Propelled by the authority of Nobel Laureates, their simplicity of execution and the excess returns they produced during the secular bull market of the 1980 and 1990s, passive investment strategies became a cornerstone of the wealth management business. Since the turn of millennium however, they have suffered two important blows: robo-advisors and market volatility. Together these have raised questions in clients’ minds about the value of advisors who offer passive strategies.
We have all witnessed the advances in technology over the last two decades. Computers that once took up an entire floor in an office building are condensed to pocket sized and can now be used to run a typical passive investment portfolio without the help of an advisor. Indeed, individuals can interact directly with the program to identify the appropriate risk model and the machines will thereafter handle deposits, withdrawals and rebalancing as necessary thereby eliminating the need for human involvement. And like with all technological advances, the machines have made these strategies both low cost and plentiful – in other words, they have become a commodity.
To make matters worse, the new millennium also re-introduced the concept of market volatility and the key risk management tools, diversification and rebalancing, that underpin passive investing have become less and less effective with each passing year. It is common knowledge that correlations in rising markets gradually move towards 1.0 due to globalization and technology; and when markets decline, correlations race to 1.0. In other words, market volatility is back. Without effective risk management tools, clients are vulnerable to the losses that come with volatility and especially with bear markets.
Consequently, one half of the traditional wealth management offering (financial planning and investment management) has become a commodity for many advisors. This begs the question; how can advisors continue to differentiate themselves?
Financial Planning. The first and most important source of differentiation is financial planning. We know clients have sophisticated needs and have neither the time nor the know-how to do it themselves. Each has their own specific circumstances and no two clients are alike. Proper financial planning can produce more value than they will ever earn in their portfolios and it is our job to communicate that value. They cannot get it on their own. They cannot get it from a robo-advisor.
Investment Customization. Robo-advisors essentially offer a one-size fits all solution. Indeed, so do most other investment solutions, including mutual funds and sub-advisors. At Pinnacle we knew that we needed to do more to accommodate the individual circumstances of our clients and the financial planning best practices that we wanted to employ with them.
- Household Management. Assets are managed as a single portfolio at the household level. Most clients have multiple accounts including both taxable and tax deferred accounts. We communicate with clients about one integrated portfolio. Transaction costs are reduced by owning a portfolio security only once across all household accounts instead of owning five identical portfolios in five accounts.
- Tax Management. Each client’s tax situation is different. Taxes can be a very direct way of engaging the client and adding value in an otherwise passive investment portfolio. This means employing both traditional tax loss harvesting techniques as well as asset location. Asset location allows us to allocate securities to the various household accounts based on the security’s tax efficiency. Studies indicate that this may add up to 0.20-0.50% to after-tax returns.*
- Other Customizations. Clients also have options in terms of cash management, which accounts fees are billed from, legacy assets and a variety of ways to transition new clients to new portfolio strategies to manage capital gains for instance.
Risk Management. Potentially the most impactful source of differentiation is risk management. Clients were lulled into complacency with seemingly risk-free equity returns during the 1980s and 1990s. Since 2000, they have experienced volatility and losses with the Tech Bust, the 2008/2009 US Financial Crisis, the 2011 European Financial Crisis and the Stealth Bear Market in 2015. Clients have become more concerned about protecting against losses with each of these downturns. Now with the second longest running bull market on record reaching its final innings, advisors and clients must once again consider and safeguard against potential losses.
The only constant is change itself. Strategic Asset Allocation has always been a cornerstone investment strategy, but has become less differentiated and less effective than it once was. In order to differentiate ourselves we continue to emphasize the value of financial planning; we employ technology that keeps us relevant to clients in strategic portfolios by providing value in portfolio management, tax management and investment customization; and finally, by addressing the greatest client concern as we approach the next bear cycle, “what can you do to protect my assets”.
*”Asset Location: A Generic Framework For Maximizing After-Tax Wealth”, Gobind Daryanani and Chris Cordaro, Journal of Financial Planning, January, 2005
