Market Volatility and Small Firms
“RED SKY IN THE MORNING, SHEPHERD’S WARNING “
After a good long run on the upside there is nothing like the emergence of serious volatility in the securities market to get everyone’s attention. Following that bouncing ball leads one to ponder the effects of a market really hitting the skids to the point where a serious downturn was on the horizon followed by a long term sideways cycle. As brokers we all realize that eternal optimism is in our D.N.A., but we’ve lived through enough cycles to know that nothing is forever.
So, that brings me to a “what if” scenario whereby you have to consider what the effects of a serious downturn in the market might mean to a small “firm”. By that I specifically mean one investment advisor who is operating on their own under a principal/agent, investment counsel/portfolio manager or correspondent network platform(s). These brokers operate largely under ‘independent’ models, pay for and support their operating structures and conduct their client service for fees pegged to assets under management. With revenue closely linked to A.U.M. and a volatile market spiralling into a serious downturn the small, independent (as described above) could now be facing a threat of survival.
Why? It’s all relatively simple arithmetic. In a buoyant market all firms, large and small, will enjoy success in the asset gathering process whether through prospecting for new accounts or through market performance. In actuality, in a bull market, the increase in assets for a small firm or individual will likely be substantially higher on a comparative basis to a percentage gain in a market measurement. Notably, a fair percentage of asset gain will be tied directly to market performance. However, the disparity between the good news is in the bad news is when the downturn occurs and the revenue results are more pronounced; as market performance buckles, asset values crumble, and assets in the form of clients take flight.
It is at this point where the survival factors begin to surface. When comparing the resources of large bank-owned firms to that of an individual owner under, say, a P/A model it will be the economies of scale that will tell the tale. This is where the asset based pricing strategy for the small firm operator will be called into question:
– Small advisors operate on much smaller margins than larger institutions and those margins will be hard pressed. A broker with a large institution does not bear the operating expenses of the firm. Payouts may be cut and support staff costs may be downgraded, but the I.A. still receives a known revenue stream. (Unless of course, they are terminated for failing to maintain production standards)
– As assets fall in value and new assets slow, clients will leave the playground. Revenue will follow suit and the income needed to run the business will shrink rapidly. Profitability for the small owner can rapidly slide to zero.
– The safety valves for small firms which depend on the maintenance of assets for their fee-based businesses will be much more difficult to turn on than those of their large competitors. I am speaking here of a firm’s traditional turn-to cuts in expense to offset falling revenue. The small operator does not have legions of support staff to lay-off or nickel and dime items to slash (payout, etc.) in order to weather the financial drought of a sideways market. Without those economies of scale to go to, a small broker will not have the wherewithal to right-size even for the short term.
– There is also a considerable impact in the running of a small business wherein many brokers operate on managing assets less than $100,000,000.00. Without a measure of traditional support staff the independent operator will be working double-time to keep up with client communications (i.e. complaints) and the daily management routine. And further, the running of a business entails hard expenses that will not disappear as quickly as the revenue.
– Lastly, a bull market covers up a lot of mistakes for brokers and firms alike. Asset-based reliant IA’s are fully aware of what their AUM is, but really don’t follow the number on a net arrive/leave basis or the impact of market performance. Without new assets coming in a’ la Glengarry Glen Ross “always be closing” scenario, the rapid decline in a severe downturn will hit quickly. (See Alex Baldwin’s motivational pep talk in the movie – a classic!)
With a continued tradition of business to be run on an asset-based fee strategy and a growing emphasis on passive investing in ETF’s and Mutual Funds for fully invested portfolios, the question around a market down – assets down – fees down scenario is what to do to diversify the deep-down revenue risk to the small, independent broker?
Maybe consider some of these that are emerging south of the border:
– Some smaller firms can weather the tough storms because they have placed greater emphasis on management technology and marketing/media innovation. Investing in new tools can be an expensive proposition but, drops your exposure to traditional expenses that will surface during the difficult periods.
– Consider what it costs to service a client account on an annual basis and charge a service fee on top of an asset-based fee.
– Some IA’s are changing their approach to the style of fee system; instead of levying fees based on size of A.U.M. they are simply charging a flat fee for service rendered on an hourly or annual basis.
– To shore up asset- based pricing there can be an escalator fee added to off-set inflation or cost of living adjustments.
– And, now that you’re not working for the company store and nobody is turning on the lights for you in the morning, try cutting back on your business life style. Sharpen your pencil and the supra-payout you’ve been enjoying will stretch your success further during the hard times.
At the end of the day the add-ons can help diversify the asset-based pricing system, but how much in a really crazy market? Of course, we don’t honestly believe the market gods will let that happen eh? Just in case, remember “ABC – Always Be Closing”!
Brian L. Curry
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