Multiple disciplines and multiple products converge in the making of independent-minded planners and their clients.
"What all this means, he said, is
that the old world is gone. The old manners are obsolete and your
graciousness is not worth a damn. ... From now on, you've got to live in
a new world and face a few realities for a change. Buck up, he said, it
won't kill you."
-Flannery O'Connor, Everything That Rises Must Converge
Financial advisors today are facing a new world with
new realities. Competition is intensifying, investment strategies are
complex and the costs of doing business are rising. At the same time,
the demand for independent advice is also rising and the independent
model is increasingly embraced.
Among the many new trends in the financial advisory profession are two related convergences-between multifamily offices and independent financial advisory firms, and among the various strategies that constitute the alternative investment universe. Let's explore how some advisors have used their understanding of these trends to grow their businesses and provide better service for their clients.
Responding To Competition
One of the strongest trends since the collapse of the bull market in 1999 has been the reaction of traditional competitors to the independent financial advisory value proposition. Wirehouses have actively repositioned themselves from being providers of product to being trusted advisors. A random walk through the retail Web sites of the wirehouses, banks and insurance companies reveals some consistent themes: holistic planning, customized services and objective advice. As Merrill Lynch proclaims: "Every aspect of a client's financial life is considered, enabling financial advisors to become essential partners to their clients and provide customized financial planning and wealth management advice, products and services."
There is more than just marketing spin involved, although certainly the marketing muscle powering the shift is impressive. For example, Merrill Lynch has in the past three years spent more than twice as much as Apple Computer Inc. on marketing and advertising with, in 2005, a total expenditure of $599 million. On the substantive side, however, nearly 9,000 (out of 15,000) Merrill Lynch Financial Advisors are certified financial managers and more than 1,000 are certified financial planners, according to the firm. The sheer physical size and presence of the major brokerage houses assures that consumers are growing more confused about the services offered by financial advisors.
But while traditional competitors are trying to look more like independent financial advisors, the independents have embarked on their own metamorphosis. In this case, we have begun to see a convergence between family offices and independent financial advisory firms.
What Is A Multifamily Office, Anyway?
Many multifamily offices (MFOs) evolved from a traditional family office that was designed to serve one extremely wealthy family. According to the Family Office Exchange, an MFO typically aggregates and focuses resources to facilitate a common interest in asset protection, cost control, financial education, family philanthropy and a host of other needs. It is structured to offer integrated, interdisciplinary services to ultrahigh-net-worth individuals and families. Historically, MFOs have provided customized service levels and confidentiality not available from larger, product-driven financial institutions. Today, many of these exclusive groups have opened access to their services to clients outside the original family.
While the key characteristic of MFOs has been large, multigenerational client relationships, several independent advisory firms have successfully positioned themselves as a worthy source of advice for ultrahigh-net-worth clients. They have managed to build an extensive array of services despite the lack of funding from an originating founding family, and have consequently been able to attract and retain the equivalent of today's Rockefellers and Mellons. These firms include Oxford Financial Group, based in Indiana, which has more than $8 billion in assets under management, and Lydian Wealth Management in Rockville, Md., which has more than $5 billion.
Today, MFOs continue to grow and gain market share from traditional competitors, including wirehouses, large banks and trust companies. The Family Wealth Alliance's Third Annual Multifamily office study shows that, according to July 31, 2006, data, assets under management by MFOs increased by an annual rate of 15.3% to $226.5 billion. Overall, according to the 2006 Moss Adams Study of the Financial Performance of Advisory Firms (co-sponsored by SEI and JPMorgan Asset Management), independent advisory firms have grown their assets under management by over 20% per year during the past three years. But perhaps most tellingly, larger firms are consistently achieving higher growth rates.
A leading indicator of where this industry is going is that larger independent advisory firms-firms that manage more than $1 billion in assets and have annual revenue in excess of $5 million-grow faster than their smaller competitors despite requiring a higher absolute volume of new business. The data clearly shows that as firms evolve, they are able to achieve very real benefits from scale.
Larger firms are more profitable. But perhaps even more significantly, Moss Adams finds that large client relationships correlate with increased owner income. In short, the ability to attract and service large clients-to act as an MFO-strongly correlates to greater income potential for owners.
Walking The Walk
An analysis of independent advisory firms that have successfully donned the MFO mantle reveals a variety of business models. There are, however, two recurrent themes: objective financial advice and the ability to deliver complex services consistently. In many cases these firms offer no investment products of their own, which allows them to claim complete independence and a total alignment with their clients' interests. The services offered typically include wealth management tools such as personal and charitable trust services, estate and generational planning and philanthropic advice. While some firms provide these services from internal resources, other firms act more as a general contractor by recommending and monitoring other service providers to work with their clients.
An increasing point of emphasis is the ability to provide alternative investments, particularly for those firms with clients who are involved in the financial services industry. Despite the common perception that alternatives are high-risk, high-return investments, most of these firms use alternatives as part of a portfolio construction process that seeks to reduce risk and volatility, and to improve return potential on the downside. The results that these firms have been achieving, and the high levels of client satisfaction, are helping to fuel one of the most significant trends today in the advisory industry: the increasing interest in, and accessibility of, alternative investments.
Once upon a time, "alternatives" to most people meant hedge funds-exclusive strategies available only to institutions and very rich people. The demand for hedge funds has fueled extraordinary growth; assets have more than doubled in the past three years to more than $1 trillion today, according to a study by the Securities and Exchange Commission (SEC). But of course, hedge funds are only a part of the broad alternatives universe.
"Alternatives" includes all investments other than stocks and bonds. Strategies generally considered as alternative investments include private equity, leveraged buyout (LBO) funds, arbitrage strategies, hedge strategies and "event-driven" strategies. Many professionals also include commodities, real estate and venture capital investments in the alternative category. Under this broad definition, there are about $3 trillion in assets invested in alternative investments, reported a recent article in The Journal of Alternative Investments.
The huge size of this collection of assets has caused a fair amount of regulatory consternation. Recent debates over whether there is an alternatives bubble have seemed to focus on a perception that alternatives are not appropriate for smaller investors. For example, the SEC recently proposed increasing the amount of money a person must have to invest in a hedge fund to $2.5 million in investable assets from $1 million in net worth. Nonetheless, despite some quite legitimate issues raised about speculation and excessive valuations in real estate and commodities, the demand for alternatives as a broad asset class has continued to grow.
This demand is poignantly captured in comments filed with the SEC: "I find the idea that the definition of an accredited investor is based solely on a net-worth requirement to be repugnant to the principles of equality of all people. Why should the 'rich' be allowed a wider array of investment options just because they are rich? This is often just as much an accident of birth as race or sex." Or, more succinctly: "You have to be rich to be smart?" The general consensus of the commentators seemed to be that the proposed SEC regulation was "inane, ill-conceived and anti-libertarian."
While the debate continues to rage, investment opportunities have continued to expand and the line of demarcation separating alternative strategies from other strategies continues to fade. The recent IPO of Fortress Investment Group indicated a fierce initial demand-after pricing at $18.50 per share, the stock hit the New York Stock Exchange at $35, a quick 89% gain for IPO investors-although perhaps the 19% drop that followed was a more reasoned reaction.
Fortress itself is an example of the convergence occurring in the alternatives space; while hedge funds reportedly make up approximately 60% of the company's total revenue, more than half of its assets under management are in private equity funds, and the company also manages two publicly traded real estate trusts with a combined market value of $3 billion. The undeniable success of Fortress thus far appears to indicate a future for broad "alternatives" managers. Eventually we may see the rise of funds featuring a comprehensive alternatives suite including hedge funds, private equity, real estate and other asset classes that can serve as a strategic complement to the traditional stock/bond portfolio.
Demand for alternatives is so strong, even mutual fund investors are beginning to participate. Some traditional long-only managers are using hedge-fund like strategies such as shorting, while others are getting a taste of the private equity boom. According to a February 23 article in The Wall Street Journal, many fund managers are actively hunting for buyout candidates in order to benefit from the current frenzied pace of private equity deals.
Structured products are beginning to gain in popularity among advisors. These products, which include a broad range of instruments that typically combine a note and a derivative, are among the fastest-growing investment vehicles in the retail market. Last year sales of these securities were estimated to have been $64 billion overall, with approximately 50% driven by retail financial advisors and their clients.
Until the 1990s these products were only used at a handful of private banks, but today more than 30 firms offer them and many brokerage and RIA platforms are making them available. While some advisors have concerns about liquidity, complexity and costs, others claim that benefits like principal protection, risk-adjusted returns and access to hard-to-reach investment sectors make these instruments an important part of their asset allocation process.
As one independent advisor recently explained: "We no longer think solely of hedge funds. We now view all alternatives-real estate, commodities, hedge funds, structured notes-as hedging strategies." The world of alternatives is itself converging, so that hedge fund managers also are private equity managers and vice versa, and real estate investment trusts are managed by both. In other words, alternative soup.
Everything That Rises Must Converge
Flannery O'Connor's exquisite short story, Everything That Rises Must Converge, concerns a bigoted mother and her cynical son during a time of transition. The mother's inability to adapt to change results in an ugly death, and the son is left bereft in a changing world.
Two trends becoming increasingly important today are an expansion of the MFO model, and an explosion of alternative investment choices. Some advisors are adapting to these changes; they are growing their firms by providing services that allow them to capture larger, more profitable client relationships. These services in many cases include the ability to deliver alternative investments.
The demand for alternatives-from institutions, wealthy individuals and everybody else-is fueling a convergence within the industry as managers with broad "alternatives" expertise begin to emerge. Now that alternatives are becoming more available, through a variety of vehicles, the challenge for advisors is to understand how they can most appropriately incorporate these strategies into their business and investment model.
Ultimately, "It's in the heart, she said, and in how you do things and how you do things is because of who you are."
-Flannery O'Connor, Everything That Rises Must Converge
Sharon Weinberg is a managing director for JPMorgan Asset Management.