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The Future of Wealth Management (Part II)

Key Points
  • The failure of traditional asset allocation in 2008 will force the wealth management industry to evolve.
  • Falling transaction costs and the proliferation of ETFs makes tactical asset allocation a viable alternative.
  • Firms that do not adapt will lose market share to discount brokers, passive investment products, and independent financial advisors.
  • This affects the asset management divisions 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). 
The challenge for fee-based wealth management firms is to provide an attractive value proposition in both bull and bear markets. The bear market of 2008 has made investors less concerned with security selection and more concerned with asset allocation. What's more, inexpensive ETFs and falling transaction costs pose an enormous challenge to traditional business models, since ETFs has made tactical asset allocation much more cost-effective and practical. Investors can easily divide their money as follows:
Portfolio Construction the Easy Way
·       50% SPY (S&P Depository Receipts, invested in the S&P 500)
·       20% AGG (iShares Barclays Aggregate Bond ETF, invested in the U.S. investment-grade bond market)
·       10% TIP (iShares Barclays TIPS Bond ETF, invested in Treasury Inflation Protected Securities)
·       5% USO (U.S. Oil Fund ETF, invested in the spot price of West Texas Intermediate crude oil)
·       5% GLD (SPDR Gold Shares, a trust invested in Gold bullion)
·       5% EEM (iShares MSCI Emerging Markets, invested in Morgan Stanley's index of emerging market stocks)
·       5% GARTX (Goldman Sachs Absolute Return Tracker, invested to replicate the Goldman Sachs ART hedge-fund index)

A diversified global portfolio of stocks, bonds, with built-in inflation protection. It is also simple, tax-efficient, and cost-effective to rebalance the portfolio as conditions change, prices move and the market outlook changes.  (Mutual funds and alternative assets, on the other hand, have tax and liquidity constraints that make tactical moves impractical.) Thus, the proliferation of ETFs puts a premium on tactical advice rather than manager selection.
Investors will accept passive management within asset classes and sub-classes, as long as there is active management of asset allocation. The desire for tactical advice is a huge challenge for wealth management business models, and ETFs make the issue much harder to ignore.
The Limitations of Passive Vehicles
Even Vanguard Founder John Bogle will admit the that ETFs and other passive vehicles have limitations for an individual investor building a diversified portfolio:
  1. No advice on baseline asset allocation. The Web is full of traditional cake mixes of stocks and bonds based on age and risk tolerance. But the baseline itself is evolving, as ETFs introduce commodities, precious metals, inflation protection, and alternative investments. Investors have moved well beyond simple mixes such as 70% stocks/30% bonds, but it isn't clear what their baseline asset allocation should be these days.
  2. No advice on tactical asset allocation. This is where fiduciaries fear to tread, since the prudent man rule could hold firms liable for losses. A portfolio that isn't properly diversified according to Modern Portfolio Theory is vulnerable, despite the failure of MPT in 2008.
  3. No advice on corporate governance. ETFs and passive products tend to vote their proxies with management. This may not hurt the individual investor, but index investing puts the burden of corporate oversight on a small group of shareholder activists.
Vested Interests in Short-Term Trading
I don't want to come off as bashing large players or a "buy-and-hold" approach. Many clients are well served by a diversified mix of well-run mutual funds. And just as traditional asset managers have a vested interest in the status quo, there are other players that have a vested interest in short-term trading:
  1. CNBC (the 24-hour news cycle rewards a short-term focus)
  2. Online media (advertisers pay for clicks, and high-frequency trading generates more signals, more stories, and more page views)
  3. Discount brokers (trading = commissions, so more trading is better)
Change Is Inevitable
The failure of traditional asset allocation and the proliferation of ETFs make change inevitable. Firms that do not adapt will lose market share to discount brokers, passive investment products, and independent financial advisors.
The pace of change is accelerated by the Internet, which is cutting prices while boosting financial literacy. The Internet reduces prices for every business it touches, and financial services are no different. It is easy to get data, information, opinion, and even investment advice on the Internet, since there is no marginal cost for content replication.
In the case of investment research, there is a rich array of free research on sites such as Seeking Alpha, which makes it hard for paid products to compete. What's more, many bloggers are motivated by fame, not money, so they offer great content for free. I should know: I ran a subscription business at that competed with firms such as Seeking Alpha. As investment web sites proliferated, subscriptions declined and the business was restructured. You simply cannot compete with "free."
1.     ETFs will continue to gain market share.
2.     Investors will increasingly demand advice on tactical asset allocation
3.     A low-return environment will make investors more fee sensitive.
4.     Investors will demand customization of portfolios based not only on their risk tolerance and time horizon, but also on a specific outlook for macroeconomic trends (economic growth, inflation, and interest rates).
Firms that do not adapt will lose market share to discount brokers and independent financial advisors. This is already underway, but wealth management firms that adapt can reverse the trend.
Disclosure: Long SPY, TIP, GLD, USO