This month’s issue of Practice Edge is the last of a three-part series that closely examines the best practices of RIA firms as revealed through AdvisorBenchmarking.com’s latest survey of 655 RIA firms. Based on the Top Firms benchmark–a composite made up of 23 firms that have met our stringent performance criteria–we compare the most successful RIA firms to the rest of the marketplace. These top firms manage assets of $330 million on median, compared to $71 million by the average RIA firm.

In this issue, we examine the best practices in the area of financial management, highlighting the success factors pertaining to effective profit management. Specifically, we take a look at three key areas: profitability focus, revenue sources, and economies of scale.

Profitability Focus

Most RIA firms tend to measure success based on their assets under management (AUM). And rightly so: last year the average firm generated 75% of its revenue from AUM fees. However, advisors often downplay the importance of profitability to their business while overemphasizing the impact of AUM on their financial health. It’s not uncommon to see one firm with three times the assets of another, but half the profitability.

Top firms, on the other hand, place more emphasis on profits and margins relative to assets. In fact, when asked to rate the “top business goals” for their firms on a scale of 1-10, top firms rated “increase profits” at 9.5, compared to only 8.8 by the average firm. Conversely, top firms gave a lower rating to “increase assets under management” at 8.5, while the average firm gave it a higher rating of 9.2. This heightened focus on profitability is one of many differentiators that set apart the top firms from the rest of the marketplace. Possibly as a result of that increased focus, top firms have net profit margins of 29.03%, compared to only 24.5% for the average firm.

Revenue Sources

As we had reported in AdvisorBenchmarking’s latest research study, RIAs across the board have increased their use of financial planning fees. Last year, RIA firms generated 23.4% of their revenues from financial planning/consulting fees, up substantially from 11.5% in 2000. One of the many forms of such fees is retainers–the advanced payment the client makes at the outset of the relationship.

Examining the revenue sources of top firms, we find that 100% of them charge retainer fees to some or all of their clients, compared to only 31% of the rest of the RIA firms. Needless to say, charging retainers is usually commensurate with the breadth of services the firm offers. Wealth management firms that offer a broad spectrum of services often find it easier to charge such advanced fees. Since a broad “range of services” was one of the criteria to qualify for the top firms’ composite, it is not surprising that all the top firms charge retainers. But the takeaway here for advisors is that charging retainers is one way you can diversify your revenues. Retainers do not just provide you with an additional source of revenues, they also provide you with a source of revenue that is not dependent on the assets you manage. This lack of correlation to AUM fees makes for a good revenue-hedging strategy when your assets and the stock market are falling.

Economies of Scale

As with most service-based businesses, large size does not always translate into economies of scale. In fact, larger RIA firms have lower profit margins than smaller ones. Sure enough, top firms (with median AUM of $330 million) incur a hefty $6,985 in expenses per client, compared to just $2,331 by the average firm.

But due to the bigger size of client accounts, top firms do achieve economies of scale when measured on the basis of assets. To that end, top firms incur only $6,697 in expenses per million dollars of AUM, compared to $9,028 by the average firm.

Clearly, these economies of scale are the result of larger accounts and not a bigger client base. So focusing on clients with higher net worth is likely to result in an increased leverage of resources, and ultimately, better economies of scale.

All in all, profit management is increasingly becoming more important for advisors. Paying closer attention to your firm’s profitability is the first step toward effective financial management. Creating a diversified revenue stream, one that includes retainers, also helps improve your financial health. Targeting affluent investors is most likely to improve your economies of scale.

To receive a copy of AdvisorBenchmarking’s 2003 Comprehensive Analysis of the RIA Marketplace Study, please e-mail Ramy Shaalan at rshaalan@advisorbenchmarking.com.

To receive a customized benchmarking analysis report of your practice, visit the free online tool www.AdvisorBenchmarking.com

AdvisorBenchmarking.com is a free online resource of research and analysis on the RIA marketplace. The service is aimed at helping advisors grow and enhance their practices. By participating in the online surveys, advisors can see how their businesses fare against other advisors, as well as learn best practices based on the most successful advisors in the business. The instant analysis they receive offers valuable insight that can help them take their practices to the next level and weather the challenging market conditions.