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Clients invest for the long haul and advisors have short-term revenue needs making the AUM model imperfect at best
June 11, 2014 — 5:26 PM UTC by Guest Columnist Robert Boslego
Brooke’s Note: This article’s suggestion, first floated by Michael Kitces a few years ago seems to come out of left field but it is also a ball thrown on a line to the catcher at the plate. The fee problem is a real one in the advisor business. See: Ron Rhoades, a lawyer, asks: Has Sheryl Garrett invented an RIA future of attorney-like comp?. Most consultants (and ex-consultants like Mark Tibergien) say advisors, at least the good ones, charge too little considering the scope of their services. Part of the problem is a business model. Commissions are imperfect, fees for AUM are imperfect and retainers are challenged at best. Robert Boslego seems to finally offer a Middle Way to gain the best of the AUM fee model and a retainer — allowing skilled advisors to get paid what they deserve and concentrate on running their practice because clients won’t chisel them on fees.
Over the past two decades, many financial advisory firms borrowed from asset managers the assets-under-management revenue model — and to many the method represents a Holy Grail of sorts.
After all, when the markets rise, advisors’ revenues rise on auto-pilot. When clients’ paper assets tumble — all things equal — so do the revenues of the firm managing the assets, which represents a form of rough justice.
But while the market’s ups and downs cause client anguish, it typically does not represent a material hit on their cash flow. This aspect of the rough justice equation is not so true for the financial advisory firm. Though few RIAs are fracking oil on the side, the firms are really very much in the same boat as Exxon-Mobil when it comes to making revenue projections for the year. The oil giant’s revenues fluctuate with the price of oil and production levels.
Too many checks?
In recent years, some advisors using the AUM method have tried mitigating this dynamic commodity effect by shifting their firm’s pricing model to fixed-fee retainers to stabilize fee income. But under a careful analysis, the fixed-fee retainer model is not the panacea it may appear to be either for the advisor or the client.
One big problem with annual retainers is that they are “salient” payment mechanisms — so named because they stand out with the subtlety of a lawyer’s invoice, requiring the client to write a check in many cases. That in-your-face quality makes this fee model inherently more difficult for advisors to market, and makes it harder for advisors to retain clients compared to the AUM model, where monthly fees can be directly deducted by the advisor from client accounts. Out of sight, out of mind.
Other downsides to the retainer model are that it may generate fewer revenues than the AUM method over time, and that advisors may still not achieve the stability they seek in prolonged down markets as compensation for the lower fees. Finally, managing a fixed-price retainer model in competition with the AUM model in a fluctuating market-price environment, as we have experienced, can produce marketing and pricing havoc in up and down markets. See: Fidelity counsels RIAs to suck it up and go after 'millionaires of tomorrow’ but with a strict discipline.
Advisors may be tempted to — consciously or subconsciously — to keep fee their income steadier by investing too conservatively.
To exaggerate absurdly to make a point, an RIA determined to have stable fee income would invest a client’s assets in all liquid, cash-equivalent assets. See: Before taking a self-imposed vow of silence, Ron Rhoades sounds off on the RIA industry and tells what’s it’s like to hit a professional wall.
With this potentially damaging misalignment of client and firm interests surrounding fees, I suggest that an RIA take a page out of the oil industry’s playbook and set up hedges on their revenues. This is a time-tested approach though, is rarely used by RIAs. Commodity businesses have found that the benefits from hedging exceed the costs. Based on my own experience advising more than 100 oil and gas companies starting in the mid-1980s, these firms widely prefer to hedge future income to meet budgets and achieve strategic plans.
In this article, I discuss why advisors should eschew shifting to the fixed retainer approach as a means of stabilizing their revenues and consider hedging AUM revenues as a more reliable, and less business-disruptive means, to stabilize revenues.
What may account for the success of the AUM pricing model with clients is the manner in which fees are paid and the apparent alignment of the advisor’s interests with the client’s interests. However, this alignment of interests is not necessarily true. Advisors’ short-term needs may be dissimilar to those of many of its clients.
The deduction of a fee from the client’s account does not necessarily trigger a cost-benefit analysis each time by the client. This is appropriate and desirable because advisors want to keep the client’s focus on the long-term, not being reactive to short-term events. Investors often respond poorly to losses, abandoning the strategy at the wrong time, in effect locking in losses. Advisors can provide value by preventing this behavior. Submitting retainer invoices after a down period in the markets can be highly counterproductive to keeping clients focused on the long-term, not to mention detrimental to the firm’s efforts at retaining clients. See: 9 things advisors to 401(k) plans must do to keep clients out of hot water.
The AUM model may also be successful because it aligns the advisor’s interests with the client’s interests to a large extent. If AUM drops in a down market, the fee drops as well, providing a discount in fees to the client when the client is feeling the loss. It also provides an incentive to the advisor to maximize the returns, within the investor’s risk tolerances. See: Which type of AUM is worth more to a buyer?.
But there is a mismatch between the short-term income requirements of advisors and the long-term investment horizons of many clients, creating different short-term risk tolerances. Down cycles that seriously reduce advisors’ revenues is the big drawback to AUM pricing.
Advisors must meet overhead one-year out and spend on marketing and infrastructure to win clients. Many wealth clients have 20 to 30 year investment time horizons. As fiduciaries, advisors are required to put their clients’ interests first when selecting their portfolio allocations. See: Performance measurement challenges for investors who live in a perpetual time horizon world.
Fixed retainer pricing makes fees more salient than AUM pricing, and research shows that more salient fees are less attractive to consumers. As Michael Kitces says in his article Why Annual Retainer Fees Won’t Overtake The AUM Model), making prospective clients more cost-conscious inevitably leads some to choose an alternative that either is less expensive, or is at least less fee-salient so the cost of services doesn’t feel as painful.
Highly noticeable annual retainer fees causes more clients, than those under AUM pricing, to deeply analyze the value proposition of the services, not just initially when becoming a client, but on an ongoing basis. Research shows that to remain competitive with the less salient AUM model, a retainer-based firm would actually have to charge less money per client for the same services. Achieving greater income stability may come at a high price in client turnover, thereby increasing marketing efforts and costs.
And retainer pricing may not result in the desired stability of revenues. Retainer pricing can result in less competitive pricing than AUM pricing when markets cycle lower. If an advisor tries to keep the same retainer fee, when AUM competitors are charging less due to lower AUM, the fixed fee may have to be reduced to compete. In other words, fees tend to ratchet downward, not up.
When markets cycle higher, it may be difficult for the advisor to raise retainers as fast as the AUM pricing model. Over a multi-year time horizon, the stickiness of fixed retainers can reduce profitability and could even threaten the viability of the business if staff and overhead costs rise faster than fixed fee revenues.
Hedging AUM income
An alternative solution to shifting to fixed retainer fees is to hedge the advisor’s AUM income. This hedging of AUM income is separate and distinct from hedging client accounts themselves. For example, if the advisor is collecting a fee of 1.2% per annum on $1 billion in AUM, the fee would be $12 million, if AUM remained steady. The AUM income hedge would be a hedge on the $12 million income stream, not the $1 billion of client assets. The advisor may wish to explain to clients why it hedges its income but not the clients’ accounts; i.e., to meet its overhead for the year.
The hedging concept itself is fairly simple. If the average allocation is 70% equities and 30% bonds, for instance, then the RIA could short an equivalent portfolio out a year. If stock or bond prices fall, the gains from the hedge could offset fees lost from AUM.
Such a hedge would to be reduce systemic market risk. The actual gain/loss from AUM income depends of course on exactly what is in their portfolios. As long as the basis risk—the difference between the gain/loss in income vs. gain/loss of the hedge — is smaller than the systemic market risk, the reduces market exposure. See: What RIAs need to know about systemic risks in the wake of the flash crash.
Oil producers and other commodity-price sensitive businesses have long learned the value of hedging their price risks. They increase their income by increasing production and assets, not by betting on prices.
Price risk affects cash flow, budgets, and competitiveness. Increasing AUM by winning new business is the path to success and prosperity. Marketing requires a dependable budget. See: The marketing naughty and nice list.
For an RIA, this could prove to be a giant competitive advantage in down markets. The firm would have the ability to spend to acquire new clients when others need to cut back due to difficult market conditions.
Prior to implementing a hedging program, it is useful to assess the potential costs and benefits of various hedging strategies vs. being unhedged for the budget and strategic plan periods. I recommend a six-step process to decide whether hedging is the solution for an advisor, and if so, what strategy to follow: Define objectives and evaluation criteria, define risk exposure, define risk tolerances, define hedge instruments and strategies, assess hedging strategies, and comparing the costs/benefits/risks of hedge strategies to unhedged AUM outcomes.
There are many dimensions to hedge strategies. One major distinction is whether the strategy is static or dynamic. A static strategy is one in which the hedge is placed and held for some pre-defined time period before it is closed or rolled. For example, if using stock and bond futures to hedge income, the hedges for each month would be closed as the AUM income stream is earned (realized).
A dynamic strategy has more moving parts. The hedge size may be increased or decreased, depending on other criteria designed to adjust hedges according to the size of the risk. Market valuations, risk preferences or other algorithms could be used in the decision process.
The most important consideration is to develop a systematic, rules-based process. Making decisions and trade offs in advance enables them to be objective and unemotional, as well as to conduct back tests to assess how the strategy would have performed.
Cost-Benefit-Risk Analysis Steps
Step 1: Define Objectives and Performance Criteria
I believe that it is very important to clearly define and link the objectives of any hedging strategy or program to achieving the advisor’s strategic plan and operating budgets. By doing so, the performance/evaluation criteria for the hedge program can be clearly defined. I believe the emphasis should be on meeting budgets and strategic plans rather than beating market benchmarks.
Having clearly defined objectives is key to not abandoning the hedge if prices temporarily go higher. It’s also important to keep in mind that the AUM for the following year(s) can be hedged at a higher level if prices go higher and stay higher.
Step 2: Perform risk analysis
In this context, I define risk as the sensitivity of AUM income to price changes. The forward risk will depend on underlying portfolio allocations and assumptions about future price means, variances, and correlations.
If there are many different assets in the portfolios, I recommend focusing on the systemic market price risk. The variance of the underlying portfolios to the market risk is known as the basis risk. As long as the basis risk is smaller than the market risk, hedging will reduce risk.
Step 3: Assess risk tolerances
One focus of this step is to assess how large a drop in income would interfere with budgeted activities and meeting overhead. The other focus is to assess how the advisor feels about different sizes of losses of AUM as well as different opportunity losses (hedge losses) if prices rise.
Step 4: Define hedge instruments and strategies
The statement of objectives, the risk analysis and risk tolerances will jointly determine which hedge strategies and instruments should be analyzed. Considerations for types of hedge strategies are whether the strategy will be static or dynamic.
Static strategies are those that are initiated and completed regardless of market developments. Dynamic strategies are those that change hedge levels based on some pre-determined criteria, such as market valuation or risk preferences.
Hedge instruments may include futures, options and ETFs. Criteria for selecting the specific instruments should include hedge effectiveness, market liquidity (bid-ask spreads) and friction costs. See: How ETFs have been oversold when it comes to flexibility, lower costs and tax efficiency.
Step 5: Assess risk/return of AUM with hedges
Just as in the unhedged risk analysis, the task is to develop scenarios as well as simulations for the forward budget and strategic plan periods to calculate the risks/costs/benefits of each strategy, as defined in the unhedged risk analysis.
Step 6: Compare costs/benefits of hedged vs. unhedged AUM strategies
As a result of the steps above, a comprehensive quantitative and qualitative comparison of your choices is needed. Risk preferences need to be used to judge the overall costs and benefits of each strategy vs. not hedging.
Hedge programs, like any form of insurance, have an expected cost over time. However, if AUM drops as a result of price decline, they can provide positive payouts in those years when needed.
Hedging also helps the advisor avoid another potential conflict of interest. Often, advisors cannot charge AUM fees on assets sitting in cash. This creates a conflict if the advisor actively manages allocations and expects stock market prices to drop. By hedging, the advisor can move assets to cash in that case without losing AUM income if prices drop. See: An X-ray of one affluent, educated and sophisticated investor’s portfolio shows how it was chewed up by fees.
Adjusting fixed retainers is a major marketing and sales effort and challenge. Implementing a hedge program along with AUM pricing structure does not require renegotiating prices with clients because the AUM percentage remains the same.
AUM pricing is more robust than fixed price retainers in marketing and retaining clients. Furthermore, fixed priced annual retainers do not provide the stability of revenues as desired by advisors. When markets cycle lower, lower AUM pricing will exert downside pressure on fixed prices, or else there may be a major client retention problem. When markets cycle higher, there is difficulty marketing the same services to the same clients for higher fees just because the market went up.
Hedging AUM enables the advisor to stick with the same pricing formulae whether in an up or down market. If the hedge makes money in a down market, the advisor is better able to continue marketing programs than its competitors who don’t hedge. This can be a major competitive advantage.
Robert Boslego is managing director of Boslego Risk Services, a consulting firm in Santa Barbara, Calif. He earned a Bachelor of Arts degree cum laude in economics from Harvard College and an MBA from the Stanford University Graduate School of Business. Contact him at Boslego@Boslego.com.
Mentioned in this article:
Boslego Risk Services
Top Executive: Robert Boslego
Top Executive: Michael Kitces
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