Advisors taking more control of portfolios, demands for transparency will shape industry, two insiders say.
This article originally appeared in the December/January 2013 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.
The growth of exchange-traded funds is not just changing the way people invest. It’s also affecting the way advisors operate their businesses and work with clients. In today’s advisory world, the trend is toward efficiency and transparency, with advisors and clients demanding more control over investments and fees. To discuss this changing environment and the role that ETFs are playing in it, we hosted a panel Oct. 4 at the Morningstar ETF Invest Conference. Joining us was Paul Hatch, vice chairman of Morgan Stanley Smith Barney, the largest wirehouse with 17,000 advisors and $1.8 trillion in assets, and Mark Wiedman, the global head of iShares, the world’s biggest provider of ETFs. Below is an edited transcript of our discussion.
Scott Burns: Today, I’d like to discuss the role of the financial advisor and how it’s changed. Paul, in your 29 years of experience, you started as an advisor and worked your way up the company. Is the role of the advisor more important, less important, or the same today as it was when you started?
Paul Hatch: I don’t know if I would use the words “more important” or “less.” The role of the advisor has always been important. I think it would be fair to say that the role of an advisor is far more challenging today than it was 30 years ago. The expansion of different types of solutions that are available to advisors, regulation, the difficulty of trying to get returns for clients in an environment in which equity returns are single digits and volatility remains with us all make it a lot harder for advisors than it was before.
The role has changed from one in which advisors focus primarily on questions such as “should we be in equities?” or “should we be in fixed income?” to really managing that whole process. Over the past five years, the rise of the rep-as-PM [representative as portfolio manager] movement, which has really been around for more than two decades, has been remarkable. It was keyed off by 2007– 2008, in which advisors thought that their third-party portfolio managers would protect them from catastrophic losses. But the third-party managers were never hired to do that. So, advisors started to change their role.
It’s going to change the industry. It is a permanent trend and changes the way advisors view themselves with their clients. They’re taking on more accountability and responsibility. It will make the wirehouse community look more like the RIA community, which I think is a good thing.
Burns: Mark, you’ve got the global view. Do we see this happening elsewhere?
Mark Wiedman: Throughout the West, the forces behind what Paul’s talking about are inexorable, and they are palpable. In the United States, over the past 10 to 15 years, we’ve seen the gradual rise of fee-based advice. We’re seeing it broadly in the asset-management industry, not just in wealth advisory. We’re seeing a value migration. It’s like an hourglass. The central piece, which is long-only active management, is slowly declining. There are many winners in that category, and there could be growth, but in general, value has migrated out of that category, and it’s going in two directions. It’s going upward toward portfolio construction and asset allocation. And then we’re also seeing value migrating to beta exposures. That’s because the real value in working with clients is constructing portfolios and then offering them broad exposures as efficiently as possible.
The same phenomenon is happening in Europe, triggered by market forces, but also by regulatory changes. On Jan. 1, the United Kingdom ends any form of inducement to sell a product for any financial advisor. What that means is that commissions and trailers go away. Unlike here, where there’s a very large fee-based community, there is a very small community like that in the UK.
Burns: As the advisor takes on more of this management and responsibility, whether it’s the selection of securities or the allocation, is this good for the client?
Hatch: I think so. The closer the portfolio manager is to the client, the more likely the solution is going to be correct for what the client wants. That presumes that the portfolio manager has adequate expertise. That’s the challenge that the industry faces today. But it’s also the changing nature of the rep-as-PM movement. Twenty years ago, the rep-as-PM movement was advisors who focused on just choosing individual securities. Today, rep as PM in the wirehouse space, and I suspect it’s the same in the RIA community, is more about asset allocation and fund selection, as Mark described. Reps are pretty good at using the resources that they have on asset allocation and matching that allocation to specific models that work for the client. That’s the problem. If you don’t have the advisor who personally knows the client, it’s very difficult to get that kind of customized list.
Now, we can all argue what kind of expertise is needed to do asset allocation and then fund selection. Frankly, I’d say that the industry is challenged there right now. I’d say that it’s not where it needs to be. But ultimately, the move to having those decisions made by the advisors is the right one, because they’re closest to their clients.
Wiedman: A key thing that gives me optimism is the alignment of transparent fee structures. A shift toward the client paying for advice directly, and knowing that he or she is paying for such, and having a transparent price in the products that the client is invested in, create a clarity of purpose that is clean. That has to be better for the client.
It does not solve the issue that Paul’s getting at, which is there are eternal mysteries. How should we allocate a portfolio? What are this client’s needs and how should we adjust our worldview to meet these needs? That has to be re-posed in a relationship between the advisor and the client. Or for those advisors who think that their whole purpose is working with clients and understanding them but they’re not really an investor, they can retain third-party managers who create the asset allocation. That is entirely consistent with what I’m talking about, the hourglass, where we have value migrating up to those third-party managers. As our CEO, Larry Fink, likes to say, “Beta is the new alpha.” Now, that’s a completely obscure phrase (laughter). I’m not sure what it means. But I think what he’s getting at is it’s a good thing to be a third-party manager.
Transparency Is the Future
Burns: I agree. This transparency of fees challenges the existing distribution paradigm. How does the asset-management world face this challenge?
Wiedman: We, as a firm, run different economic models in how we work with distributors. The fundamental issue to me is that the advisor and the platform that the advisor works with have to get paid somehow. I have a personal preference that it’s best if that person pays for it transparently. That is not the market reality almost anywhere outside the United States today. So, we also have many relationships with big distributors, because that’s ultimately how they get paid.
In Europe, for example, you will see that, typically, mutual funds will cost 175 basis points or so. Canada is even higher, 220 or so. All of the economics of paying the advisor or the distributor, as opposed to the actual alpha generation or portfolio management, are completely obscure to the end investor. So, I don’t think we have a perfect world here in the United States. But it’s pretty good by most standards.
Hatch: Transparency is good. It’s just like competition. It drives us to a place where we provide better value, and it’s going to be a better value for clients. When it becomes a better value for clients, we have more people who come into the business. Business as a whole will ultimately benefit by driving and embracing transparency rather than trying to move away from it. It’s the difference between a communist society and a democratic free-market society (laughter).
Burns: This move will have a very big impact on the economics of your platform.
Hatch: Sure, it hits our economics. There is only so much money to go around. Transparency will drive more of that out, not give us more. But we do have to get to a better place. We do have to challenge ourselves as an industry, and we have to challenge our advisors. If you ask any advisor, I’m certain they would say, “Listen, if everybody’s going to play by the same rules, I’m OK with disclosing all of my compensation.” I think most advisors would be surprised that their clients have no clue how they’re paid. But ultimately, it’s the best place for us to go. The wirehouse community is OK with it.
Burns: There’s a lot of talk about the fiduciary standard. Where do things stand with the regulators, or does it even matter?
Hatch: It’s a lot of hot air. Anything that we do on the fiduciary side is good, but come on. All of the advisors in this room who don’t believe you’re fiduciary, please raise your hand. Not a single one of them will raise their hand. They all grew up thinking that their job was to take care of their clients. “The most important thing is what happens with my clients.” That’s how advisors think. They embrace what we think of as their fiduciary obligation. I’m all for what Congress is doing. If it helps consumers have confidence in the system, then I’m for that. But it doesn’t help advisors. They already think they’re fiduciaries. The vast majority of them act every day in that capacity.
Burns: Mark, when you’re out there talking to clients in the market, how are you dealing with trust? How should we get people back into trusting investing, trusting advisors?
Wiedman: It’s about fee structures and transparency. It’s much more important than legal standards. As fee structures change behavior changes. My dad’s a doctor. He is a real fiduciary. He’s 83, still practicing medicine. He is old-school and cannot believe any of the shenanigans of the last 30 years of modern medicine. He watches medical reps walking in to offer various training seminars and the like to physicians. That modifies their behavior. They are physicians who are still acting as a fiduciary, but they’re perhaps favoring this drug over another one. Fee structure changes behavior.
If you want to know what’s going to happen to ETFs in the retail world, just follow fee-based accounts. Wherever they arise, ETFs follow. Wherever they don’t exist, no one sells ETFs. So, I think the world does change with fee standards being different, because all those physicians, they think they’re doing the right thing for their patients.
Hatch: There is a difference between advisors and every other business in the world. Advisors start with their client; they’re going to have that client 40 years from now. So, everything they do, they know, comes back to roost. They care about them. They are like family. That’s how advisors think about clients.
Yes, I get how economics works. It says that people will move differently depending on their incentives. But there is a difference in this industry, and it’s because advisors’ view is dominated by what they have to do for clients in the long term. Even the ones who we don’t think are doing as good a job, if you ask them, they think they are.
That said, while I disagree with your doctor analogy, I would be happy if the industry went to nothing but fee-based. Truthfully, I would. I just think it’s the right thing for the client.
The New Benchmarking
Burns: So, we’ve got incentives aligned. We’ve got advisors acting closer to the investor’s portfolio. How do we know if they’re doing a good job or not?
Hatch: We have a real challenge, because the industry tracks performance by products. But the client doesn’t care about products. The client cares about their actual solution. We don’t do a good job of finding out how well clients do, although when we do—and I know Morningstar has done some great work on this—it’s clear that clients’ actual returns aren’t good.
In the wirehouse space, advisors don’t have their own track record. As an industry, that’s where we have to go. If we’re going to embrace reps as PMs, then we should challenge and make sure that the job they’re doing is adequate for their clients. Ultimately, we should get to a place where advisors should have to disclose what their returns are to their clients, how much they have in assets, and the type of client base that they have. That would spur the kind of force we need to get advisors who don’t meet those standards to move up to those standards. Everybody improves when standards are improved.
Burns: I totally agree. We want to create a situation where the investor can ask, before they sign up with somebody, “What am I getting myself into?” Not just how did you do, but how did you do it? They are the same questions Morningstar has been asking of asset managers for 25 years.
Hatch: But if we do that, one of the things that we all have to get away from is that we’ve been spinning this web of lies for a long time. We’ve been telling investors they should measure themselves relative to other indexes or other investors. But they don’t care! They can’t use their relative return to send their kid to college or retire on. In 2007–2008, if you told me I’d beat the benchmark by 10%, I don’t care. I still lost 25%! I can’t retire anymore. I’m not excited. I didn’t go to my advisor and say, “Hey, thanks, we’re only losing 25%.”
We just have to get to a better place in how we focus on solutions for our clients, that the solutions are absolute according to their needs, and that advisors are required to disclose how well they actually do. If we do that, the really good advisors will rise to the top. Everybody in this room should love and embrace that particular concept, because we should all say that the people who can’t do a good job—if they’re not capable of meeting clients’ needs—they shouldn’t be allowed to do it.
Burns: The move to goal from benchmark is a real shift.
Hatch: We realized we needed to do this. We have a system now that benchmarks all of our clients and all of our advisors, and we compare them in risk-adjusted buckets. That’s the first step. I would like to see us also create absolute benchmarks, in which clients define the type of return or, probably more appropriately, the kind of risk that they want to take—risk defined by both volatility as well as absolute loss—and use those benchmarks to see how close advisors can come to getting portfolios put together for that.
I’m not saying it’s an easy thing. I’m not saying it’s not complex. But I’m tired of people in the industry telling me that it’s difficult, so we can’t do it. That’s not true. We all make more money than God, and if we’re going to take those kinds of returns, then we owe it to our clients to ensure that we meet their needs. I would say that, today, we don’t meet their needs.
Burns: Shifting gears a bit, I’d like to focus on what’s happening outside the United States and on another way the role of advisors is changing. Paul, how much attention are advisors paying to Europe, compared to what they were doing even 10 years ago?
Hatch: A lot more, but all of our clients today in the U.S. are still making huge bets that the U.S. is going to outperform the rest of the world. I’m not sure that’s a really good bet. So, while there has been a great deal of flow to global products, particularly in emerging markets, over the last five years, it’s still so underallocated. Additionally, all of us in the brokerage community are trying to grow our business outside the United States as fast as we can. So, the trend towards global products is just starting. It’s going to be much more important five years and 10 years from now than it is today.
Burns: Mark, when you go outside the U.S., is home-country bias more or less than what we see in the U.S.?
Wiedman: Let me frame it this way. One percent of the portfolios of Asia ex- Japan investors are invested in U.S. equities. So, the home bias is pronounced everywhere in the world, but it is diminishing slowly. Our own home bias has to do with the insularity of the United States. In Europe, they think of European investing as an asset class. They’ll go to the U.S., but going global is another matter.
I was at lunch today with a group of professional investors, advisors, and I asked what their cash allocation was in the early summer. They said that it was somewhere around 5% to 10% across their portfolios. In Europe, the allocations at the same time were around 35% to 40% to cash, due to tremendous fear in the eurozone. Something in my mind doesn’t compute between those two numbers, because the speed of transmission between a financial problem in Europe and an impact in the United States is five hours. London opens five hours before New York. When I think about a truly global investing community, people would have a deeper appreciation that the failure of a bank in 1938 called Creditanstalt immediately triggered global panic. And the same thing could happen today. People still have such a heavy home bias.
Burns: Paul, we talk about it, you see it: Portfolios are “light” in diversification. How do we change this investment behavior?
Hatch: It’s the advisor. I hate to keep going back to the same solution, but investors range from people who have not the first clue as to what a stock is to people who are brain surgeons and spend all their spare time studying the markets. But even the brain surgeons can’t come close to the amount of time that portfolio managers spend in their lifetimes on investing. Retail investors have always made terrible timing decisions. They make terrible decisions, even professional investors do. So, there is plenty of reasons to believe that people in the United States ought to be required to get an investors license, just like a driver’s license, before they can invest for themselves (laughter). One of the worst things that ever happened was self-directed accounts. They’re terrible. They’re not diversified. Target-date funds are great because they took the decision away from investors.
The way that we can change this industry is to have more reps as PM—more reps taking on the advisor role for clients and taking on discretion on behalf of their clients and being held accountable for what happens to those clients. Because today what happens in nondiscretionary accounts? Nobody’s accountable. Everybody just says, “Well, the client made the decision.” Then, we argue about whether or not there was enough disclosure or whether it was suitable. But we get back to the same place: a bad result for the client.
I believe that we need to move toward outcome-based solutions, or however you want to define it, to help advisors make those decisions, rather than have those decisions be made further and further away from the client, or having the client make those decisions. Advisors should be held accountable, they should be held responsible, and they should be compensated for it.
Transforming Fixed Income
Burns: When I always talk about ETFs, I always talk about them as a technology. Mark, you and I have talked about how technology and ETFs are changing the fixed-income market, which is a lot bigger than the stock market. What’s happening there?
Wiedman: Over the next 10 years, it is going to be one of the most fundamental transformations in investing in capital markets, The trading and liquidity in fixed-income instruments will migrate out of an over-the-counter interaction between a customer and a dealer to public, transparent liquid markets. It’s happening for a couple of reasons.
One is that ETF technology and the notion of putting financial exposures out on a market and having it priced intraday has caught investors’ imagination—both retail and institutional. The other big driver is that investment-bank dealer balance sheets are shrinking. Corporate inventories at big investment banks have shrunk by 70%. Somebody has to provide the liquidity, the matching service. I suggest that that is migrating out into the public markets in the form of ETFs or other vehicles that will look like ETFs—maybe not exactly as they’re structured today.
To give you a sense of potential, currently only 0.3% of all U.S. bonds are sitting inside of an ETF. Equities is 2.2%. I submit that the logic behind a fixed-income ETF is even more compelling for the fixed-income markets than it is for an equity-based ETF. One of the guys I had lunch with today does tax-managed index accounts, which means he creates a separate account and buys hundreds of securities for his high-net-worth client. Terrific, very logical. He tax-manages it very efficiently. He can’t do that in the bonds space. Liquidity has dried up to the point in the bond world that not even financial institutions can do that so easily.
We’re going to see a transformation. We in this room tend to think of ETFs as substitutes for mutual funds. That’s half the story. The other half is that they’re capital markets instruments. They’re trading vehicles. Because they can marry different buyers and sellers in a central marketplace in a world where the dealers are stepping back, ETFs have tremendous opportunity to transform the fixed-income market and shine a giant light right into the markets. We’ll see it in retail world. We’ll see it in institutional world.
Just to give you a sense of the potential, earlier this year, we did, in one day, a $1.4 billion ETF fixed-income trade. This client consolidated 1,400 individual line items into four ETFs. What did they get? They got liquidity, they got simplicity, and in this case, they also have got immediate premium because the NAV was lower than the market price. That kind of transition is just starting. In the future, you’ll see banks, insurance companies, and pension funds—the real fixed-income players— moving into the ETF market. The benefit for the people in this room is liquidity. The benefit for them is transparency.
This is the spot of the ETF business where there’s still evangelization necessary. In ETF equity land, people have heard this story, and they’re either buyers or they’re not. In fixed-income land, we’re still in very early stages. I met with a chief investment officer of a top insurance company in the United States. He did not know about the basic ability to in-kind an ETF out of the security. That basic arbitrage mechanism was unknown to him. Why? Because he’s a fixed-income professional, and fixed-income people don’t really know a lot about ETFs. So, what we’ll need to do is make our vehicles look more like bonds, but yet retain the transparency and democratic nature of the ETF.
Hatch: Most advisors for the last 25 to 30 years thought they could manage fixed income. You hear them talk about it all the time. “I don’t need to a managed account for fixed income; I just ladder bonds. What’s so hard? You don’t have to do any credit stuff. You just choose them based on their maturity and what month they pay and then you buy them.”
Obviously, they realized they can’t do that anymore. They realized that many of the markets that they thought were rate markets are credit markets—that’s the first thing that happened to them. Second thing that happened to them is all the rates were low, so it’s difficult for them to get the kind of flow that their clients are looking for in order to pay for what they have. In order to do that, they have to move further and further out on the curve, which makes them less and less comfortable, and they have to move further and further out on the credit spectrum, which also makes them less comfortable. Now, they realize interest rates are some day going to rise. It may be 400 years from now, I don’t know. But they know it’s something that’s going to happen. Their confidence about managing a laddered-bond portfolio when interest rates are secularly down is very different than their confidence in managing a fixed-income portfolio when interest rates are secularly up.
Because of that, ETFs are starting to get some flows, which they should. That’s an enlightened approach. It’s a better for our clients. It’s better pricing. It’s better risk management. It’s better all the way around. Advisors can instead focus on the things that they do best.
Wiedman: This market, especially as it affects wealth advisors and their clients, is shrouded in darkness. People think, “Oh, I can buy individual bonds.” Matt Tucker, who is responsible for portfolio management of our fixed-income ETFs, did an experiment. He bought an individual muni bond at $103 at one place and went out and tried to purchase it at another place. The guy tries to sell him at $108, and he says, “That’s five points more. I got a Bloomberg, OK. What are you doing?” The guy says, “That’s great, but I’m still selling it to you at $108, and if you don’t want to buy it, somebody else will.” That fundamental opacity—five points—gets me excited about the future of fixed-income ETFs.
Burns: Paul, the role of fixed income in the portfolio is also undergoing dramatic change. For so long, it was the ballast, but are we in a place now where fixed income is the risk and not the reducer of risk?
Hatch: Fixed income is such a broad category today. Thirty years ago, a lot of the retail investing in fixed income was Treasuries and munis. Today, I see much broader market, and it is because of the low-rate environment. I don’t believe that fixed-income allocations are going to go down, not in the U.S. As our population gets older, fixed income will continue to play a very important role in clients’ portfolios. As interest rates eventually go higher, how we manage that will be important. But people don’t look at fixed income the way they did before. Most advisors today use it for income and they use it because they’re trying to control overall lost.
Burns: But it’s incredibly challenging for an advisor. There are folks in the boomer generation who were overallocated to equity, whether it was in their 401(k) or elsewhere. They come out of that and…
Hatch: Now, they’re overallocated to fixed income.
Burns: But how do you tell somebody who’s moving from accumulation to decumulation, hey, from an asset-allocation risk standpoint, the math says more fixed income. From a price fundamentals standpoint, the math says less fixed income. How are advisors solving this? It’s a very strong tension.
Hatch: Being an advisor has always been a combination of cold-blooded analysis and cold-hearted reality. We have to be both a professor and a psychologist to work with our clients. There’s an old saying, “You help your client invest to the sleeping point.” What kind of risk does the client want to take, so that when they wake up in the morning that they don’t freak out every day.
If you just do a straight analysis—this is how much money you have, this is the your goal, there’s the straight line that says how you’re going to invest it, and historically this is what happened, we ran Monte Carlo—they don’t care!
In the end, what you say is, “We’re going to put 50% of your portfolio in fixed income, because that means tomorrow you’re not going to come here and take all your money out and go put it in the back yard.” Now, if that’s what advisors have to do to do that, that’s what we do.
Most advisors are trying to do the very best job they can for their clients. It’s better for them than just giving up and saying, “Go take the money and put it in a money market fund,” which every day that our clients do that is another day that they’re going to have to take more risk in the future in order to get the returns they need. So I think most of them are using fixed income to get clients comfortable. The reality is most of our clients are probably underallocated to equities and will be underallocated for the next two decades.