Three years ago, we published a research paper-The Future of the Financial Advisory Business and the Delivery of Advice to the Semi-Affluent-that predicted a series of sweeping changes to the advisory business over the next decade. Our prognostications in that report, and in a subsequent one published in September 2000, ignited a firestorm of controversy in the financial advisor community. Part of this firestorm was due in no small part to our prediction that "the financial advisory industry's structure will be very different from that of today" facing advisory firms with three choices-seek economies of scale, specialize or continue to operate as a generic provider of financial advice. And the choices made then by advisors would largely determine the long-term profitability of their companies. Our forecast held that by no later than 2009 and perhaps as early as 2006, the financial advisory business would mostly consist of three kinds of companies: a small number of very large, profitable firms; many small but very profitable specialty niche competitors; and a large group of small, marginally profitable advisory businesses that had little or no economic enterprise value. An equal source of this controversy, however, was the failure of many-not all-journalists and industry experts who have written and/or commented about our research to actually read it. We are confident in this assertion because nearly every time that we were interviewed or participated in a panel about it, our first question to journalists or fellow panelists was to ask if they had read the document. This question usually caused a lengthy period of awkward silence, followed by an admission that they had "scanned it" or had "read the executive summary." As a result, a series of misleading apocalyptic forecasts ("all small advisory firms will be out of business in a few years" or "there will only be a handful of advisory firms very soon") have been attributed to our report. A few recent articles have proclaimed that the research paper's forecasts have not been borne out by subsequent events. Since it is now the third anniversary of the paper's publication, it is a good time to look back at what we actually predicted and what has happened since September 1999. It is important to remember, however, that all of our forecasts assumed a seven- to-ten-year horizon. Hence, this is only an early mid-term report. Background Back in 1999, the advisory business had grown from what had been a cottage industry in the early 1980s to a major segment of the financial services business that controlled more than a trillion dollars of assets. The emergence of this young profession was driven by two factors. First, while many brokerages, banks and insurance companies offered financial advice to their clients, most of these organizations had a structural conflict of interest in the manner in which they provided this service. Relying on transaction-based compensation systems and not providing the broker or agent with independence in product selection often created a conflict between a client's best interests and their broker's or agent's interests. The failure of independent advisors' largest competitors to re-engineer their mechanisms for delivering financial advice created a vacuum between what clients really wanted and what was available from these organizations. The financial advisory business filled that vacuum. Second, the demand for financial advice exploded in the 1990s. The typical client of advisory businesses is the "millionaire next door," and the supply of such individuals grew nearly seven-fold during that decade. Hence, at the same time that large organizations were not delivering financial advice in the manner sought by clients, the demand for the service soared. As a result, advisory firms were inundated with potential clients. For most of the 1990s-and to some degree still today-the supply of potential clients significantly exceeded the industry's ability to capture them. This supply-demand imbalance created an inefficient and not yet rationalized industry. Advisory firms spent little or no part of their revenues on marketing. Cost accounting, contribution analysis and competitive analyses were largely nonexistent in the industry. Some advisory business owners even spent more of their time researching arcane financial theories or participating in industry groups and seminars than in managing their businesses. What Were Our Predictions? Our paper argued, however, that two forces-competition and technology-would rationalize the industry over the next seven to ten years. 1. Competition-We forecasted that a "flood of new entrants" would enter the business. In addition, many larger competitors would, in effect, reinvent their service offerings to at least look like those of financial advisory businesses. Combined, these two factors would significantly increase the capacity to service clients. As a result, demand for clients would equal supply at some point, sparking a series of changes in the industry. As in any other competitive environment, industry participants would face severe margin compression. Costs would rise for several reasons. First, advisory firms would be expected to do more for their clients for the same or lower fees. Second, marketing costs would skyrocket as more firms competed for fewer available clients. Finally, advisory firms would face increased competition and thus higher costs for their personnel. 2. Technology-We forecasted that technology, on the other hand, would serve primarily as a catalyst for many of the changes brought on by competition. Rather than replace the role of the advisor (as many "Internet gurus" had predicted), we argued that technology would increasingly become an integral part of advisory businesses. It would serve as a key tool in making advisory businesses more efficient, leveraging the time of professionals. Advisory firms that embraced technology would be far more capable of withstanding the inevitable margin compression that would accompany a more competitive environment. New Shape Of The Profession The combined effect of competition and technology would reshape the structure of the advisory business by 2009. A group of 40 to 50 competitors would capitalize on these changes to grow their businesses substantially and would eventually become household names in their markets. These organizations would have in excess of $15 billion under management, and some might have more than $50 billion. To be clear, we did not necessarily believe that these future dominant competitors would be made up of large brokerages, banks and insurance companies. Rather, it was equally likely that they would emerge from the ranks of the existing participants in the advisory profession. Like any other industry, a group of specialists also would emerge. These small firms would offer very high value-added services to their clients and would dominate niche market segments. Although they would be small relative to the size of dominant competitors, they would be very profitable organizations. The majority of advisory businesses, however, would remain relatively generic providers of financial advice. While many, if not most, of these organizations would survive, they would suffer the most from the two forces reshaping the industry. Their operating margins would be crushed, their owners would have to work harder for less money, and they would have little or no enterprise value. The key issue for advisory firms was to decide which group they hoped that their firm would eventually wind up in and to take the necessary actions to ensure this outcome. However, it would be very difficult to reposition an advisory firm after the combined effects of competition and technology were felt. Hence, the actions taken by owners over the next couple of years would largely decide the long-term destinies of their organizations. So, three years into a 10-year cycle, what has happened? Competition Intensifies There have been hundreds of new entrants to the advisory business, including accounting firms, insurance companies and personal financial services companies. Some of the more notable entrants include: Accounting firms-Nearly every major accounting firm has created a financial advisory unit or has acquired one. Fidelity signed an agreement with the AICPA to serve as the preferred vendor to accounting firms creating advisory units. Moss Adams acquired Financial Security Group in Seattle and has had great initial success in cross-selling advisory services to accounting clients. Plante and Moran's advisory unit is one of the largest and most successful advisory firms in Michigan. And 1st Global now offers a turnkey program (including personnel) that will allow nearly any accounting firm to create its own advisory unit almost overnight. Insurance companies-Northwestern Mutual Life acquired the Frank Russell Co. and has converted its system of agents into the NML Financial Advisory Network. AXA has completely reengineered its advisory unit, offering independence in investment selection and requiring either a CFP or a CFA designation for a majority of its advisors. Personal financial services companies-Both Charles Schwab and Fidelity have launched programs to offer advice to individuals through their extensive branch systems and have, in some locations, established "special" private client offices. H&R Block has refocused its business away from tax preparation to comprehensive financial advice. Venture capitalists have poured more than $100 million into MyCFO.com, a technology-driven financial advisory firm. Dozens of national and regional banks have created advisory units that cross-sell investment advice and products to traditional banking clients. Even E-Trade, an organization whose fundamental premise was to offer investors a cheaper and smarter way to invest their money on their own, has refocused its business on providing advice to consumers. At the same time, several of the larger brokerages have also completely remade their advertising campaigns to make them appear as though they offer the same services as financial advisors. Relying on focus-group studies that have highlighted the importance of independent comprehensive advice, organizations such as Morgan Stanley are running advertisements that make it sound as though they are members of NAPFA. Again, to be clear, we do not believe that these organizations have necessarily changed or improved their services. Rather, they have cleverly repackaged themselves so that they appear to be offering something similar to advisory firms. And in marketing to clients, it does not matter what you do, but what people think you do. Client Supply Still Exceeds Demand Although the flood of new entrants and the repackaging of brokerages has caused a dramatic increase in the capacity to capture clients, it does not appear that the supply-demand crossover point that will trigger the rationalization of the advisory business has been reached. Many advisory firms still spend next to nothing on acquiring clients. Many refuse to pay referral fees to outside organizations. Others still fire clients regularly. Outside of the market correction, these organizations have felt few, if any effects, from added capacity to the industry. This is not surprising for two reasons. First, the sheer number of potential clients seeking advice is so large that despite the new entrants and repackaging, it still will take some time before supply equals demand. In addition, the severe correction in the equity markets has created a near-term surge in the demand for advice. Many individuals who thought they could manage their money on their own have learned that doing so is a lot harder than it appears. Other investors who relied on brokers to pick stocks for them have lost large amounts of money. Both of these groups are now flocking to advisory firms. At the same time however, the market correction has shrunk the overall pool of potential clients. Many individuals who only a couple of years ago were millionaires (and thus potential advisory clients) have suffered losses to their net worth as great as 70%. Hence, while in the near term some advisory firms have benefited from the market correction, its long-term effect will be to hasten the point at which supply equals demand. Second, the effects of competition do not occur linearly in any business. Rather, they appear somewhat off in the distance, like a rumbling sound, and then, in a step-function fashion at the point of supply equaling demand, overwhelm an industry. This nonlinear effect of competition is why many industries (such as computer manufacturers in the early 1980s) have dozens of flourishing competitors one day and many bankruptcies the next. And for the advisory business, there are the distant rumbling sounds of the first symptoms of a more competitive environment. A More Competitive Environment In The Future The most obvious reflection of a potentially more competitive environment is Schwab's transformation of its AdvisorSource program. In exchange for referrals of potential new clients, Schwab now demands 15% of the advisory revenue over the life of the relationship, regardless of the starting level of assets. While some accounting and law firms have long sought referral fees, Schwab's demand is notable in that it has had no difficulty finding advisory firms willing to pay these fees. This repricing of one of the advisory community's largest client referral systems is a signal that increasing competition-and the accompanying higher costs of client acquisition-is on its way. And in four to seven years, we believe that 15% of revenue is going to look fairly inexpensive. Our research uncovered two small, relatively isolated markets (one in the Southwest and the other in the Northeast) in which, for a variety of reasons, there emerged intense competition for referrals from accounting firms. In both cases, the cost of referrals ultimately went from free to 50% of revenues. Other, less obvious symptoms of competition also are starting to emerge. Several advisory firms report that they, for the first time, are in competitive presentations. Instead of simply evaluating a potential client and deciding whether to accept them, these organizations must now make a case as to why they should be selected by the potential client. Still, other organizations have begun to take steps to reposition themselves to capitalize on what they believe will be a more competitive environment. Several advisory firms have entered into strategic partnerships with either law firms or accounting organizations. Other advisory businesses have considered acquisitions or mergers to provide more scale. A good example is the Chicago-based firm of Balasa Dinverno Foltz & Hoffman LLC. It is the result of the merger of two mid-sized advisory businesses. A key reason that these firms decided to merge was their owners' belief that a larger business would be better positioned to grow in a much more competitive environment in the future. Technology Spawns Contrary to many Internet futurists' predictions three years ago, the last three years have also shown that technology will not replace the role of the financial advisor, but enhance it. And technology does not provide any sustainable advantage to its users. In the words of one specialist, "Technology is like an arms race. You have to have it to survive. But it is ubiquitous and smart firms will be able to get it cheaply." MyCFO.com is the best example of technology's limitations. This organization has made immense investments in systems and equipment so that it can better communicate with clients and provide more comprehensive advice. However, as this company's backers have learned, it is far easier to start with an organization with many clients and acquire technology than it is to build sophisticated software systems and then try to get clients. Outsourcing Nonrevenue Functions Technology's primary role over the last three years has been to allow advisory businesses to be more efficient by effectively sub-contracting out the report preparation and reconciliation functions. A cottage industry of 15 or so companies such as Envestnet, AdvisorPort and FundQuest have emerged as turnkey providers of platforms that provide these services along with investment research and tools. Traditional providers of technology such as Schwab, Fidelity, and TD Waterhouse are in the process of expanding their platforms to provide similar functions to advisory firms. Over time, as advisory businesses need to operate more efficiently to offset the effects of margin compression resulting from competition, the use of technology platforms will play a larger role in maintaining profitability. It will be a key source of operating leverage for advisory firm owners and professionals. A second, less obvious change in the role of technology has been the linking of vendors through aggregation software. Companies such as Yodlee and ByAllAccounts offer systems that allow individuals to electronically track all of their accounts and communicate online with their service providers. The first generation of aggregation software was fairly rudimentary, relying on a "screen-scraping" approach that did not produce useable data. The next generation will be far more sophisticated and will allow end-users to track all of their assets and communicate with all of their vendors on a real-time basis from anywhere in the world. Several of these next-generation software platforms are currently in the beta-test stage, and their developers are working closely with organizations such as Schwab, Fidelity and TD Waterhouse to tie them into their custodial technology platforms. The long-term effect of this next generation of aggregation software will be to link all of a client's vendors electronically. Once linked, it will be only a matter of time before some advisory firms (in particular large ones trying to take advantage of their scale) begin to offer bundled service pricing. With bundled service pricing, the client would pay one flat fee for all services, such as tax preparation and advice, estate planning, insurance, financial planning, etc. Multiple vendors would still provide these services, but they would all be compensated out of that one flat fee. Bundled pricing mechanisms are commonplace in other industries, such as software and phone service. They allow larger competitors to change the fee structure of an industry and make it harder for smaller competitors to remain profitable. Bundled pricing will likewise allow larger advisory firms to force all industry participants to do more for clients for the same price. As more individuals are linked electronically to all of their service providers, it will be far easier for larger organizations to implement these kinds of pricing structures across a wide variety of clients with many different vendors. Implications Of Market Correction The recent drop in the equity markets has provided advisory business owners with a preview of some of the margin compression that will sweep through the industry over the next four to seven years. For many years, the largest client of many advisory firms was the market. The S&P 500 delivered average annual returns of 18% in the 1990s, simultaneously increasing advisory revenues almost automatically every year. With such a subsidy mechanism, advisory firms did not have to worry about things such as cost controls or acquiring new clients. Revenues went up simply by retaining existing clients. The world has changed considerably over the last three years. The same markets that effectively subsidized inefficient advisory business practices for more than a decade are now causing severe margin compression in many firms. According to Cerulli Associates, the industry's assets have declined by 17% since their peak in 2000. But a more critical problem for advisory firms is that operating margins fell by almost 33% from 1999 to 2001, according to the most recent FPA/Moss Adams study. And 2002 has only been worse. With the S&P 500 already down more than 25% year-to-date, further reducing advisory revenues, many firms are facing a crisis. Their revenues have declined precipitously, but their costs have remained fixed. As a result, owner compensation is only a fraction of what it used to be. Many firms, in particular those with strong reputations within their communities, have been able to offset this margin compression by seeking scale. They have replaced their lost revenues by recruiting new clients. The correction in the markets has increased the near-term demand for financial advice and these organizations have benefited. Many now have the same level of revenues but are earning less per client. In the future, however, advisory firms will face margin compression that will not be so easily remedied. At the point that industry supply and demand eventually meet, advisors will face margin compression from a variety of factors. It will also be much harder-and much more expensive-to replace lost profitability by simply adding clients. Firms will either forego more revenue to referral fees or have to invest in marketing forces in order to attract new clients. And in a more competitive environment, they will be successful less often in winning mandates. Even at current growth rates, many advisory firms will soon face capacity problems. Most advisory businesses are not structured to handle large volumes of clients, and a program of hyper-client growth is not sustainable. These organizations will have to get much more efficient and recruit additional personnel. In other words, they will need to get a lot bigger if they are going to sustain their profitability. Conclusion It is too early to determine if our prognostications are true. Our forecast looked forward a decade, and 2009 is still a long way off. The events of the last three years, however, have only reinforced our belief that the advisory business is in the process of a major evolution. Competition is clearly increasing and will soon force a vigorous rationalization of the industry. That rationalization will be accelerated by technology and the removal of revenue subsidies generated by a bubble in the equity markets. Unfortunately, many advisory firms have been lulled into complacency by the ease at which they have been able to withstand the margin compression caused by the drop in the equity markets. They believe that in the future, there will be an inexhaustible supply of potential clients that they can capture at little or no cost to replace lost profitability. Should we publish a similar update to our paper three to four years hence, we expect that these firms will have been rudely shaken by the reality of a much more competitive environment. Mark Hurley is chairman and CEO of Undiscovered Managers, an investment company based in Dallas, Texas.