The independent advisory business had the good fortune to emerge during one of the greatest bull markets in U.S. history. From the end of 1990, when the profession first began to shift into a major segment of the financial services industry, through the first quarter of last year the Nasdaq returned more than 1,300% on a cumulative basis. The S&P 500 returned more than 500%, the Russell 2000 returned nearly 400% and the EAFE returned nearly 200%.
With such high levels of systematic returns, it has been difficult (until about a year ago) to pick an equity mutual fund that did not generate reasonably high absolute investment performance. As a result, most advisors have been able to rely solely on portfolios of traditional long-only investments and still deliver acceptable investment results for their clients. Until 15 months ago, many clients were satisfied with the value, or perceived value, their advisor delivered. These days many advisors are voicing concerns that, in clients' eyes, their primary value-added has been fairly limited - ensuring adequate diversification for their clients' assets and trying to identify active managers that might add, on average across a portfolio, an alpha of 1% to 1.5%.
At the same time that advisors have not been adding an immense amount of value-added to their clients' investments, the euphorically high equity premium of the last decade has shielded a key aspect of advisory businesses - fees - from the level of scrutiny common to other industries. Charging 1% of assets seems quite reasonable when diversified portfolios return 12% to 14%.
Many leading economists, analysts, and money managers, however, believe the market environment over the next five years will be very different from the last 10. They have forecasted an equity premium of only 2%. If their predictions are correct and interest rates also remain fairly low, diversified long-only client portfolios may generate returns of 3.5% to 4%.
To be clear, nobody can say with any certainty what the financial markets will do over the next five minutes, much less the next five years. However, should these experts' prognostications prove accurate, advisory businesses are going to face some serious problems.
Overpriced Services Won't Solve Problems
First, the same 1% fee that appeared fairly reasonable in a 6% to 8% equity premium environment now is going to look very expensive to many clients. Second, and more vexing, while clients do not hire advisors to generate exceptional investment returns, they do hire advisors to solve their problems. And most current financial plans are based on an assumption of 6% to 8% returns, after fees. Advisors may suddenly find that their clients view their services as both overpriced and incapable of solving their problems.
Even more problematic, advisors may find the shrinking equity premium may coincide with other forces already rationalizing the advisory business, such as competition and technology. Competition will make it harder to capture new clients, technology will accelerate bundling of services and pricing, and a shrinking equity premium may make it much harder for advisory firms in their current form to retain existing clients at any, much less current, fee levels.
We have already discussed in our research papers on the future of the advisory business a wide range of strategic alternatives for advisory firms that address the issue of increased competition and the effects of technology. However, our research did not consider the potential of a significantly smaller equity premium for several years. Clearly, a substantial drop in the absolute rate of returns would only serve as a further catalyst accelerating the rationalization of the industry. It will likely change the advisory business most quickly in three ways.
Customization Will Increase Sharply
First, advisory firms that hope to prosper in the future will offer significantly higher levels of investing value-added. They will develop much more customized investment solutions for each of their clients that go far beyond traditional generic mutual fund or separate-account products. They will use investment products that are designed for the individual client and factor the client's risk profile, tax situation, embedded labor risk and other investments into the selection of individual securities.
Similar to many of the most sophisticated pensions, foundations and endowments, future successful advisory firms also will expand from solely long-only, somewhat diversified portfolios of investments to include asset classes and strategies that are not dependent upon directional moves of the market to generate returns. Absolute-return strategies such as convertible arbitrage, distressed securities and long/short equity have become fairly standard investments in most institutional portfolios and will likely become a regular allocation of advisory client holdings.
Although offering such investment capabilities may seem somewhat futuristic, the future is much closer that it appears. Technological advancements now make it possible for money-management firms to provide customized accounts down to the individual investor as small as $250,000. With regard to alternative investments, although as currently structured there are few opportunities to invest in such asset classes in a way that makes sense and that meets the suitability and liquidity requirements of a semi-affluent investor, this also will soon change. Many money-management firms are racing to build and launch investment vehicles that will allow semi-affluent investors to invest relatively small amounts (more than $50,000) into a fund of funds that, in turn, invests in absolute-return strategies with some of the world's leading hedge funds managers. These kinds of vehicles will be relatively commonplace in a few years.
From an advisor-education standpoint, a flood of research has been generated over the last couple of years by both academic institutions and major brokerages on customized benchmarking and on alternative investments. Advisory firms that make a concerted effort can quickly get up the learning curve on these strategies and asset classes.
Service Will Be Expanded
The second manner in which the advisory business will be changed, should the equity premium decline substantially, will be the need for advisory firms to expand their services significantly. Advisors will have to do more for their clients-such as provide tax advice and/or preparation, estate planning and insurance advice as well as an array of family-office services-for the same fee they currently charge for supplying only investment management and financial planning. Firms will also have to offer more customized and specialized services that help clients with their careers, businesses or lifestyles.
The need to shift to broader services will not result solely from a lower equity premium. Competition from other organizations entering the advisory business will force advisory firms to do more for less. However, potential lower absolute rates of portfolio returns would accelerate this requirement.
A Move To Value-Based Pricing
Finally, the potential for lower absolute rates of return also may force advisory firms to shift away more quickly from fee-based pricing structures to value-based ones. Most advisors currently provide little or no additional value-added to clients who have $2 million of assets than they do for those with $1million. They do, however, charge the larger clients a higher fee in dollar terms.
These fee-based pricing structures will not likely persist, regardless of future absolute rates of return. They are analogous to a physician basing the cost of a medical procedure on the patient's net worth. Just as a doctor must base pricing on the level of value-added provided, so too will advisory firms price their services in the future. If nothing else, competition will ultimately force this rationalization.
Should the equity premium decline and remain low for a long period of time, this shift to value-based pricing will likely accelerate. Future successful advisory firms will offer specific services for set prices, based on the level of value-added provided and not on the clients' assets or hourly fees. Likewise, justifying the appropriateness of fee levels and demonstrating value-added to clients will be key marketing challenges for all advisory firms.
Although our organization gained notoriety through its less-than-cheery forecast for growing competition for advisory clients, as a sponsor of a family of long-only mutual funds, we are actually rooting for an inflated equity premium for the foreseeable future. However, a lot of very smart people are betting that this period of abnormally high returns is over. If they are right, things will change very quickly for many advisory firms. The days of simple investing strategies, limited services and asset-based fees will quickly end as part of a series of changes that will sweep through the industry as it rationalizes.
Mark Hurley is chairman & CEO of Undiscovered Managers, LLC. Tom Fuller is director of research. In addition to their research papers on the future of the industry, Hurley and Fuller are drafting for publication in July a major study of alternative investments and advisory businesses. All of their research is available at no cost @www.undiscoveredmanagers.com.