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Growing in Difficult

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It was more than three years ago that Mark Hurley released his first controversial white paper on the “Future of the Financial Advisory Industry.” Hurley forecast the industry would inevitably meet the same fate as that of the institutional investment management industry back in the ’70s: the dominance of a few large competitors, the extinction of small players, and the survival of those exceptional businesses serving a niche market.

While most of Hurley’s ominous predictions haven’t come to pass so far, the state of the industry today is far from the rosy picture many of Hurley’s opponents steadfastly painted. Many advisors are reevaluating–and the savvies are reinventing–their businesses in response to the strong trends that emerged during 2002. We take a look at some of these trends below.

The Winds of Change: Trends of 2002

(All 2002 year-end financial performance numbers cited are strictly preliminary and based on financial data provided by 14 RIA firms. The final numbers, based on the financial data of nearly 700 RIA firms that participate in our surveys, will be released in Q1 of 2003.)

From the decline in existing accounts’ revenues to the increased cost of acquiring new clients through vendor referrals, advisory firms faced many hurdles last year. Here are the most significant negative trends for the RIA business that developed in 2002. This information was gleaned through interviews with a focus group of 25 large RIA firms as well as from three years of survey data from

  1. Profit margins are shrinking (21.5% in 2002 vs. 29% in 2001)
  2. The cost of acquiring new clients is rising (marketing and client acquisition expense as a percentage of total expenses: 9.87% in 2002 vs. 7.7% in 2001)
  3. The fee-dependent revenue model is dragging down the bottom line in light of shrinking assets (Net profit $212K in 2002 vs. $229K in 2001)
  4. Many clients, even smaller ones, are demanding a family-office-like range of services
  5. Full-service brokerages are moving downmarket (23.1% of advisors lost one or more clients to a full-service brokerage in 2002 vs. 21.7% in 2001)

A discussion of these developments follows, including courses of action planned for 2003 by some of the largest RIA firms.

Profit margins are shrinking and the cost of acquiring new clients is rising: The margin squeeze (29% in 2001 vs. 21.5% in 2002) has been triggered by two factors: the decline in revenues generated from asset fees ($645K in 2002 vs. $715K in 2001) and the increase in spending on client-services staff and marketing (9.87% in of total expenses in 2002 vs. 7.7% in 2001). And no, the downward fee pressure is too mild (average fees 1.14% in 2002 vs. 1.15% in 2001) to be equally responsible for those failing margins (see “The margin squeeze” and “Net profits declined 8.02% in 2002″ Links below).

As counterintuitive as it may sound, improving margins should not be an absolute goal. You shouldn’t be overly concerned about expenses that are investments back into your business, such as retaining an attorney on staff to provide estate-planning services to your clients or purchasing a new CRM system that will reduce time spent on client statement preparation. If adding that estate planning component to your practice results in new and bigger accounts, as well as more satisfied clients, then your ROI will make it worthwhile, even if not within the same year.

The most successful advisor looks at each capital spending item and asks himself, “Is this going to make my practice better and bigger three years from now? Is this where I want my practice to be three years from now? Can I afford to absorb the costs gradually over the next three years?” If you think the answer to those questions is yes, then you should consider investing back in your practice.

When implemented successfully, your revenue stream stands to eventually grow as a result of new assets, and your need for additional capital spending will be minimal. Needless to say, there are other non-capital expense items that you should try to reduce. Those differ drastically from one practice to another and the assessment of whether to reduce or eliminate them should be made in light of their perceived impact on your operations.

The fee-dependent revenue model is dragging down the bottom line as assets are shrinking: (Average assets declined by 7.3%, revenues from asset management fees declined by 9.79% and net profits declined by 7.42% in 2002) The decline in existing assets under management over the last year has clearly had an adverse effect on revenues from asset fees. Lately, there have been growing discussions about possible means to offset that decline–including imposing a minimum dollar fee on existing accounts, charging a retainer on new accounts, and billing an additional quarter for financial planning services offered beyond the normal course of asset management advice rendered.

Despite the obvious ramifications of such models for the client, even the most successful firms in the business have yet to conjure up more novel ideas to overcome the problem–except for hiking the minimum initial investment to stave off smaller unprofitable accounts. This problem is perceived, and rightly so, as a natural outcome of the fee-based business model. The potential solution, therefore, is doomed to be one of conflicting outcome, such as hiking the asset management fees. But by enhancing and expanding your service offerings–and consequently attracting new clients to your practice–you stand to grow your asset base, and your revenue stream (see “Revenues fell by 9.79% in 2002″ link below).

Clients are demanding a family-office-like range of services and full-service brokers are moving downmarket: With full-service brokers moving downmarket–offering services ranging from tax planning and executive compensation consulting to cash management and concierge services–many RIA firms are thriving by broadening their wealth management offerings. But offering clients a full range of wealth management services is not for everyone. First, the manpower needed to offer the services competently requires more than just forging a partnership with an attorney and an accountant. Second, many practices don’t have enough clients who require such services. Lastly, offering these services at no additional charge and as part of an all-inclusive asset fee require you to offer them only to clients with very sizable accounts–possibly $2 million and higher–in order to be profitable (see “Full-service brokers continue to go after advisors’ clients” link below).

Expanding your practice to include such services, therefore, should be a strategic initiative driven by your vision of your practice, as opposed to a sporadic service you offer to a few of your clients. In our interviews with large RIA firms, there was an overriding caution about the soundness of adding such services in cases where the firm did not have the capacity to excel and profit from that expansion. In fact, many firms indicated that they would survey their clients first and determine the demand potential. Additionally, many of the firms we interviewed that already offer these services explained that they initially started by outsourcing these functions. When the determination was made that enough clients would require the service, the firms hired the necessary talent to fulfill their clients’ needs in-house.

While clients are seemingly demanding a comprehensive range of services, advisors should approach this from a long-term perspective, keeping in mind that once they start offering such services, there is almost no turning back. Advisors should determine whether they can offer such services competently, what percentage of their clients are likely to bring in additional assets, and what pricing models would work best. If the decision is made to offer those services, then some of the best practices highlighted earlier should be followed.

With the new year upon us, there are many ways advisors can seek to capitalize on the current challenging business conditions and turn these hurdles into opportunities. While no one can control the stock market, there are steps advisors can take–from investing in your practice to having a warmer relationship with clients–to improve your practice’s response to the market.

Best of luck growing your practice in 2003.


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