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Right Blend Investing, LLC is a registered investment advisor based in Hawthorne, New Jersey. RBI is independently owned and fee-based. RBI was founded by Robert Martorana, who has worked on the buy-side since 1985 as a stock analyst, portfolio manager, research director, financial advisor, and... More
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  • The Future of Wealth Management (Part I) 0 comments
    Aug 5, 2009 2:17 PM
    Key Points
    • The biggest players in wealth management have a vested interest in traditional asset allocation and fund selection.
    • As a result, they neglect passive investment products, tactical asset allocation, and the idea of cash as an asset class.
    • The proliferation of ETFs and the demand for tactical asset allocation will transform the asset management business at all of the large banks.
    Better to meet a bear robbed of her cubs than a fool in his folly. (Proverbs 17:22)
    On July 10, the Wall Street Journal had a front-page article about the failure of asset allocation in 2008. The bear market devastated portfolios, and diversification didn't help: All asset classes become correlated, except cash and Treasurys.  Modern Portfolio Theory now has one foot in the grave, and investors want tactical asset allocation advice from their financial advisors.
    Simple Questions Challenge the Status Quo
    This failure of traditional asset allocation is a huge challenge for fiduciaries in the investment management business. This includes the trust businesses and asset management arms at JPM Chase (NYSE:JPM), Bank of America (NYSE:BAC), Wells Fargo Corp. (NYSE:WFC), Citigroup (NYSE:C), U.S. Bancorp (NYSE:USB), and Fifth Third Bancorp (NASDAQ:FITB). Why? The current model has a hard time answering some very simple questions:
    1. If buy-and-hold is best, why can't I just buy some ETFs from a discount broker?
    2. Since asset allocation determines over 90% of returns, why does tactical asset allocation get so little attention and fund selection get so much attention?
    3. Why is cash neglected as an asset class? 
    A Bear Robbed of Her Cubs
    An investment advisor would rather face a bear robbed of her cubs than to answer questions like these. Candid answers get to the heart of money management as a business (not a profession), and require an admission of how compensation influences investment recommendations.
    Consequently, these discussions rarely happen. The industry has a vested interest in the current system, despite its obvious shortfalls during bear markets. After all, large banks and brokerages are asset-gathering machines that are paid on a fee basis. The best business strategy, then, is to outsource investment performance to third-party managers so the firm can focus on growing assets under management. It's also good business strategy to stick with conventional asset allocation, and not to stray too far from consensus thinking.
    Large firms are no place for folks who rock the boat by stating the obvious. To paraphrase the proverb above, it's better to face a bear market than an investment firm in its folly.
    Tactical Asset Allocation
    An obvious solution to a bear market is tactical asset allocation: Portfolio construction should reflect not only client goals, but the current macroeconomic environment. This would help protect investors from threats that are specific to their investment horizon (i.e., retirement during a period of rising inflation). This requires decisive recommendations and ongoing customization, which clients welcome.
    Alas, change is slow in coming. The asset management business reflexively dismisses tactical asset allocation as a pipe dream, unworthy of serious research and attention. And even though more than 90% of investment returns come from asset allocation, attempts to add value via tactical asset allocation are derided as "market-timing," and dismissed as impossible in principle.
    The Status Quo and Vested Interests
    Why the hostility? The largest players in the asset management industry serving retail and high-net-worth customers have a vested interest in the status quo. Their goal is asset gathering, which encourages the big firms to recommend standard asset mixes, diversified by asset class, and outsourced to third-party providers. Standardization of client portfolios allows firms to spend less money on research and investment performance, and more money on sales and asset gathering.
    While this is a sound strategy during most markets, its assumptions fall apart under stress. Clients find that alternative assets and pooled vehicles are not liquid, and that their investment providers are ill-equipped to adjust their asset allocation in a bear market. Managers are also reluctant to raise cash, since cash generates no fees.
    Consequently, the largest players have vested interests in:
    1.     Asset mixes based on simplistic risk buckets (aggressive, moderate, conservative)
    2.     A long-term approach to asset allocation, with minimal tactical changes
    3.     Standardization of client portfolios
    4.     Neglect of cash as an asset class
    Simplistic risk buckets spit out a mix of stocks and bonds for "aggressive" investors, "conservative" investors, and everyone in between. These tools would now reflexively put a conservative investor in long-term U.S. government bonds. Unfortunately, duration risk now makes long-term bonds very risky vis-à-vis inflation and long-term purchasing power. Nevertheless, this is what Modern Portfolio Theory would recommend. Meanwhile, cash continues to get neglected, despite perfect liquidity, zero credit and duration risk, and its excellent track record as an inflation hedge. But who gets paid to recommend cash?

    It Is Better to Fail Conventionally…
    Since asset management businesses depend on a steady flow of fees, it's best not to rock the boat. Challenges to the current business model are derided as preposterously risky, and not in a client's best interest. The industry values conformity over investment performance, and clients suffer the consequences. I like the way Peter Bernstein put it in Against the Gods: "It is better to fail conventionally than to succeed unconventionally."  
    Outsourcing Is Cheaper, and Less Risky
    It wasn't always this way. Early in my career, from 1985 to 1995, most asset managers had a "do-it-yourself" approach to security selection and portfolio construction. Since wealth managers did everything in-house, we were completely responsible for investment performance. Over time, firms outsourced peripheral asset classes to save money and to broaden their product mix. Eventually, firms outsourced all asset classes as the business fully embraced "best of breed" manager selection. The wealth manager selects the best manager in each asset class, and allocates them accordingly.
    Today, we have the bizarre situation where many players in the industry have successfully outsourced their core business, investment management. This eliminates the risk of underperformance: If an outside manager fails to deliver, the client just gets a new fund. 
    The benefits of this approach are considerable. Investment performance will rarely differ from benchmarks, so client complaints are less frequent, and easier to address. This approach is also very scalable across client portfolios, so more effort can be put into sales, and less into research and investment management.
    Compensation Always Affects Advice
    The evolution to the "best-of-breed" model affects everything at an asset management firm, including compensation. Compensation will be structured to reward conformity to the house view, and the sourcing of new business. Compensation affects advice at any firm, driving everything from portfolio construction to risk-taking behavior. It's well known, for example, that performance fees can encourage excessive risk-taking, so hedge funds address this by using high-water marks. It's less well-known that fee-based compensation encourages conformity, since asset gatherers value the fees from an ongoing relationship rather than investment performance for any given time period. (Hourly fees are even more disconnected from investment performance, but that's another story.)
    Every System Has Its Pros and Cons
    It is essential for professional fiduciaries to be candid with ourselves and our clients about how compensation affects the business of investment management. As fiduciaries, we simply offer the best advice we can within any given system. But it does help for investors to understand how different business models create vested interests in certain approaches to investment management.  
    Disclosure: No positions in stocks mentioned
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