Unicorns, Skittles and the Delusions of Bull Markets

Commentary March 08, 2017 at 05:07 AM
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Much like the stock market itself, I've found that you'd be an idiot if you observe the independent advisory industry for long enough and don't realize that it tends to go through the same boring (i.e., predictable) cycles. For instance, the only time that prospective consulting clients ask me where I got my degree is after the stock market has experienced a significant run-up.

I believe the reason for this is that most owner-advisors tend to be rather cost conscious by nature. So when the markets are down or even flat, and their cash flow and profit is also flat, they are looking to get their consulting help at a bargain basement prices. But when markets are up, and their businesses are flush with cash, they suddenly adopt a "nothing but the best" mentality. Unfortunately for them, many advisors tend to equate one's alma mater—rather than experience and track record—with high-quality advice.

I'll spare you the trouble Googling me and inform you that I got my degree in personal financial planning at a CFP-registered program, one of the top programs in the country, at little ole' mostly agricultural public university Kansas State University.

K State's program is housed in the College of Human Services, not even aligned with the business school. Why put CFP programs in business schools anyway? Isn't it about helping people? But I digress.

Even more unfortunate, during booming markets such as the one we're currently experiencing, I've found that many owner advisors tend to apply this same mentality to running their businesses, usually in two key areas: hiring and fees. In both cases, their misguided perception of "quality" usually proves to be quite costly.

Consider this my warning.

As we've seen during the past five or six years, when the stock market is booming, most firm owners start looking to expand their business, which almost always means hiring advisors. And, because they are flush with cash, more often than not, they want to hire "top" talent. That, as I said, tends to mean hiring kids out of top business schools, and/or advisors with considerable experience at other advisory firms. 

While there's nothing inherently wrong with hiring advisors out of Wharton or Harvard Business School, the problems are created by the firm owners themselves. To start with, they tend to overpay for young advisors they deem to be blue-chip candidates, which leads owners to place unrealistic expectations on them from the start.

For instance (and for reasons that escape me), owners tend to expect these recent graduates to hit the ground running (and advisors from other firms), with little or no additional training. You can guess how well that works out.

What's more, their excessively high starting salaries tend to create a sense of entitlement among those young blue-chip advisors; leading them to believe that don't need to work very hard, or to continue to learn, in their new jobs.

You can see how this might lead to less than ideal—and highly overcompensated—new employees. And as I said, it happens in every bull market (visions of the movie Groundhog Day just flashed brightly through my sugar-plum head).

The second major trend that I've noticed that coincides with every bull market is a robust discussion of transitioning from charging AUM fees to flat retainer fees.

The driving force behind this notion seems to be the combination of the memory of the last down stock market and the resulting decline of AUM revenues, with the fear of having the same thing happen to today's currently high-fee cash flow. That leads many firm owners to want to lock in those high fees now, so they don't dwindle in the next market downturn.

On its face, flat fees do seem to be a good idea. But as I said, with the benefit of hindsight from a few market cycles, the trends tend to be educational. During the next market downturn, flat fees will undoubtedly have a very positive effect on firm revenues. But experience tells us that many clients might not be as happy about that as many firm owners are.

For one thing, as most flat fees are calculated based on the dollar amount most clients were paying in AUM fees,a  down market usually means the clients with smaller portfolios then will be paying a fee that is actually a higher percentage of AUM than their old AUM fee—at a time when they can afford it less. And if clients don't figure this out for themselves, you can bet that brokers, breakaway brokers and other advisors will be more than happy to educate them.

The reality is that a flat advisory fee replaces an AUM fee (under which the advisor suffers financially right along with the client) with a system where the advisor increases his/her compensation (on a percentage basis) while the clients lose money. In my experience, the majority of clients won't even mention it: what they will do is find another advisor.

Perhaps the worst part is that because they were heavily pitched the advantages of flat fees when they made the transition away from AUM fees, it will be very difficult for most advisors to talk to their clients about going back. 

Just as with every bull stock market, there will always be those who argue that history is no guide because 'this time, it's different.' But another thing that history teaches us is that it rarely is different, and for the few times when it really is different, that's pretty obvious, too.

As for advisors in bull markets, saving your cash to help weather the eventual market downturn is probably a better idea than spending it frivolously because you can. Changing your pricing model away from sharing your clients' financial experience probably isn't as good as preparing your firm for the market downturn. 

See these recent Angie Herbers blog posts and columns:

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