Weekend Reading for Financial Planners (February 10-11) 2018


Executive Summary

Enjoy the current installment of “weekend reading for financial planners” – this week’s edition kicks off with some potential talking points to clients about the recent market volatility (and a good reminder that while it’s stressful, this is a time to reinforce your value with clients, and even encourage them to refer other friends and family who may be nervous as well).

Also in the news this week are some new regulatory initiatives around advisory fee disclosures, including both the latest exam priorities from the SEC that are targeting both advisory fees and any less-transparent behind-the-scenes compensation advisors may be earning, and a new standardized “fee table” that Massachusetts may soon start to require all RIAs to use to clearly (and consistently) disclose their compensation.

From there, we have several additional investment-related articles, including a discussion of the implosion $XIV (the short/inverse VIX fund that may have accelerated/amplified the market decline), a look at why the Shiller CAPE ratio deserves more credit than it has being given in recent years, why the rising interest in using actively managed bond funds to deal with potentially rising interest rates may be misplaced, and a strikingly candid discussion from Morningstar on how its new Analyst Ratings have been performing over the past 5 years (and where they can still be improved).

We also have several articles specifically on marketing and business development, from a look at the research on the psychology of referrals and word-of-mouth marketing (hint: it’s all about what the referrer believes he/she can gain in social capital by making the referral, not about helping the advisor being referred!), a good discussion on how closing online prospects who find you via your website is different than the traditional sales process for new clients, and why advisors need to be very careful when promoting any awards or rankings that the firm receives.

We wrap up with three interesting articles, all around the theme of looking differently at common problems: the first looks at how, when we compare income inequality across multiple countries, many of the common explanations for why it is occurring (e.g., decline of unions, rising immigration, etc.) don’t hold up, and that instead it may be the rise of regulatory barriers that are actually insulating and compounding income inequality (especially in professional services, health care, and the financial industry); the second explores how becoming an expert may actually make you more referrable than “just” being a specialist in a niche (though becoming a recognized expert is also arguably harder than “just” focusing on a niche); and the last raises the question of whether the traditional industry mantra “life insurance is sold, not bought” may simply be because historically insurance was so opaque and so hard to buy, and whether the rise of “InsurTech” tools will lead even fee-compensated advisors to increasingly implement insurance recommendations directly for clients, as it becomes easier and easier to actually do so!

Enjoy the “light” reading!


Weekend reading for February 9th – 10th:

How to Communicate With Your Clients About Market Volatility (Claire Akin, Indigo Marketing) – With the sudden rise of significant market volatility this week, which has already put us in the “correction” zone (markets down more than 10% from their highs), client nervousness begins to rise… along with outright phone calls and emails from some clients. Which simply means that now is the time to get proactive in communicating with clients about market volatility (although bear in mind that your most hands-off delegator clients may not have even heard the news in the first place, so don’t scare them!). In terms of what to actually say, Akin suggests some straightforward but good reminder talking points,  including: “This is expected” (volatility is a normal part of market cycles, and in fact a 10% pullback already happens on average about once per year… so we were actually overdue!); remind them that their portfolios are not likely down as much as the market (as a diversified portfolio of stocks and bonds is down far less than the 10%+ decline from the peak of the S&P 500 itself); they haven’t realized any losses yet and now is not the time to sell (yes, it seems ‘obvious’ to you, but it’s still important to actually say it), and in fact may be a time to buy (as a recent Schroders analysis this week shows that the 10 biggest one-day stock declines in the past 30 years produced an average of 25% returns over the following 12 months!). In fact, Akin suggests that this can actually be a good time to encourage referrals, since many people don’t feel a need to change advisors when times are good, but are reminder about the need when the market turns. Accordingly, she suggests strategies like offering a complimentary second opinion to any friends and family of clients, make it easy for people to schedule a quick meeting with you if they want to check in (e.g., using an Online Scheduling software tool), or bring up the question of how their “outside” accounts are doing if there’s still a portion of their portfolio that you’re not managing yourself.

SEC Exam Priorities Target Fee Disclosures To Retail Investors (Mark Schoeff, Investment News) – In its latest “2018 Exam Priorities List” released this week (and the first released by new SEC Commissioner Jay Clayton), the SEC announced that this year it is specifically targeting advisors who charge “excessive” fees and fail to properly disclose them. The primary concern appears to not just be advisors that may be charging high AUM fees, but those who are receiving additional (and potentially undisclosed or not-clearly-disclosed) payments as well, such as also getting 12b-1 fees or other back-end revenue-sharing payments. The SEC is also concerned about whether advisors are actually executing their billing processes properly – i.e., whether fees actually billed from the account are all properly calculated, and are consistent with the advisory agreement that the client originally signed. Notably, the SEC’s exam priorities also note reviewed FINRA’s own operations and regulatory programs, as the SEC evaluates how effectively FINRA is fulfilling its own mission of overseeing broker-dealers in the current landscape.

Massachusetts Regulator Mulls Greater Fee Disclosure (Investment News) – With the ongoing evolution of advisory firm models, Massachusetts regulators are concerned that clients may have trouble fully understanding all the different ways that advisors are being paid, from AUM fees to retainer or subscription fees to potential additional cost layers for third-party TAMP or “robo-advisor-for-advisors” FinTech platforms. Accordingly, the Massachusetts regulator is proposing its own version of a required fee table that all RIAs would have to provide, with the intention of making it easier to compare the different types of fees across various financial advisors. At this point, the proposed is still in the early stages with an initial comment period that is open now, which will be followed by a more formal proposal-and-public-comment process.

$XIV Volpocalypse: A Sea Of Disinformation And Misunderstanding (Kid Dynamite) – Monday’s market downturn coincided with a huge uptick in not just market volatility itself, but also the VIX volatility index, which in turn caused ‘catastrophic’ losses to inverse funds that were shorting volatility (such as the $XIV Credit Suisse Velocity Shares). Understanding the blow-up, though, necessitates a better understanding of the underlying structure itself. $XIV is an Exchange-Traded Note, that had about 15 million shares outstanding (which at $100/share was roughly $1.5B of exposure to short VIX futures), and attempts on a daily basis to adjust its exposure to ensure it continues to provide its expected inverse daily returns. As the VIX began to rise, though, $XIV began to experience losses… which forces it to buy more futures to rebalance itself. Except given the size of $XIV, and the relative illiquidity of the VIX futures market, the necessary buying from $XIV drove the VIX futures higher, which in turn caused greater losses, which triggered a need to buy even more futures to rebalance, in a cascading effect that eventually led to the fund losing more than 80% of its value in a single day. The key point, though, was that the implosion of $XIV, and the associated spike in the VIX that it may have partially helped cause, wasn’t driven by “margin calls” or turmoil of the underlying ETN issuer (Credit Suisse), but instead was simply driven by the rebalancing mechanics of $XIV itself and the feedback loop that can be triggered when an illiquid market moves the “wrong” direction while it still needs to be rebalanced by the end of each day. And because a lot of other market traders take queues from moves in the VIX (and also ProShares’ short VIX ETF, SVXY), the feedback loop that imploded $XIV appears to have contributed to the speed and magnitude of the market decline itself.

CAPE Fear: Why CAPE Naysayers Are Wrong (Rob Arnott & Vitali Kalesnik & Jim Mastruzo, Research Affiliates) – The Shiller P/E10 ratio, also known as “Cyclically Adjusted PE” or CAPE, has been roundly criticized in recent years, in part because it is currently high and has been flashing “warning” signals… yet the market has just continued to power higher (at least, until this week!). CAPE critics have suggested this is because the CAPE is not really as elevated as it may appear, due to the fact that both inflation, volatility, and interest rates are so low (which may justify higher CAPE ratios). Yet as Arnott and his colleagues point out, those factors may ultimately prove temporary, which means if and when they go away, suddenly CAPE ratios will appear to be dangerously high after well… which is notable because interest rates, inflation, and volatility are unlikely to stay permanently low from here. And of course, there’s the simple reality that a high volume of research has already shown that the CAPE ratio is predictive of future (long-term) market returns, and the CAPE predictive value has been supported with both US and international data. Notably, some debate does exist about whether the long-term average CAPE ratio of 16.6 is really still relevant in today’s market, but when the CAPE ratio is nearly 30, the reality is that even with some questions around what the long-term average “should” be, the CAPE ratio is still very high today, which augurs for lower returns from here. In fact, if CAPE ratios merely remain where they are, expected real 10-year returns from here may be no more than about 2% (dividend yields) + 1.5% (long-term real earnings growth) = 3.5% for equities, and even worse if CAPE ratios revert to their long-term means. Though even Arnott and his team acknowledge that the timing of this is very uncertain; while CAPE may be an effective predictor of long-term returns, it remains a poor indicator for short-term market timing.

Fixed Income Fantasies (Cliff Asness, AQR) – In recent years there has been a growing concern that active stock-picking is getting harder and harder with less and less alpha on the table… yet when it comes to fixed income, strong interest remains for active bond managers (especially with the looming potential for a rising interest rate environment). The justifications range from the view that fixed income markets are less efficient, or that blindly purchasing a bond index benchmark to gain access to bonds may be riskier (than just buying the stock index to gain access to a basket of stocks). Yet Asness points out that the bulk of long-term alpha of active bond managers appears to be due less to their actual bond-picking skills, and more to the fact that they simply tend to overweight the amount of credit risk they take relative to their benchmarks (roughly akin to an equity manager who is always overweight in stocks, and tends to outperform simply because stocks go up more often than they go down). Which is even more ironic given that most individual investors purchase bonds as a diversifier for stocks, yet the credit risk of bonds is the part that’s most correlated to stocks… which means that buying active bond managers may actually increase the correlation of the bond allocation to the stock allocation. Though Asness doesn’t go so far as to suggest that investors should only buy a bond index; instead, he notes that bonds appear to exhibit many of their own factors that drive returns (similar to the value, momentum, and other factors for stocks), and that in the future we may simply slice and dice our bond factors the way we are increasingly doing the same with factor investing in stocks as well.

Report Card: How Well Has The Morningstar Analyst Rating Performed? (Jeff Ptak, Morningstar) – The Morningstar Analyst Rating was launched in November 2011, and was intended to be a forward-looking system of evaluating a fund’s potential ability to outperform its peers over a market cycle, granting funds a rating of either Gold, Silver, Bronze, Neutral, or Negative, based on their “five pillars” of the fund’s process, performance, people, parent company, and pricing (as contrasted with the Morningstar Star Ratings, which are purely backward-looking based on performance alone). Looking back on nearly 6 years of data, a Morningstar regression analysis finds that higher-rated funds really did produce better risk-adjusted returns than lower-rated funds – specifically, that any combination of Gold/Silver/Bronze funds materially outperformed Negative funds, and particularly amongst equity (stock) and asset allocation funds. However, there was a non-trivial amount of variability from one time period to another and across various asset classes and geographic regions, and a subsequent event-study analysis of outcomes found limited predictive value for US fixed income funds in particular (though in general Gold ratings were especially predictive in a favorable manner, and once again Negative ratings were highly predictive of funds to avoid). Accordingly, Morningstar acknowledges its own areas for potential improvement to the Analyst Rating approach, and notes that they will look more closely at evaluating predictive value for both risk-adjusted and un-adjusted returns (as some investors just flat out want higher returns, regardless of risk), that there needs to be more distinction between Silver, Bronze, and lower-rated funds (which often had similar results, with only Gold materially outperforming and Negative underperforming), and that additional factors may need to be considered for U.S. funds in particular where the Analyst Ratings were less predictive overall (with the caveat that the entire test period was a fairly strong and consistent bull market in the U.S., and that perhaps the Analyst ratings will show better once a full bull and bear market cycle has occurred).

The Psychology Behind Word-Of-Mouth Marketing (Angela Southall, Social Media Today) – While businesses across all industries have long relied on referrals and word-of-mouth marketing, the nature of social media and the internet has made it more feasible than ever to drive such word-of-mouth marketing efforts. Especially since the reality is that as human beings, we are herd (or “tribal”) animals, where it feels good to be in good standing with the tribe – which means as a consumer of something, if we can refer others to it, we feel good as the referrer to have helped someone in the tribe. Of course, the caveat is that making a referral that does not go well can impair our social status… which means in practice referrals are heavily driven by the perceived risks for the referrer about whether the referral will have a good outcome, or not. Beyond the psychic value of feeling good for marketing a referral, though, as human beings we do respond to incentives, which means providing an incentive (like a reward or prize) can also drive additional referrals… at least, as long as the referral process isn’t seen as being too arduous, and as long as we aren’t still concerned that the financial or other reward may be more than offset by the loss of social capital if the referral doesn’t turn out well. Which reinforces once again that the real driver of referrals and word-of-mouth marketing is not about whether the referrer is financially rewarded, or whether he/she wants to help the person receiving the referral (e.g., the advisor)… instead, it’s almost entirely about whether the referrer feels that his/her own social capital and social standing will be improved by confidently making a referral that turns out well.

How To Close Online Leads (Sara Grillo, Advisor Perspectives) – Learning how to “sell” and close prospective clients is a skill that takes time to develop, as convincing someone to trust you with their financial decisions and life savings is no small feat. But as Grillo points out, the process and what it takes to successfully turn leads and prospects into clients also varies by the means that they contact you – in particular, that convincing in-person and referred prospects to do business with you is different than closing leads that come to you online (e.g., via your advisor website). The reason is that people who shop online to buy products and services tend to really shop online – in other words, they tend to do more research, and come to the table more informed. Which means if your website isn’t effective at communicating information to them, they may not even contact you in the first place! In addition, they’re more likely to be contacting multiple advisors at the same time to explore options… which means it’s especially important to make the first response quickly (i.e., within 2 hours). And because you’re likely being scrutinized carefully from the start, be absolutely certain that anything you commit to is something you actually follow through on (e.g., if you say you are going to send them something, send it, because if you don’t you’ll have broken trust with them before you even have a chance to meet with them!). Ultimately, though, Grillo suggests that the end goal of an online lead shouldn’t necessarily be to close them via email; instead, ask them a probing question (e.g., “what is the #1 thing that resonated with you when you read my blog?”), and try to get them to engage in a follow-up call or meeting with you, which is where you’ll ultimately ask them to do business with you.

Won An Award? Brag With Caution (Tom Giachetti, Investment Advisor) – It’s an honor for your advisory firm to receive an award or recognition for its growth and success… both as validation of a job well done, and because it provides a form of “social proof” that can be very effective at communicating to prospects that the firm is credible and trustworthy. However, Giachetti cautions that Rule 206(4) of the Investment Advisers Act prohibits RIAs from publishing any kind of advertising that directly or indirectly refers to a testimonial regarding the RIA’s advice, analysis, reports, or other services. Fortunately, the SEC has issued no-action letters to at least clarify that if the award is from an unbiased third party, and doesn’t contain any overt statements of a client’s experience or endorsement, the award will not automatically run afoul of the testimonial rules. Nonetheless, if an advisory firm is going to market or refer to any rewards, they are required to also clearly disclose (in a “significant and prominent” manner) the awards’ qualifications and limitations (e.g., how advisors were evaluated, the metrics used to determine the award results, etc.) so consumers are not misled about exactly what the award does (and does not) actually say about the advisory firm’s accomplishments. Which is important, because Giachetti notes that the SEC has been increasingly aggressive on this issue in recent years!

The Captured Economy by Brink Lindsey and Steven TelesMyths Of The 1%: What [Really] Puts People At The Top (Jonathan Rothwell, The Upshot) – Income inequality has become a hot topic in recent years, both around the world, and here within the US. In fact, the US is notable because here, the national share of income to the top 1% has nearly doubled from 11% in 1980 to more than 20% today, which is a more rapid increase in income inequality than any of the other 35 countries in the OECD. Rothwell looks at the economic research that tries to identify why this trend has evolved in the US, and notes that despite the popular discussion, international trade doesn’t appear to be a driver (as ultimately the US imports only a small fraction of the value of its economy, while Denmark and the Netherlands are far more dependent on imports, and have had far less income inequality), nor does it appear to be driven by the rise of technology and other inventions (as countries with a higher volume of patent filings for inventions actually show lower income inequality than countries with less inventive activity). Similarly, when comparing across multiple countries, there’s no evidence that the decline of unions (and associated decline in labor share) in the U.S. are actually driving income inequality, as Britain saw an increase in labor share but also saw an increase in income inequality over the past several decades, while the Netherlands had a decline in labor share but no rise in inequality. And there’s also no apparent correlation between changing immigration shares in the past 20 years, and the rise of top-income shares in various countries; in fact, countries that have absorbed the most immigrants per capital have seen income inequality fall in the past 20 years. So what is the cause? Rothwell suggests that it may ultimately be an indirect and unintended consequence of regulatory barriers that have been erected around various professional services, as almost all of the income growth for top earners has come from just three economic sectors – professional services, finance/insurance, and healthcare – where regulations that are typically intended to protect consumers also have the end result of inhibiting competition. In essence, the case being made – in books like Lindsey and Teles “The Captured Economy” – is that protections intended to protect the average consumer in these various sectors (e.g., protection of software and pharmaceutical patents, indirect subsidies for the financial sector’s risk-taking, the escalation of land-use controls, professions that limit the licensing of paraprofessionals that might provide similar services at a lower cost, etc.) may just be exacerbating income inequality coming out of those very sectors.

Experts Get More Referrals Than Specialists (Steve Wershing, Client Driven Practice) – It’s much easier to attract clients when you have some kind of unique niche that clearly differentiates you, whether by being a specialist in a particular need (e.g., having specialized training, knowledge, and skills to handle a particular scenario or problem for a certain type of clientele), or a recognized expert in a certain topic or subject matter. Though as Wershing points out, specialists by their nature tend to be narrower than experts, such that while both can work, experts tend to get more referrals, because being a thought leader in a particular area of expertise (e.g., by teaching, publishing, appearing in the press, etc.) is able to have broader reach and be relevant (and referral-earning) to a widen range of potential prospects (including even some specialists who themselves need deeper expert help in a particular area). Of course, the caveat is that it’s also arguably even more difficult to become a true recognized expert in an entire subject matter or domain, than to “just” be an accomplished specialist in a particular niche (because the reality is that the narrower the niche is, the ‘easier’ it is to know more about it than anyone else and become a specialist, while the demands of becoming a true expert are broader).

Life Insurance 2.0: Bought And Not Sold (John Lefferts & Chris Aitkens, InsuranceNewsNet) – A common mantra of the life insurance industry is that “life insurance is sold and not bought”, in recognition that because life insurance is complicated and requires people to make difficult decisions about future low-probability events, it “must” have a salesperson to persuade anyone to make the good decision to purchase it because they won’t do it by themselves (even if they need it). But Lefferts and Aitkens suggest that perhaps the real problem is not that insurance must be sold, but that today’s insurance must be sold because of the problem ways that products are designed and distributed in the first place. For instance, the purchasing process for life insurance itself, which includes thumbing through hard-to-understand 20-page illustrations (supported by reams of legalese disclosures), followed by a painfully long and detailed multipage application, scheduling someone to come and take your blood and urine… and then sometimes waiting a month or more to get an answer, resulting in a total process that can take 2-3 months or more. But these are at least mostly problems that technology, and particularly the new category of “InsurTech”, are aiming to improve. For instance, fast and ever-lower-cost gene sequencing technology could soon eliminate the need to go through the traditional medical underwriting process of collecting blood and urine, while improving technology is making the application process itself easier and faster. Which will not only make it easier for consumers to buy insurance, but also make it easier for fee-compensated CFP professionals to evaluate it and make recommendations as well. In fact, given the limited actual success of robo-advisors (but the growing popularity of “robo-technology-for-advisors”), arguably the future of digitized life insurance will not be direct-to-consumer insurance that is bought, but a new wave of tools that make it easier than ever for fee-compensated financial advisors to easily recommend and implement themselves, instead.


I hope you enjoyed the reading! Please leave a comment below to share your thoughts, or make a suggestion of any articles you think I should highlight in a future column!

In the meantime, if you’re interested in more news and information regarding advisor technology, I’d highly recommend checking out Bill Winterberg’s “FPPad” blog on technology for advisors as well.





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