Four for Friday ~ The Investment Advisory World

“Four for Friday” postings feature topics related to a single theme, this time the realm of investment advisory firms.

The future of advice

EY released a report entitled “How will you reframe the future of advice if today’s client is changing?”  Here are the “defining features” that are cited regarding the future of advice:

Overt duty of care

Data and algorithms

True personalization

Transparency and trust

Value for money

Participation and accessibility

And this is the positioning of different competitors, as conceived by EY (click to enlarge):

The report seems to be primarily written for what it terms “Wealth and Private Banks” (WPB) — those larger organizations that are most likely to be EY clients — but the framework allows a firm of any type or size to consider its threats and opportunities in the environment envisioned.

There is a graphic plotting digital adoption preferences of various demographic groups versus their “willingness to share data with WPB,” and one showing current and future technologies “transforming the future of advice.”  With all of those variables in flux, the ecosystem is bound to be full of surprises.

Channels and standards

The channels for investment advice adhere to different standards of advice depending on jurisdiction.  But EY’s “overt duty of care” item referenced above is defined as requiring that “all advice to incorporate and reflect clients’ best interests.”

In the United States, there are registered investment advisory (RIA) firms and broker-dealers, which have different rules.  And many firms are “dual-registered,” wearing both hats.

In her paper, “The worst of both worlds? Dual-registered investment advisers,” Nicole Boyson argues:

As fiduciaries, Registered Investment Advisers (RIAs) must place client interests ahead of their own.  Many fiduciaries are dual-registered as brokers (DRs) and have potential conflicts of interest including revenue sharing from mutual funds, receiving asset-based fees and transaction-based commissions on the same security, and preferential treatment of affiliated mutual funds.  Regulators frequently discipline DRs for these conflicts.  DRs charge their retail RIA clients higher fees than their brokerage clients or clients of independent RIAs.  Finally, DRs prefer institutional share classes of the same underperforming mutual funds they offer brokerage clients.  Many DRs appear to fall short of the fiduciary standard.

Boyson’s analysis focused on the effects on smaller retail clients of the firms.  In another paper, Michael Finke, et. al surveyed advisors, concluding:

Independent RIAs are far more likely to value information on the most important characteristic predicting future returns (expense ratio), to select passive funds, and to implement a passive investing strategy than broker-dealer representatives.

Further, the authors find that dual-registered firms are like brokers in their selection of investments, and unlike independent RIAs.

Will the three categories of advisors stand going forward or will one standard of advice emerge despite pushback from the industry?

Portfolio gaps

A number of asset managers conduct portfolio analyses for RIAs.  In December of 2021, the Capital Group summarized what it saw as three “common gaps” in advisor portfolios.

Fixed income

There’s a preference for what David Swensen called “impure fixed income”:

Although the vast majority of advisors state that equity risk diversification is the top objective for their fixed income portfolios, our analyses show that the average advisor’s fixed income allocation instead tends to be more focused on generating income.

Growth and value

There often is a heavy tilt toward growth stocks, even in distribution-focused portfolios, and “value indexes may be ‘growthier’ than you expect.”  This warning on the eve of 2022 turned out to be prophetic:

With equity markets trading near historic highs from a price-to-earnings perspective, our analyses show that a P/E contractionary event would pose significant risk to many advisors’ portfolios and could be devastating for distribution portfolios in particular.

International equities

Not as prophetic was the statement that “it is possible that we are moving into a devaluation period for the dollar.”  On the contrary, it has been full steam ahead for the currency.

Capital noted the large home-country bias of most portfolios (even when relative valuations on international stocks are attractive), but urged “nuance” in allocations, noting that geographic exposures calculated using revenue look quite different than those based on market capitalization.

Some tendencies like these tend to float (with a lag) according to what has worked in the most recent past, while others tend to be stickier.  The Capital piece is a marketing document for its analysis service and for its way of seeing the world, but such reviews ought to precipitate discussions about which exposures are deemed to be ongoing based on a firm’s beliefs and which are transitory (and why).

Conversations

The EY report focused heavily on the use of technology in the provision of investment advice.  Brian Portnoy turned that idea around in a thread of tweets that started with this one:

Want to know the cutting edge technology in applied behavioral finance?

It’s not what you think.  It’s not a new risk questionnaire nor some piece of software.

In a word, it is:  Conversation.

He offered five core principles “for having impactful conversations.”  They are empathy, attention, humility, openness, and self-awareness.

In a Citywire article on “ways to improve client conversations,” Daniel Crosby took a somewhat different tack, focusing on the stages he feels are necessary in the client conversation.  He also offers five items, starting in the same place as Portnoy did:  empathize, normalize, purpose, proof, and process.

(The balance between the personal and technological aspects of investment advice will be covered in future postings.)