The world of Registered Investment Advisors (RIA) is heading downstairs. Typically a community focused on the high net worth (HNW) individual with between $1 million and $5 million of assets to manage; however, the world of financial services is rapidly changing. A wider wealth demographic is looking for financial advice, and a new breed of advisors are looking to capture the middle market. Unfortunately, the time and costs to maintain accounts below a certain dollar value can make accepting those clients prohibitive.
The Investment Company Institute or ICI, reports that 82% of households aged 25-64 with income of at least $100,000 own equities outside of mutual funds. They also report that households aged 65 or older own individual stocks own individual stocks outside of employment retirement plans versus roughly 30% of those younger than 65. That translates to 40 million account holders. A number of them use financial advisors, however, as of 2011, 45% of advisor clients were unsatisfied with the returns they earned on their portfolios. More interestingly, as many as 18 million of them get no financial advice at all. That is a large untapped market. With the population of pre-retirees (40-65) and retirees (65-plus) accounting for roughly half the population by 2020 – more and more of which are retiring with Defined Contribution Plans as opposed to Defined Benefit Plans, it is a market that will continue to grow. RIAs need to create a cost-effective solution that allows them to expand their reach.
Currently, most advisors park clients assets in mutual funds or ETFs. However, these vehicles can be costly to the client and rarely beat the market with any consistency. Per the New York Times, when it comes to mutual funds, fees have a huge range and vary across asset classes. Average annual fees are 1.44% on equity funds. For instance, about 1 in 10 equity funds charge fees of 0.78% or lower (mostly index funds), while another 1 in 10 charge 2.2% or higher. These fees are not including administrative fees, 12b-1 fees or loads, which all can add to the total cost. The “cheaper” alternative is a portfolio of ETFs. Yet, the fees of an advisor managed portfolio of ETFs add up quickly too. ETFs charge, on average, 0.25% to 0.5% in annual management expense; ETF “strategist” fees add another 0.1% to 1.25%, or more; custodial fees range from 0.1% to 0.25% and transaction costs to trade the ETFs add another 0.15%. These are fees that are draining on the client, and of equal importance to the RIA, fees being paid to third parties. Consequently, the appropriate response is to find a cheaper approach for the client that allows the RIA to capture a greater share of the fees paid – thus a win/win.
A number of RIAs have chosen to build their own mutual funds. According to RIABiz, Gemini Fund Services created 50 new funds this year alone, and have added $5 billion in assets under management to such funds. In a separate RIABiz article they note, “Registered investment advisors typically earn their bread and butter by investing client assets in separately managed accounts. While SMAs unquestionably remain a viable business model and a vital trick of the RIA trade, they also may present limitations to RIAs approaching their critical mass – especially ones handling hundreds or thousands of mass-affluent clients… For many advisors, the solution to these dilemmas is to launch a mutual fund of their own.”
Although a self-managed mutual fund has a number of advantages (e.g., small initial investments, ability to raise capital from non-clients through wholesalers, only one portfolio to manage), there is a certain level of critical mass needed for it to be a profitable venture. The start-up costs range between $60,000 and $100,000, plus ongoing annual maintenance costs between $125,000 to $200,000 – on the low side. An advisor would need combined assets of at least $8 million before reaching a breakeven level. In addition to the fees associated with running the fund, there is a new level of compliance especially if the fund is required to regsiter with the Securities and Exchange Commission. The chart on the above is the matrix which Gemini shows to potential mutual fund clients regarding the responsibilities of a fund. Finally, the creation of only one mutual fund requires that all clients follow the same investment strategy rather than a diversified style that matches his or her risk parameters.
What if RIAs could create separate accounts – or essentially individualized mutual funds – that offer the ability to manage a client’s stock portfolio without become a traditional fund manager? Bloodhound Investment Research offers such an approach. An advisor could work with the client to craft the best investment style based on their own individualized needs of risk and return. The Bloodhound System can back-test that strategy over 26-years in a matter of seconds, providing detailed results far beyond that of any mutual fund. The System is a software as a service that allows advisors to build their own customized investment strategy or search a proprietary database of over one million pre-computed strategies. The process strengthens the client relationship by creating meaningful, risk-spreading portfolios that are systematic, impartial and -most importantly – understandable. It facilitates a dialog between client and advisor, enabling them to agree upon the investment strategy that matches the client’s goals and risk tolerance, and thereby the construction of a portfolio that implements that strategy. Finally, it provides the ongoing management of that portfolio with limited future requirements by the advisor to achieve superior returns and more importantly create confidence and trust in the advisor.
RIAs are heading towards a bit of a crossroads. The wealth advisory profession was created as a result of scarcity of relevant knowledge. That knowledge is being codified into automated systems referred to as “robot advisors.” As they grow in sophistication, they will grow beyond the needs of those with limited capital to those of the affluent. At the same time, the number of individuals seeking financial guidance is growing at all wealth levels. The RIA community would like to retain its existing base and capture that growth on a cost effective basis. The creation of personalized mutual funds would be a first step.