’s a last desperate attempt to salvage a top-heavy business model that can’t compete in the current marketplace.
That’s the reality, at least as I read the Cerulli tea leaves. The independent advisory channel has been steadily gaining market share for the past 30 years and recently got a shot in the arm when the big brokerage firms shot themselves in the foot with mortgage-backed securities. As further evidence of the emergence of independent advice at the center of the industry stage, Cerulli found that essentially half of all assets at independent firms are now at RIAs with more than $1 billion in AUM. It’s time for the financial services industry to face the evidence and admit that independent firms are simply a better, more efficient and more profitable way to deliver financial advice.