War Room

Maybe it was the bailout of investment bank giant Bear Stearns or the government takeover of Fannie and Freddie. Perhaps it was the steep decline in home prices combined with tumultuous energy costs. Whether it was a single debacle or the entire chain of events that dominated headlines for the better part of the year, Wall Street’s bad news has changed the mood on Main Street. Risk management is now top of mind for individual investors–some who may be in or near retirement–as well as those who are simply striving to make ends meet in an ever-challenging economy. Advisors, too, have felt the market’s woes and are looking to ease clients’ fears while buffering their practices against declining profit margins and other business risks.

The 2008 annual Rydex AdvisorBenchmarking study, which examines practice management trends in the registered investment advisor (RIA) space–including financial performance and operations, investment and organizational management, marketing and client relations–reveals some surprising truths about the industry. The study showcases the best practices of the most successful firms in the business, highlighting opportunities for planners looking to step up their risk management efforts.

Everyone Shares the Pain

Regardless of whether or not you believe there’s light at the end of this bear market, there’s no denying the hefty burden that some families and individual investors still carry. In fact, many are reeling from the continuing decline in value of their often largest and most important asset: their homes. Nearly a quarter of advisors say the housing slump has impacted their clients’ ability to sell their homes or get their anticipated asking price.

“The American consumer accounts for two-thirds of economic spending…With no credit, property values falling, incomes stagnant, job security a thing of the past, and higher fuel, utilities, and food costs sucking up every dime of disposable income, the American consumer is tapped out,” says George Cheatham, founder and president of American Financial Consultants, Inc. of Columbus, Kentucky.

For some clients, a bit of budgetary consulting or asset shifting may be enough to ease the pain. But those who are approaching retirement or who have already retired are likely unable to stomach extreme market volatility. Tightening the belt will only go so far and for these clients especially, advisors will need to take a closer look at how they approach investment management risk.

A Flight Toward Safety and Alternatives

While the majority of advisors (50%) consider themselves strategic or “buy and hold” investors, more than one-third (35%) take a tactical approach to managing money–which some feel offers the ability to be more reflexive to market conditions.

“It is extremely important to stress absolute returns in a negative relative returns environment; in other words, tactical asset allocation should provide a shield for clients from the full brunt of market downturns,” says Paul Bennett of C5 Wealth Management in Great Falls, Virginia, who moved clients to cash, short mutual funds, Treasury inflation-indexed securities (TIPs), and gold. “These moves have dampened volatility and preserved capital for our clients,” he adds.

Not only are planners shifting clients’ assets to areas they consider safe havens, but they’re also adding exposure to nontraditional investments to reduce portfolio volatility. Driven by a demand for absolute returns and access to assets that don’t necessarily correlate with stocks and bonds, advisors are increasingly turning to alternative investments to help diversify clients’ portfolios and mitigate downside risk. Alternative or nontraditional investments–defined as those assets other than stocks, bonds, or cash–can include asset classes like commodities, currency, and real estate. They also encompass absolute return, long/short, leveraged, and managed futures strategies.

AdvisorBenchmarking findings indicate that 80% of advisors have increased their use of alternatives over the past six years, with 18% increasing their use of these investments by more than 100%.

In addition to achieving portfolio diversification, some advisors are seeking to generate alpha for their clients by keeping costs at a minimum. Considering exchange traded funds’ reputation for being cost-effective investment vehicles, perhaps it comes as no surprise that ETF usage has risen substantially. Ninety percent of advisors report that they have increased their use of ETFs in the last five years, with nearly half (42%) increasing their use by more than 25%. For the first time ever, ETFs surpass individual stocks in advisor portfolios. What’s more, it looks as if this trend is here to stay. Half of advisors (49%) believe that ETFs will become as important, if not much more important, than stocks and mutual funds.

Keeping the Lines Buzzing

Regardless of the investment techniques advisors employ, managing client expectations is essential, particularly during challenging market environments such as these. In fact, 42% of advisors consider managing client expectations to be the biggest challenge in their business. Open and frequent communication with clients can go a long way towards reducing the risk that clients are surprised and/or dissatisfied with investment management results. While the great majority of advisors communicate with clients via email (80%) or newsletters (73%), a smaller majority (51%) report they are staying even closer through one-on-one quarterly meetings and annual client reviews. The most successful advisors realize that there’s no substitute for face time with clients. Top firms spend the majority of their time (55%) with clients compared to average advisors who spend only 25% of their time with clients. Moreover, past Rydex AdvisorBenchmarking research, and the most recent study, has found that advisors who spend 60% or more of their time in client-facing situations are up to eight times more profitable.

Meanwhile, on the Eastern Front . . .

Reducing investment risk for clients is only half the battle for advisors hoping to grow their practices in a tough economy. As the RIA industry becomes increasingly competitive, advisors must take a hard look inside their firms to address business risks that could threaten future profitability.