by Frazer Rice
For example, a lack of concern about taxes is part of the reason hedge funds have fallen into trouble. Many hedge funds have high turnover, which can trigger tax events for investors. Investors holding those hedge fund investments in taxable accounts may find themselves saying, Wait a minute. My hedge fund didn’t grow in value and barely broke even, yet I received a huge tax bill. What the heck is going on here?
The answer is that this investment’s overall performance will be affected by its structure and location from a tax standpoint. If your hedge fund or private equity fund is held in a taxable account, you’ll need to factor in the potential tax hit. However, if you could put those hedge funds into a tax-deferred IRA account or another shielded entity, you would get the benefit of being invested in that product, as well as the after-tax benefit of using structures for your own taxable advantage. Asset location will become a bigger part of the advice that wealth managers and financial advisors give.
There are entire books written about the topic of legal tax avoidance, and the accounting profession is geared toward providing wealthy families this advice. Many other examples of tax planning litter the landscape: tax loss harvesting, planning for the disposition of low basis investments, accelerating or decelerating income to take advantage of varying rates or deduction features, using charitable contributions to lower tax bills, among others. The future of wealth management will center on the advisors’ ability to ascertain and deliver “tax value” to individual families in conjunction with a client’s accounting team. The value of tax savings can be enough to justify fees that outstrip commoditized investment management costs.
A Premium for Customized Services
Due to the compression of fees and the impact of automation on investing, a client with $100,000 won’t be able to garner the same level of attention among investment advisors as they once did. In fact, people who don’t have millions of dollars to invest will need to rely on a computerized, automated advisory service. Robo-advisors or individual advisors with significant “robo-help” are already helping to fill this gap.
Lots of new firms are taking advantage of the technological improvements around investments and building strong businesses around them. Firms like Wealthfront and Betterment—along with larger players like Fidelity, Vanguard and Charles Schwab—do a good job of providing a low-cost algorithmic format for individual investors. Tech behemoths like Google or Amazon can further revolutionize the space. The word “blockchain” will reverberate through the industry as a way to make operations more efficient. That said, it remains to be seen whether these firms can provide the individual attention that the wealthy have become accustomed to seeing.
For customized and personal service with many wealth management firms, clients will likely need to have a minimum of $3 million in assets. Some of the larger wealth management firms may turn away individual wealth business when a client’s assets are below $10 million or may service those clients with a more automated option.
Wealth management firms will want to avoid outliers. Your wealth may have to fit within a model that is built around their goal of reducing risk and a model in which compliance managers oversee portfolio managers. It’s cheaper and less risky for the firm. The idea of a portfolio manager taking a concentrated bet on behalf of a client is becoming less common in the banking world. In a world where diversification is king, this kind of customization requires too much oversight and research to adequately manage across a whole firm.
Instead, the premium wealth management firms will provide clients with a “customized” approach that is easy to manage centrally without the outsized risk that specialized positions present. Wealthy clients who engage those firms will have to pay up—way up—for the benefits that come with that level of service.
Consolidation of Advisors
In the future, I believe we’ll see many advisory firms begin to merge. These consolidations will be driven by the growing cost of compliance and technology, as well as the costly aggravation of dealing with regulators.
For firms that manage less than $500 million in assets, it will be especially onerous to keep investment processes up to speed. How can an investment shop continue to compete and drive value if they don’t have the resources to provide other services and grow? The only way for them to scale up will be to merge with groups that already have the necessary resources or the ability to build them.
Many wealth firms in that $500 million niche have long, proud pedigrees built on advising families on succession planning, and similarly, they’re trying to figure out how to help their business survive its founders. Ironically, like the housekeeper who doesn’t take care of their own place, many wealth firms—whether they are sixty years old or a new entrant to the industry—are struggling to find their way in a market environment where providing customized approaches has become expensive.
There will be a wave of firms trying to figure out how to maneuver the next ten to fifteen years. It will be a challenging environment where technology investment is required to compete with more scalable business models, to provide adequate tools and products for advisors, and to keep up with regulatory and compliance demands. It will be too much for many of them to tackle alone. As a result, many firms will achieve business succession through the solution of consolidation.
When speaking with your wealth manager, take the pulse of their business environment. With such change in the industry, change is inevitable. See if it’s affecting the firm you are using. A great question to ask your wealth manager at a yearly review is whether there have been changes in management or changes in the direction of their firm. Another good question is whether the wealth manager’s compensation structure has been changed in the recent past, and if so, how? Are they investing in technology? Where are they getting their new clients from? Are they seeing new competitors? The answers to those questions can yield great insights beyond the firm’s pitch books.
Higher Barriers of Entry
Firms trying to drive more value may move into the world of financial planning advice, lending capabilities, concierge services, or a trust company feature. The barriers to entry for those types of services are becoming much more expensive. The trust world, for example, is low in profit margins and high in liability. Right now, I think it would be a crazy idea to start a trust company.
Financial planning requires specific training to be effective, and the expertise around the field can be expensive. Additionally, as financial planning becomes more software based, the business model around the field is changing rapidly. It’s difficult to attract and retain talent in the field and to have it drive meaningful business. Wealth management firms that think it’s easy to “bolt on” this offering will be in for a rude surprise.
Finally, while lending to wealthy people can provide a juicy source of revenue (and differentiation), I think it would be difficult for a wealth management firm to start a bank right now. Raising capital in the current environment is especially complicated. Margins are compressing. Smaller established banks are under severe pressure when it comes to dealing with regulatory concerns. The cross-sell of products is coming under increased scrutiny. It will be a supreme challenge for a wealth management firm to start up, fund, and develop a bank with a responsible underwriting culture. Merging a banking operation with a robust fiduciary investment environment will be even tougher.
Management: Active versus Passive
We alluded to this discussion in the investment section. Passive management is a low-cost way to get market returns. If one is going to pay for someone to manage assets, one should expect the manager be able to consistently beat those benchmarks. Otherwise, there is the perfectly acceptable (and cheaper) option of passive management.
However, for much of the past decade, passive managers have outperformed active managers, while also charging much less in management fees. As you recall, fees are a major drag on investor returns. If you can get market returns with
out active management, shouldn’t you have your investments in low-cost, passively managed index funds and ETFs? The answer is that you probably should.
First, the concept of active management can be misleading. Some active managers are high-cost managers who generate index-like returns because they don’t take risks. They are “benchmark huggers.” These types of managers used to be able to say that their “analysis” generated value. In this age of increased information and accountability, these managers are an endangered species. Investors demand performance over a benchmark if they are paying a manager fee.
There is room for high-cost managers who look for opportunities, take risks, and deliver on performance. However, the active managers who deliver consistent high returns on an after-fee basis are difficult to identify and often difficult to access. Active managers who charge low fees, take lots of risks, and provided outsized returns do exist—temporarily. In the world of mutual funds and active managers, where a fund manager might be managing an efficient asset class like large cap stocks, it’s extremely difficult to provide outsized returns over time. To achieve that, the manager would need to make concentrated bets and would need to be right. The manager would need to buy low and sell high, consistently and often. This is a scenario that is difficult to repeat consistently over time.
The counterargument is that everything regresses to a mean, and the people taking more risks may outperform passive management over time. That may be the case, and it’s possible we’ll see a short-term increase in active management returns. However, I still see two major problems with active management in the future.
First, it’s difficult to find these good managers. It’s difficult to predict who is going to make the right calls this quarter and whether their process will continue to be successful. If a manager has a process that has worked over time, other market participants will eventually discover it and mute the advantage. Active managers are reading the same reports and interviewing the same company management teams.
It’s extremely difficult to maintain an investing advantage when information continues to spread as quickly and as widely as possible. These “active” advantages will only deteriorate as it becomes more expensive technologically to gather information to make smarter bets. How many investment managers are going to be able to afford the satellite to count the cars in the company parking lot or track the frequency of trucks moving from a distribution center to an Amazon drone delivery station? How durable is their investment process when the rest of the market catches up? Are managers used to adapting when their “edge” has been discovered (and used) by other managers?
As information becomes more pervasive, it will become harder and harder for investment managers to beat the market. These same difficulties are being experienced in the hedge fund world, where promises are made to deliver market returns with less risk. Since 2008, most hedge funds have delivered disappointing returns. This has led to a compression of their fees and fewer resources to be able to beat market indexes.
Second, on the fee compression side, a high-cost active manager who doesn’t look much different from the passively managed index fund is going to get pulverized. If the S&P 500 index fund can be purchased for three basis points, and you have a fund manager whose fund looks generally the same as the S&P 500 but costs fifty basis points in fees, that fund manager will have to outperform the index fund by forty-seven basis points. Merely outperforming the index isn’t enough; the manager has to outperform it on an after-fee basis. That’s a difficult and challenging hurdle. Some academics think it’s impossible.
You may hear that active managers are getting better and bringing returns, but the trend toward lower-cost managers will continue to put downward pressure on management fees, even for the great active managers. Ultimately, most of these managers will drive their performance through low-cost market exposure (a.k.a. beta) as opposed to individual ideas. Investors will figure out that gambit and move their money to lower-cost alternatives that provide the same performance.
I would square the argument for passive management with the idea that the wealth management industry has been preaching for quite a long time: asset allocation, rather than the choice of asset manager, is what truly drives returns.
Increased Focus on Asset Allocation
Asset allocation is Wealth Management 101, a core concept that will only increase in importance. We’ve been conditioned over time to learn that the allocation of assets provides roughly 85–90 percent of the returns in someone’s portfolio. Shifting assets between asset classes (a strategy known as tactical rebalancing) is thought to provide 8–12 percent of a portfolio’s returns. Last, the selection of the fund manager accounts for up to 5 percent of the return, at best.
In the future, I think the focus on tactical rebalancing and manager selection will diminish, and the focus on asset allocation will grow. In a world where active management is under attack, people are already skeptical of the value of manager selection.
It’s also tough to time the markets well enough to tactically rebalance assets on a consistent basis. I’m all in favor of periodically rebalancing a portfolio to avoid overconcentration in asset classes.
For instance, if the stock market went up 50 percent in a quarter and a client’s portfolio became too heavily weighted in stocks, it’s appropriate to refer back to the plan laid out in the investment policy statement to make sure that investments are allocated according to the client’s needs. Avoiding overconcentration with subtle directional shifts among major asset classes is a good idea. Usually, this involves shifts between stocks versus bonds and cash or shifts between domestic versus international equity. I would recommend reviewing this once a quarter or as needed.
That said, many firms make lots of tactical adjustments in order to look busy. They make lots of little moves within small, highly specialized asset classes. Not only do these moves usually have little impact, but they can also be costly and confusing for the client. To reduce your investment in domestic stocks by half a percent and go from 0.5 to 1 percent in gold doesn’t move the needle. That’s not where most clients want to be when evaluating their portfolios. Even when the moves work out and generate a positive return in that piece of the portfolio, it usually doesn’t add enough return to help you on an after-tax, after-fee, after-inflation basis.
As clients scrutinize the performance they receive on an after-fee basis, we will likely see a redoubled emphasis on asset allocation. In determining the ideal allocation of assets, advisors will spend more time with clients to ensure that the first set of guardrails is in place. They will not only safeguard the ability to grow and preserve wealth but also work to attain the overall goals of the client. Some managers will continue to resort to complicated tactics to give the appearance of adding value, but for the most part, asset allocation will be the primary area of emphasis. My prediction is that instead of focusing so much on tactical rebalancing, more calories will be expended by advisors on moves that will generate more tax savings for clients.
Final Takeaways
As you move forward and assemble your cabinet of advisors, remember to look for a wealth manager (and other advisors) who shows the ability and willingness to listen, diagnose, fix, and anticipate.
A great advisor listens to your problems and examines your situation—where you stand now and where you want to go. The best advisors can diagnose what is and isn’t working in your plan, and they can use their experience and resources to fix the obstacles that stand in the way of the goals you have for your current wealth and your future legacy. A spectacular advisor will then continue to anticipate your needs as conditions change, such as laws, life events, or any number of factors that affect your planning. Additionally, each advisor should be able to work well with the rest of the advisors in your cabinet to ensure you have an integrated approach toward solving your problems and achieving your goals.
Remember to use the tools we’ve discussed
to analyze investments and opportunities. Again, these temptations and opportunities will come from many sources. You might be bombarded with funding pitches at cocktail parties, your brother-in-law may mount an assault to get money for his start-up, or maybe even a faded celebrity on a television commercial urges you to buy an annuity or a set of “specially minted” gold coins.
When opportunities are flying at you from every direction, it’s easy to be overwhelmed or confused. That’s why it’s important to have a process in place and to evaluate each investment based on whether it advances the goals you’ve laid out in your investment policy statement. This statement is vital. It will remind you of the purpose of your investments, and those purposes should drive how you evaluate the liquidity, transparency, and yield of any investment presented to you. You’ll often find many investments to be good for other people’s goals, but not for yours.
If you want to maintain your wealth for your lifetime as well as for future generations, the key to success is often found in the investments you don’t make. Avoiding loss and excessive risk is crucial to success. If you make a critical and expensive mistake in your retirement years, it will be difficult to earn that money back.