Observations from 2012 – The Good, the Bad and the Ugly

Thursday, 10 January 2013 Posted in SpringReef Insights

At Aronson SpringReef, our work with high net worth families has allowed us the unique opportunity to review dozens of financial advisors and firms across the main advisory models in the wealth management industry – broker-dealers, RIAs, private banks and trust companies. By advising our clients on the quality and performance of these advisors, we have gained unparalleled insight into the trends and practices most prevalent within the industry today.

These trends and practices fall into three categories – the good, the bad and the ugly. For our purposes, the ‘good’ indicates practices followed by some of the most exceptional advisors in the industry, the ‘bad’ highlights substandard trends associated with less capable advisors, and the ‘ugly’ indicates some of the more troubling issues we’ve seen.

As we embark upon a new year, we are pleased to present to you our most noteworthy observations from 2012.

The Good…

1. Impactful Application of Client Fees

In a slow growth, lower return environment, fees can have a meaningful impact on investor returns. Best-in-class financial advisors understand this. They allocate fees to active management in asset classes where there is significant variance around the benchmark such as small cap stocks, international stocks and emerging markets. They simultaneously increase the use of lower cost solutions like ETFs, index funds and laddered portfolios in low variance classes such as U.S. large cap stocks or high-grade U.S. fixed income.

2. Intelligent Response to Lower Yields on Quality Fixed Income

Rather than chasing yield by increasing duration or lowering investment quality, best-in-class advisors have been diversifying into a broad array of low-correlated asset classes such as commodities, MLPs, real estate, equity dividend income and secured equity options to provide not only current income, but also the opportunity for measured growth over time.

3. Using Firm Scale for the Benefit of the Client

Best-in-class financial advisors use the size of their organization and the buying power of their combined client base to access best-of-breed third-party managers and garner pricing improvements for their clients. As a result of this strategy, clients gain access to high-quality manager talent that is often inaccessible to all but the wealthiest investors, while enjoying the reduced fees that come along with their firm’s total commitment to the manager. Additionally, clients are provided with greater diversification within asset classes given they are able to split their allocation among multiple managers.

The Bad…

1. Fees, Fees and More Fees

In 2012, the lowest fee we found was 0.05% (5 basis points), the expense ratio for the Vanguard S&P 500 ETF. The most expensive investment we came across, excluding hedge funds, was a limited partnership that charges 1.25% annually on top of an underlying manager, who charges another 2.00% annually. In our view, there is little chance of consistent outperformance when you start 3.25% behind the benchmark. We see this situation all too frequently – fee levels that far exceed what can be justified based on asset level, complexity of the client need and value of the advisor solution.

Unfortunately, it is not just about the magnitude of the fees, but also the lack of transparency surrounding them. In many cases we have seen, clients are unaware of their total costs and the multiple layers of fees they are paying.

2. Sub-Par Performance Reporting

Performance reporting continues to be an issue in the industry, with numerous firms and advisors failing to provide clients with a clear, comprehensive assessment of how they are performing versus a meaningful benchmark. We continue to regularly see complex portfolios being compared to simple benchmarks, improper benchmark selection, lack of accurate blended benchmarks, hand-crafted Excel® spreadsheets full of errors, and poor accounting of significant cash flows on returns.

3. Excessive Use of Structured Products

In 2012, advisors sold 7,909 separate structured products to U.S. clients, worth just over $39 billion. For the more sophisticated investors, guided by informed, knowledgeable advisors, these vehicles may have been an appropriate component of their overall portfolios. For many other individuals, however, we suspect this may not have been the case.

All too often, we see clients who have been placed in vehicles they don’t understand and that their advisors can’t explain. These vehicles are highly complex, employ derivatives, have poor liquidity, carry counterparty credit risk, lack transparency and carry imbedded fees estimated between 3% and 6% of invested capital.

It appears that some firms and advisors have short memories of lessons learned from prior product failures – rich fees, product complexity and lack of understanding are a potentially dangerous combination.

And the Ugly…

1. Not-So-Open “Open Architecture”

Despite their claims of offering clients a universe of best-in-class solutions, some firms continue to overuse homegrown proprietary products for a significant percentage of their proposed solutions, often despite limited or mediocre performance records.

Additionally, a lack of disclosure regarding revenue sharing and fee concessions continues to create significant conflicts around third-party solution recommendations. We believe ‘best-in-class’ should mean just that – investors shouldn’t have to dig to determine if the ‘class’ is limited to those where the offering advisor or firm makes the most money.

2. Misleading Sample Portfolios

When courting prospective clients, advisors may present a portfolio of managers or mutual funds they are currently recommending. They typically also include the past performance of these managers, depicting how well they have fared over previous years relative to their respective benchmarks.

Unfortunately, the fact that actual clients of the firm may never have owned these specific groups of funds or in these allocations remains hidden deep in the fine-print disclaimers at the back of the presentation – if it is disclosed at all.

In many of these cases, actual client results would have included managers or funds that are no longer recommended by the firm, presumably because of poor performance. And because including them would paint quite a different picture for a prospective client, they are simply excluded.

In short, selecting managers for a current or sample portfolio based on outperformance in prior years, then showing the returns of those managers without proper and visible disclosures is a marketing gimmick that borders on the disingenuous.

3. No Movement on Fiduciary Standard

Two years in the making, the potential SEC rule that would require brokers to act in the best interest of their clients – a significantly higher bar than the suitability standard they must currently meet – has yet to be enacted.

Final Thoughts

The latest data on the wealth management industry indicates there are over 4,200 broker-dealers, more than 315,000 financial advisors, and approximately 26,000 RIAs in the United States. Of these firms and advisors, only a small percentage has the experience, knowledge, and capabilities critical to handling the unique and often complex needs of high net worth individuals and families.

For readers left wondering whether their advisors fall into this small percentage, considering the trends and practices above – the good, the bad and the ugly – is a solid place to start.

Please feel free to contact us if you have any questions about our Insights pieces.

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