[Editor's Note: This is the third article in a series. To read the other articles, click here: Article 1, Article 2]

Investment management has always been a somewhat schizophrenic part of wealth management. On one hand, it’s one of the lowest value-added functions that wealth managers provide. But at the same time, most advisory fees are tied to it.

It’s also a negatively convex function—i.e., if you do a great job at it, it doesn’t really help you to get more business. But if you screw it up, you’re toast. 

Like everything else wealth managers do for clients, this function is going to change over the next decade. This article—the third in a series on the future economic model of wealth managers—looks at exactly how.   

Wealth manager investment management today largely consists of allocating client assets across publicly traded securities, mutual funds and ETFs. To be sure, some firms utilize outside separate account managers for a portion of the portfolio and/or include the erstwhile-pooled fund of funds vehicle for private equity or commodities investments. Some have also dabbled in derivative securities such as structured notes (with varying degrees of success). A handful of firms have even tried to create some sizzle by including a “custom” portfolio of individual stocks selected by the firm’s investment team that (remarkably) in aggregate, tracks quite closely to a major index such as the S&P500. 

But going forward, successful wealth management firms are going to have to provide much more value added in this function. Why? Robos and ETFs have made what advisors do today a commodity.

Clients on their own can now easily do a relatively good job of investing their money (perhaps not so good as a wealth manager does, but close enough) and they can do it at almost no cost. And whenever someone can easily do something themselves for a very low cost, they aren’t going to indefinitely pay a lot for someone else to do it for them.

There are many things that wealth managers will do in the future to address this issue. However, there are three that will be common to the most successful firms:

First, rather than just sitting back and letting technology obliterate their value added, they instead are going to embrace it to substantially reduce their clients’ costs and be more tax efficient.

More specifically, there are technology platforms currently used by a handful of UNHW firms that effectively change the role of outside investment managers into “design” firms (i.e., they only select securities). These managers enter their trades through an online portal and all trade execution is done at the wealth manager client portfolio level. This is overseen by an overlay manager, which tracks individual securities by lot (to ensure maximum tax efficiency) and also prevents one part of the portfolio from trading against the other.   

But because the outside manager is only providing the design function (rather than a fully integrated model of design, trading and packaging), many top decile active managers are willing to accept only 0.25 percent of assets for their services instead of their usual 0.65 to 0.85 percent. Thus, the UNHW firm’s clients can take advantage of very good active management at a price that makes more sense and do so in a much more tax efficient manner.

(To be sure, many brokerage firms also use this type of technology. However, they are brokerages and thus, pocket the savings rather than pass them onto their clients.)

At some point in the near future, this technology will migrate down from the UNHW sector to wealth managers that work with mid-sized and smaller clients. It will enable wealth managers to invest client assets at a much lower cost than clients can do on their own—so much so that the savings will offset a large portion of the wealth manager’s fees. (Does this sound a bit familiar to 30 years ago when there were no ETFs and this new thing called “institutional classes” of mutual funds allowed wealth managers to more cost effectively invest client assets than they could do on their own?)

Of course, at some point this technology ultimately will wind up on the desk of the consumer. But there will be a window of time in which wealth managers will have a new relative pricing power. However, these cost savings alone will not fully offset clients’ ability to rationally allocate and acceptably invest their assets for next to nothing.

Second, future successful wealth managers will therefore increase their value added in the investment function by providing access to investments that clients cannot source on their own.

One such area will involve investing in private companies. As noted earlier, most wealth management firm client portfolios today have little to no exposure to these kinds of investments. This is a bit absurd given that the private markets are often much less efficient than the public ones and that private companies constitute more than half of the economy. 

However, to date it has been very hard for wealth managers to rationally invest their client assets into private transactions. The only current means for doing so is through funds of funds that invest in PE blind pools, an archaic method that is quickly headed toward the ash heap of financial history. Why? The pools’ core clients—sovereign funds and pensions—have figured out that this structure is expensive and often creates conflicting incentives between the client and the PE firm.

Consequently, both sovereigns and pensions are racing to disintermediate their PE managers by creating their own direct private equity investment capabilities. And although the PE industry is currently breast stroking its way through an ocean of $100 bills that it needs to find someplace to invest, over time it will have to find new sources of capital. One obvious one is the $5T wealth management industry that is growing at a very high rate and that needs to find investments that clients cannot source on their own.

That much said, it is unlikely that wealth managers will create their own private equity arms. It is not their core competency and the cost of developing these capabilities will be (at least in the near term) prohibitive for most firms. More importantly, the independent wealth management industry is premised on the idea that it provides unconflicted advice and offering products violates that pact.

Hence, it is more likely that future successful firms will directly invest their clients’ assets into individual private companies in the same manner as many family offices do today—i.e., by partnering with specialist private equity firms which will source, negotiate and manage transactions and structure individual investments to meet the unique needs and goals of their clients.

Third, future successful wealth managers will increase their investment value added by going beyond just generating returns that meet their clients’ financial objectives. They are also going to help clients to meet their social goals.

To be sure, “socially conscious” (or “socially responsible”, “economic, social and governance”, etc.) investing has been around for decades. Some of the robos have even included these kinds of portfolios in their offerings. However, this type of investing has historically largely been a negative screening process that excludes certain types of companies (such as tobacco, guns, etc.) and often has produced abysmal investment returns.

Recently, a handful of leading firms (such as Wetherby Asset Management) have developed a much more sophisticated generation of this type of investing. Known as “Impact Investing,” it both produces attractive returns while at the same time evaluating and measuring the social benefit that individual companies produce during an investment period. And clients can now quantify how much social benefit their portfolios are creating on an ongoing basis. 

Many of the industry’s leading wealth management firms are racing to develop similar investment capabilities. Why? Because they can see its importance to large numbers of current and prospective clients. Either they develop these capabilities or they will find themselves at a substantial competitive disadvantage in the future. They also can see that it will be very hard for clients to do this kind of investing on their own. 

I recognize that for many readers, all of these ideas may sound a bit premature, if not a wee bit dramatic. Right now, keeping existing clients and capturing new ones isn’t very hard. And not too many industry participants are getting puckered up.

At the same time, however, many of smartest people in this industry recognize that it’s going to be hard to keep charging a high price for what effectively has already become a commodity. Thus, they are racing to upgrade the value added that they provide in their investment management function. 

As an outside observer of the industry and a believer in the efficiency of markets over time, it will be interesting to see what happens when clients do figure all of this out and things suddenly begin to change. I’m not sure I’d want to be in the position of having to play catch-up.

Mark Hurley is the founder of Undiscovered Managers and the co-founder of Fiduciary Network.