Now that many advisory firms have mostly recovered from the down markets of 2008 and 2009, it may be time to address what I’ve come to believe is a rather serious flaw in the independent advisory business model. This idea was brought home to me the other day as I was catching up with an old friend who runs a small, but successful, fee-only independent firm. She was lamenting the fact that her firm’s revenues had begun to recover when the market took its downturn this past spring; as a result, her cash flow was once again below a comfortable level.
Most financial advisors who base their services on financial planning also recommend that their clients buy and hold carefully constructed portfolios, with their holdings allocated between low-correlating asset classes to reduce risk and smooth out market downturns. The idea is that much like the homes that clients own, investment portfolios don’t really experience losses until the holdings are actually sold. If they don’t sell out when asset values are down, and have the fortitude and a long enough time horizon to wait until the markets and their asset values recover, they will continue to grow their portfolios at acceptable rates. This makes financial sense because the powerful U.S. economy always manages to recover, and grow larger.
This is all well and good for the clients. Although some advisors today are beginning to question this long-term, buy-and-hold strategy, the markets have indeed always recovered and this strategy has well served at least two generations of financial planning clients: there are also many advisors today who see no reason to try something else.
Does Buy and Hold Help Advisors?
Here’s my question: Has the long-term buy-and-hold investment strategy served the independent advisors who recommend it as well as it has served the clients who use it? The problem is that advisory firms don’t have nearly the long-term time horizons as most of their clients. What’s more, most of their clients have jobs that generate a separate cash flow, some of which, of course, goes into their portfolios. But most advisory firms don’t have another source of revenues: because they charge fees based on a percentage of their client assets under management, their only source of revenues is the assets themselves. So when those assets go down, so do firm revenues—sometimes quite significantly, as they did in 2008-2009.
This is what the business school guys would call a weak business model: It is locked into delivering a set of services that virtually guarantees a wildly cyclical revenue stream. In the investment advisory business, periods of substantially lower revenues aren’t unfortunate occurrences; they are regular, entirely predictable events: we may not know exactly when they are going to happen, but we know for sure they will happen, with some regularity. Since I’ve been covering financial advisors, I’ve witnessed four such periods: 1987, 1991, 2001, and 2008.
Back in 2002, after the dust of the dot.com crash and 9/11 had started to settle, veteran financial advisor and industry leader Harold Evensky wrote an article questioning the advisory business model, suggesting that advisory firms switch their compensation structure to flat, rather than asset-based, fees. I have to admit that I didn’t think very much of Harold’s idea, and wrote as much at the time. My objection was that from a PR perspective, advisors would look like jerks converting to flat fees at a time when portfolio values had fallen, and asset-based revenues were down.
But bad timing aside, Harold’s model may very well have been the right one: Or at least some combination of fixed and asset-based compensation. Because it’s very hard to grow an advisory business when every seven to 10 years cash flow falls into the red. Only this time, let’s make sure that portfolio assets are back up before we start talking to clients about changing their fee structures.