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Enjoy It While It Lasts

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During my 30-year career as a financial journalist (wow: that’s sobering), I’ve witnessed four major market downturns: in 1987, 1991, 2001 and 2008. During every one of them, I remember major financial services companies and financial publishing companies (which rely on the financial services companies for advertising revenues) acting as if they were caught completely by surprise.

I particularly remember Dow Jones & Company executives, owners of Investment Advisor magazine at the time, freaking out during the dot-com crash of 2001, and thinking: “Come on, guys, you’ve been doing this since 1882; market downturns can’t come as a big surprise.”

These were my thoughts as I was reading through FA Insight’s recently released “2014 Study of Advisory Firms: Growth by Design,” the results of which authors Dan Inveen and Eliza De Pardo summed up this way: “On aggregate, advisory firms enjoyed a stellar year in 2013, and the typical firm owner is optimistic that prosperity will continue through 2014. […] Undoubtedly, appreciating security markets, an improving economy and growing demand for financial advice are working in favor of advisory firms.”

And as you’ll see, the performance results from the 342 (60% RIA) participants in the study are quite stellar. Yet, as much as I hate to be Donny Downer here, what is “working in favor” of advisors is a six-year bull market that began after a market crash that cut the portfolios of many advisory clients in half. It seems to me that rather than patting each other on the back, now might be a good time for advisors to think about avoiding the traditional financial services head-in-the-sand, bull-markets-go-on-forever mentality and consider positioning their firms for the inevitable market downturn.

But first, the good news: FA Insight’s data tells us that between 2011 and 2013, the average number of advisory firms’ clients grew by 20.3%. Client AUM increased by 50.2%, and firm revenues shot up 41.3%.

In the five years from 2009 to 2013, average firm profitability has increased from 11.3% to 22.1%, pushing the average income per owner up from $227,959 to $344,279.

These are very healthy numbers, indeed, but before we get too giddy about this trend, it might be instructive to consider what’s behind them. In a nice little piece by InvestmentNews announcing the annual “Financial Performance Study of Advisory Firms,” released in September in partnership with Moss Adams, Matt Sirinides addressed “the real reason behind advisory firms’ big gains in AUM.” That study found a 19.2% increase in advisory AUM in 2013, which followed a 15.5% increase in 2012, representing a cumulative 37.7% two-year growth in AUM. This seems to be in the ballpark of FA Insight’s three-year 50.2% growth.

According to Sirinides, the Moss Adams/InvestmentNews study found that while the S&P 500 Index grew by 13% in 2012 and 30% in 2013, “the market still accounted for the identical proportion of AUM increase” in both years: 39% of new assets. New assets from new clients (45%) and from existing clients (16%) made up the difference in 2013. (The study also broke down the sources for those assets from “new clients”: client referrals, 30%; professional referrals, 23%; business development, 47%.)

As for information that can help owner-advisors manage their firms better, like most surveys, FA Insight’s breaks participants down by firm size (annual revenues), which they call “developmental stages.” Unfortunately, their four stages are called Operators ($100,000 to $500,000), Cultivators ($500,000 to $1.5 million), Accelerators ($1.5 million to $ 4 million) and Innovators (more than $4 million). I write about this study every year, and every year, I have to copy this list and tape it to my computer monitor so I can remember who is what. (Note to Dan and Eliza: To be user friendly, category names should obviously relate to the categories they describe. For instance: small, bigger, biggest and huge, to pick four out of the blue.)

Using these categories, the FA Insight study provides an interesting—if not very meaningful—comparison of standard business metrics from 2012 to 2013. For instance, Operators (small) had the highest revenue increase of 19.2%, while Innovators had the smallest—13.6%. That might suggest that smaller firms are more sensitive to market gains or that they added more clients. Either would be interesting, but FA Insight didn’t provide historical figures for comparison.

Revenue per professional, on the other hand, is about what one would expect: $246,107 at the smaller firms and $726,267 at the largest firms. Yet, owner income per revenue dollar, at $0.61, is quite a bit higher (42%) at the small firms than at the largest firms: $0.43. This suggests to me that despite all the hoopla we hear about how great the larger firms are with their “economies of scale,” the smaller firms actually have more efficient operations; they just get buried on volume. It also suggests there might be plenty of opportunity at the larger firms to increase efficiency—and the bottom line.

To help advisors identify how they can make their firms more efficient, FA Insight compares the top 25% of each developmental stage, which they call Standouts (good name, guys), ranked by a combination of firm growth and total owner income by various operational metrics. Across all four size categories, the Standout firms share these characteristics: They believe that “superior client experience” is the key to their growth; they have much lower overhead expenses (as a percentage of revenue); the average age of their primary owners are lower; and their revenue per professional and profit per client are higher.

Profit Per Client, Standouts Versus Others (Source: FA Insight 2014 Advisory Study: Growth by Design)While you might think the above differences are fairly predictable, the last area where the Standouts stand out is a real shocker, at least to me—not because the Standouts are better at it, but because it’s actually possible to be better at it. Are you ready? At every developmental stage, Standout firms achieve higher profits per client—much higher (see chart).

Now that’s what I call striking differences. Here’s what Inveen and De Pardo say about them: “Despite no material differences in the size of client investment portfolios, Standout firms at every stage earned significantly more profit per client. Generating more profit per client embodies many of the previously cited common best practices from Standouts—including distributed ownership, client focus and expenses management.”

Yet as dramatic as the “profit per client” numbers are at the best firms, they are still the result of the five-year, post-crash market. As the Moss Adams/InvestmentNews study shows, today’s AUM increases, which are driving all these climbing performance numbers, result from market increases and new clients. As we saw in the wake of the 2008 meltdown, both of those factors are driven by the stock market. FA Insight offers advisors no information about how to position a firm (Innovator or Operator) for the next downturn.

In September, Axel Merk of Merk Investments raised the specter of another meltdown in a note to his investors (see “Potential Market Crash Ahead, Axel Merk Warns,”, Sept. 5, 2014). Citing equity markets that are at or near historic highs, investor complacency (measured by the VIX Index, which is at its lowest), Treasury yields near record lows, and concerns that the “U.S. recovery may not be as robust as it appears” and that the Fed is “entering a rising interest rate environment,” Merk cautioned his investors about a potential crash, arguing that the U.S. “recovery is based on asset price inflation.” The implication is that if the Fed should pursue an “exit, risk premia might expand once again, compromising not only asset prices, but also the entire recovery.”

I have no idea if Merk is right, but my stock market barometer is that when the bears start to sound plausible, there’s probably a downturn somewhere in the offing.

The independent advisory industry has its own barometer: When things have been going swimmingly for half a decade or so, there’s probably a downturn coming. In light of advisors’ collective experience in 2007 and 2008, it may well be time to start thinking about doing all the things they wished they’d done in 2006 (slow down staff growth a bit, manage expenses, beef up client services and communications, and step up marketing) because when the downturn comes, it will be too late—again. So, try not to fall into the financial services model of being “shocked, shocked” that the market could go down.


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