Whichever way you choose to grow your advice practice a robust plan is essential.

There is increasing commentary about the need for financial advice firms to grow in order to survive. This question of growth is starting to reappear post an elongated period of consternation and consolidation in our profession.

This article, sponsored by Insight Investment, will explore the two means traditionally used to grow financial advice practices – through acquisition and organically.

Acquisition

Acquisition – or inorganic growth – has been responsible for the creation of financial planning behemoths such as the big four bank, AMP and IOOF. A glance at any ‘top 100 dealer group survey’ published over the last decade will feature these groups in the top 20 and, more often, the top 10 when ranked by planner numbers.

In the post Royal Commission environment, most of these corporates have or are in the process of divesting or simply closing their financial planning businesses – some at a significant loss – creating a new series of M&A activity among the next tier of dealer groups.

The key benefits of inorganic growth are that it enables you to buy:

• market share – increase growth and profitability quickly
• talent – increase your talent pool through acquisition, particularly skillsets not already available in your team
• clients – you can target acquisition of groups that have the types of clients you want, to either grow a specific segment or diversify your client base.

The 2019 EY Global Capital Confidence Barometer found that companies, broadly, are responding to the pressure to grow or defend their market position against the challenges being posed through digital and technology through mergers and acquisition (M&A).

Interestingly, this year’s barometer found that company management is under increasing pressure to generate long term value that goes beyond just delivering returns for shareholders. There’s a greater focus on creating long-term value for customers, employees, and society as a whole. Arguably, the first of these metrics, long term value for customers, should be front and centre with any transaction between financial advice businesses. If anyone was in any doubt about the importance of a customer-centric view, last year’s Royal Commission put this to rest.

M&A activity in Australia was expected to increase over 2019 according to respondents to KPMG’s Evolving Deals Landscape 2018 survey. At a time where digital disruption is rife, there’s increased competition for clients and the regulatory environment continues to tighten, companies need to increase their capabilities and identify growth opportunities.

The KPMG survey showed that 40 percent of M&A activity is being driven by companies wanting to increase market share, and 38 percent through industry consolidation. KPMG identified a busy year this year for financial services; 48 percent of survey respondents expected an increase in M&A activity, hardly surprising given the big four banks and other vertically integrated businesses had indicated their collective exits from financial advice.

According to the KMPG survey there are drivers and barriers for M&A activity (figure one). Interestingly, a key barrier of increasing impact to M&A is legal and regulatory constraints. KPGM identified this increase as being driven by respondents in the financial services sector, with 52 percent identifying regulatory issues as a key barrier to M&A.

What makes a successful acquisition?

For an acquisition strategy to be successful, a clear strategy for value creation post deal is critical. Essential ingredients include cultural fit, the retention of key people and effective due diligence. While these are broad metrics, they’re as applicable to M&A activity between financial advice practices. After all, while acquisition can be an effective growth strategy for advice practices, it comes adorned with cautionary tales that have seen various dealer groups and financial planning firms come and go over the years.

The key issues for M&A within the financial advice sector are typically centred around the terms of acquisition (including price), cultural alignment issues that are often present when bringing two entities (and associated personalities) together, and effective deployment of current resourcing to the new combined entity. The transition from revenue to EBIT valuation models, potential lack of visibility of financials and further regulatory change can also add to the complexity of the acquisition strategy.

Organic growth

Finding the right business to buy, and at the right price, can be challenging. By the time you make sure the cultural fit is right, the numbers may not add up. The numbers may add up, but key talent may indicate their unwillingness to stay. Acquired clients may not feel loyalty to the new firm, particularly if the adviser with whom they have a relationship with departs. There are many moving parts, and each has the capacity to derail a plan that looks good on paper.

For those advice firms that are considering long-term growth, an organic growth strategy may prove to be lower risk and more sustainable. One way to do this is through a client segmentation strategy.

Much has been discussed about the growing inability of financial advice firms to service clients with simpler needs or smaller investment balances due to the rising operational and compliance costs associated with a highly regulated environment. In particular, the cost of managing investment portfolios (particularly bespoke portfolios) has from many reports become preclusive for financial advice firms and their clients.

As a result many firms have segmented their client base to reflect appropriate matching of their advice value proposition and particular segments of client needs. This has been a positive step for many firms, creating better alignment with clients and facilitating a more sustainable business model.

Client segmentation strategy

Conceptually, a client segmentation strategy concept is relatively straightforward. It aims to improve the efficiency and profitability of a financial advice business by matching the level of services provided to each client and their value to the firm.

Traditionally, clients have been segmented as A, B, C (and so on), with A clients being the high net worth, high touch clients and those at the lower end being the basic, low end clients with few assets and basic needs. It’s important, however, to ensure that all clients receive advice that is compliant, in line with client objectives and meets the best interests test.

On top of providing a compliant level of advice, you can then define the services provided for each segment. By starting with the absolute must do requirements for each client, you can add service levels to the higher touch clients.

If for example, your segments were A, B and C, you can define the basic service provided to each, adding more services for top-tier clients or differentiating between each based on service delivery. For example, a financial planning practice may charge A and B clients a regular monthly or quarterly fee (and provide the services to justify it) but simply charge C clients on an hourly basis as services are required.

It’s a good idea to develop a client segment matrix (figure two). Consider what value add you and your team can provide to clients. For example, you may provide a quarterly newsletter to all clients, but provide additional opportunities for A and B clients to meet with or hear from a range of finance professions – investment managers, research analysts, brokers or tax specialists.

Building a pipeline of ‘potential’ segment clients in a controlled manner may create a lower cost alternative to acquiring clients that meet the segment criteria ‘on paper’ or waiting until these clients meet the target segment profile at some point in the future. The financial advice relationship is built on trust, which in most cases develops over a period of time.

This organic approach allows time to build trust and may present the adviser with profitable and loyal clients over time, as long as the cost to serve this pipeline segment is managed efficiently. And remember; clients don’t necessarily remain in their segments, they may move up over time as they accumulate assets, receive inheritances, progress in their careers or grow their businesses.

If you choose to segment your clients and then grow specific segments, it is imperative to manage the cost to serve. One element of this is portfolio governance and implementation. In-house or bespoke portfolios are likely to be uneconomic for clients with smaller balances, so a solution is required that is reasonably priced, but provides sufficient diversification within a robust governance and implementation framework in order to minimise agency risk.

Organic growth holds inherently less risk than acquisition and has historically been present in many financial planning firms by way of fee structures based on percentage of assets (allowing investment portfolio growth to provide revenue uplift over time) and all important client referrals. However the move to fee for service pricing models has changed the nature of business growth.

Strong financial planning firms continue to attract client referrals and as is supported by various academic studies, referred clients are more profitable and exhibit greater loyalty^[1]. However when assessing potential client suitability, are financial planning firms compelled to accept only those referrals that meet their preferred segment attributes currently? What if a referred prospective client has strong potential to meet the criteria at some point in the not so distant future?  Can this be managed without diluting the benefits of the segmented client model?

The answer may lie in the relative risk and expense of organic growth versus acquisition. This requires an assessment of cost per client via acquisition versus the cost of serving a ‘potential’ segment client. For example, assuming a client with $500,000 in superannuation, with insurances, mortgage and ongoing budget coaching program generates $6,000 in revenue per year. Assuming a multiple of 2.5 times, the cost of client acquisition is $15,000 without allowing for associated financing of acquisition^[2].

Whichever way you choose to grow your advice practice – by acquisition or through organic growth – a robust plan and a sound understanding of costs to service your newly acquired (and existing) clients is essential to ensure the ongoing success and profitability of your practice.

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[1] Do referral programs increase profits? Faculty Wharton Case Study Vol. 5, No 1, 2013; Philipp Schmidt, Bernd Skiera and Christophe Van den Bulte
[2] Example only, assumptions made are not an actual case, a forecast or a guide to client pricing models

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This allocation of money into investible assets in portfolio construction has evolved over time to become an integral part of investment.

Modern Portfolio Theory, pioneered by Harry Markowitz in 1952, introduced investors to the risk/return trade-off. It focused on how investors can construct a portfolio to maximise expected return for a given level of risk. This allocation of money into investible assets has evolved over time to become an integral part of investing.

This article will explore asset allocation – strategic, tactical and dynamic – and consider how each can add value to an investment portfolio.

What is asset allocation?

When Markowitz first introduced the concept of asset allocation, there were but few asset classes to choose from – shares, bonds, property and cash. Today there are significantly more. Share investments can span developed and emerging markets, large, mid and small-cap companies, or be focused on specific sectors. Bonds have evolved into fixed income, which can be short or long-dated, issued by governments, semi-government authorities or corporates in developed or developing countries. Hybrid investments carrying attributes of shared and bonds proliferate, while esoteric ways of packaging debt for investors abound. Then, of course, there is the burgeoning alternatives sector.

Asset allocation aims to balance risk and return by allocating a portfolio’s assets according to stated objectives, which include return goals, risk tolerance and investment horizon. Assets are divided within and across asset classes and aims to provide diversification, an investment tenet that underpins portfolio construction.

For investors to benefit from diversification, investments need to be allocated across assets that are not correlated with one another; or, in other words, behave differently from each other. Every asset class has a relationship with others – some have very little or no relation to each other (or low correlation), whereas others are inversely connected, performing at different times of the investment cycle (negatively correlated). Other assets might be highly correlated, meaning they tend to do well – or not – at the same point of the investment cycle.

Diversification is a key investment tenet because it helps to spread risk by allocated assets across a range of investments, thereby reducing the potential for losses. Diversification not only spreads investment risk, it can help increase longer-term returns by minimising drawdowns over an investment cycle.

Asset allocation is often held up as the driver of overall returns, more so than individual investment selection. As such, asset allocation needs to be viewed as a dynamic process, constantly reviewed to ensure the asset mix will continue to meet investors’ objectives.

Strategic asset allocation

Strategic asset allocation aims to balance a portfolio’s risk and return by setting the target weightings of different asset classes according to a given set of investment objectives, time horizon and risk tolerance. The output is a proportional combination of assets based on the expected risk and return for each asset class. It is not set and forget; asset allocation needs to be rebalanced within target ranges from time to time, as investment returns can impact allocation to asset classes within the portfolio over time.

Asset allocation models are designed to meet specific investment objectives; this generally informs the proportion of growth and defensive assets, which is a key role of strategic asset allocation.

A more conservative investment objective (lower growth, more risk averse, capital protection) generally favours a greater proportion of defensive assets. A high growth objective typically favours growth investments.

Figure one provides strategic asset allocation ranges for three diversified funds offered by an Australian superannuation fund – conservative, balanced and high growth. The allocation ranges are driven by the investment objectives for each portfolio.

Strategic asset allocation is generally driven by a number of assumptions, such as long-term historical risk, returns and correlation of asset classes, or may be based on forecasts of long term returns, risk and correlation of asset classes. Forecasts used in strategic asset allocation are generally based on long term expectations for economic growth and inflation, interest rates, corporate earnings growth and other economic and market factors.

Tactical asset allocation

Tactical asset allocation takes a more active stance on the relatively passive strategic asset allocation, by adjusting target asset allocation weights for shorter periods. This aims to opportunistically allocate capital to the most attractive asset classes at different times in the investment cycle.

The key difference between strategic asset allocation and tactical asset allocation is the time horizon across which asset allocation decisions are made. Strategic asset allocation models are focused on investment across the investment cycles to generate long-term average returns from each asset class; tactical decisions aim to generate attractive returns and avoid losses by focusing on a shorter term outlook for asset classes and investments within those asset classes.

Tactical asset allocation decisions can be based on a range of factors; relative valuations between asset classes, momentum or investor sentiment. Decisions can be made at the fund manager’s discretion or may be systematic or model driven.

Dynamic asset allocation

While tactical asset allocation considered to be short-term and strategic asset allocation longer term, dynamic asset allocation is somewhere in between. Like tactical, dynamic asset allocation is a derivation from strategic asset allocation. The difference, however, is that tactical asset allocation is generally adopted in conjunction with strategic asset allocation. Dynamic asset allocation may be used as a discrete approach to allocating assets.

Dynamic asset allocation is a recognition that asset classes often behave in different ways at different points in economic and market cycles. As a result, it requires the investment team to constantly adjust the mix of assets as markets rise and fall, and as the economy strengthens and weakens. The dynamic asset allocation process allows a portfolio to reflect new information and adjust the asset allocation accordingly.

At its simplest, a dynamic asset allocation strategy sees the sale of assets that decline and the purchase of assets that increase in value. For example, if the Australian sharemarket shows weakness, a dynamic asset allocator would sell Australian shares in anticipation of further decreases; conversely, if the market is strong, they would purchase shares in anticipation of continued gains.

As such, dynamic asset allocation relies on a portfolio manager’s expertise and judgment, rather than a target mix of assets. It generally involves regular portfolio adjustments over the shorter term in response to market or economic conditions. Dynamic asset allocation typically has no target asset mix, because asset allocation decisions are driven by assessments of current and future market and economic trends.

Dynamic asset allocation generally does not rely on historical correlations. Correlations can change over time and can increase during economic instability. For example, prior to the Global Financial Crisis, it was widely accepted that bonds and equities are negatively correlated. During the GFC – and several times since – that correlation changed significantly.

Dynamic asset allocation recognises that markets are driven by cycles, both longer term cycles and ‘mini-cycles’. A multi-year ‘secular’ cycle generally drives the primary trends in the share market and are driven by valuations. Shorter cycles, often driven by investor sentiment, economic conditions and central bank actions, can also impact investor returns. As outlined in the following case study, ‘mini-cycles’ can have a significant impact on the risk and return profile of a portfolio.

Case study: Insight Investment – Government bonds in a low inflation world – an asset allocation perspective

Globalisation and technology have been key factors in the low inflation story. There has been some academic debate as to whether the dis-inflationary impact of globalisation may be waning and, amid President Trump’s administration’s use of tariffs as a trade weapon, that may well be the case. But some analysis suggests the impact of technology on inflation has been increasing. At present, technology may well be exerting a greater role than globalisation on low inflation in the US.

So long as the inflation backdrop remains benign, it is likely that the equity-bond correlation will remain negative. As a general rule, the role of government bonds in Insight Investments’ multi-asset portfolio is determined by two key factors:

• The fundamental assessment of their attractiveness on a standalone basis
• Their potential to act as a diversifying asset

At current levels of yield, it would be controversial to make a strong case to hold government bonds on an absolute valuation basis. But on the latter criteria, the case is clear.

In a low inflation regime where CPI consistently undershoots central bank targets, government bonds are a diversifying asset in an environment where risk assets are highly dependent on the growth outlook.

Many of Insight Investments’ asset allocation models tend to focus on relative valuations. Specifically, income (dividends for equity, coupon from bonds) are the most stable component of the return structure in each asset class over the long-term. However, these series trend through time (i.e. they are not stationary). That is probably because of changes in inflation and risk premia which cause ‘regime shifts’. De-trending the relative valuation series gets around many of the problems of ‘changing levels’. These ‘rate of change’ models, based on the dividend-yield gap, tend to perform better than their unadjusted counterparts.

Such indicators are useful because even in an environment where the correlation between equities and bonds is generally negative, we have seen windows where that correlation switches and sharp rises in bond yields adverse impacts on equity markets and other risk assets can have – as they did, for example, in the ‘tapertantrum’ of 2013.

Clearly, at present, yields would have to back up some way to present a valuation threat to equity markets. But could it be that the benign inflation environment that has enabled government bonds to perform so well will eventually impact on equities which, in turn, could drag the economy lower?

Source: Global Macro Research – Asset Allocation and Growth Cycles August 2019

There is a significant body of research that confirms the importance of asset allocation in determining portfolio returns from a diversified portfolio. Advisers should consider the type of asset allocation used to build portfolios for clients, whether investing in a multi-asset or diversified fund, or through a managed account. Asset allocation decisions, particularly when market conditions change, can determine whether clients’ investment objectives are met.

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A significant amount of effort and expertise is required to get to the point of portfolio construction.

Financial advice practices face a myriad of decisions every day. One of the more important decisions is whether to insource or outsource portfolio construction at a financial planning practice level. While on the surface it may seem a reasonably simple binary decision, a significant amount of effort and expertise is required to get to the point of portfolio construction and ongoing portfolio management. This article discusses a range of factors that advice practices would need to consider if they were to insource portfolio construction.

The decision to insource or outsource portfolio construction is an important one. The investment approach taken by your practice will impact your clients and their ability to realise their financial objectives. Whichever route you take, due diligence is required to ensure it’s the best approach for both your business and your clients. If you are considering insourcing portfolio construction and management, there are a number of important considerations.

Investment policy

An investment policy provides the blueprint for how you will manage investments. It would generally describe your investment beliefs (for example, a focus on a particular investment style or approach), establish your long term objectives, and detail the investment processes that will enable you to achieve those objectives. Importantly, your investment policy should inform your clients how and why you invest.

An investment policy could consider issues such as:

• What type of returns are you targeting?
• How do you propose to harvest those returns?
• What risk management approach will you take?
• How will you execute positions?
• How will you ensure portfolios remain on track?
• What expertise will you use?
• How will you remain accountable to your clients regarding their portfolios?
• Under what circumstances will you review this investment policy?

The blueprint laid down by the investment policy can be divided into five core components as illustrated in figure one. Each of those components will be examined.

Consider:

Can you clearly articulate your investment beliefs and how they translate to investment policy?

Have you defined how this investment policy will benefit your clients?

Investment philosophy

An investment philosophy is a set of core investment principles and beliefs that guide a person’s investment decision making processes. Its application in practice is reflected in the way investment portfolios are constructed and managed. Importantly, an investment philosophy needs to be understood by a range of stakeholders, including your clients.

A sound investment philosophy would generally consider the investor’s objectives, likely investment horizon, risk tolerance and capital needs. It might consider other factors – a desire for ‘ethical’ investments or a focus on income generation. A large number of decisions need to be made and clearly expressed when setting an investment philosophy. Some of these decisions might include:

• Investment universe – traditional, such as equities, bonds and cash, versus alternatives such as real assets or private equity
• Investment style – growth, value, neutral – and the market conditions that will and won’t suit this approach
• Active versus passive management
• Strategic (long term) and tactical (short term) asset allocation
• The integration of environmental, social and governance (ESG) factors
• Fees and costs – for example, will a performance fee be charged?
• Research approach and decision making process
• Risk management approach.

Without a clear investment philosophy, you risk lacking direction when you need it most – particularly in volatile markets when your investment approach might be challenged.

Most investors who achieve long-term success develop a clearly expressed and well supported investment philosophy and hone it over time – they do not make significant shifts in response changing market conditions, they do not chase returns. Investors do, however, need to be aware of structural shifts that might impact longer term investment outcomes. The changing correlation between equities and bonds is one such structural shift.

Example – the Future Fund’s investment philosophy

We believe that:

• Portfolios are most efficiently managed as a whole, rather than a collection of sub-portfolios.
• Focus should be on appropriate exposure to market risk factors because these are a stronger driver of long-term total portfolio risk and return than skill-related risk.
• A higher expected return per unit risk (investment efficiency) can be obtained from a broadly diversified allocation across different return drivers.
• Prospective returns and risks vary materially over time in a way that is at least partially observable and hence exploitable. The amount of risk taken should therefore be managed dynamically as conditions change.
• The management of costs is very important to maximising returns.

Consider:

Is your investment philosophy clear and easy to understand?

Will your investment philosophy provide direction in all market conditions?

Investment strategy and implementation

Your investment strategy will guide your more granular decision making, based on factors such as objectives, risk tolerance and capital needs. Some investment strategies focus on capital growth, whereas others may focus more on capital protection. The investment strategy and process are guided by your investment philosophy.

At this stage, you need to make a range of decisions. These might include:

• Buying and selling securities – do you use a single broker or a panel for listed securities?
• Will you invest in unlisted securities?
• Investment research – outsourced or insourced?
• Access to information, systems and tools
• Building in-house investment products versus using externally managed products
• Implementation and management of compliance processes
• Investment and operational risk management
• Portfolio construction approach
• Alignment of interests and management of conflicts
• A system for measuring the effectiveness of your investment strategy
• Tax management
• The framework for managing governance.

Importantly, an investment strategy should be documented in a way that enables your clients to understand your approach. A well-articulated, transparent strategy will engender trust with your clients and ensure they stick with you, even in the bad times.

A well formulated strategy also gives you something to refer to in challenging markets. Not only will it help you avoid making emotional investment decisions, it can make the client conversation a lot easier too.

Consider:

Do you have the requisite understanding and investment experience to develop and implement a robust investment strategy?

Do you have adequate resources to support the systems, processes and personnel required to develop and implement an investment strategy?

Good governance requires the right people – and time

In the same way you expect investment managers to have investment committees comprised of the best and brightest, clients (and regulators) would expect the same of any firm taking responsibility for portfolio construction. Persistently disappointing returns are often attributable to ineffective investment committees, which in turn may result in ineffective structures and processes.

The role of an investment committees is to provide a decision-making framework. Its responsibilities include setting investment objectives, agreeing on an investment approach and monitoring and oversight of investment decisions. It also includes construction of investment portfolios, risk management and compliance with regulatory guidelines.

An investment committee is generally made up of several people with investment expertise and specialisation, as well as those with operational and governance experience. By way of example, consider the Board of Guardians responsible for deciding how to invest the assets managed by the Future Fund. The Board consists of a Chair and six other members, each selected for their expertise in investing in financial assets, managing investments and corporate governance.

As well as specific expertise, do the people you have identified have the time to contribute to both the investment committee, as well as the day-to-day monitoring and ongoing management of the portfolio/s? Although likely to be more time intensive at establishment, the ongoing management of client portfolios may require an additional number of part or full-time hours; whether employing additional resources to undertake an investment role, or replacing internal resources who will do this, internalising portfolio management will likely add to your business’s head count.

Consider:

Do you have the diversity of knowledge, qualifications and depth of experience in-house, or will you need to bring in external expertise?

Do your internal resources have the time to commit to bringing portfolio management in-house?

Regulatory obligations

The regulatory and compliance burden on advice firms has increased over the past decade. Bringing portfolio management in-house will generally add to the regulatory requirements an advisory practice must fulfil.

In the first instance, additional Australian financial services (AFS) licence obligations will apply, along with compliance with additional Regulatory Guidelines issued by ASIC. For example:

• RG105 – licensing organisation competence, which ensures Responsible Managers have the appropriate qualifications and experience
• RG133 – details the roles of companies in relation to holding assets and sets out minimum standards for asset holders
• RG181 – managing conflicts of interests – of particular relevance for managing and distributing financial products in-house
• RG259 – risk management systems of responsible entities.

Importantly, you need to ensure you comply with the best interests duty and related obligations, which are contained in Division 2 of Part 7.7A of the Corporations Act 2001 (Cth). Are your internally managed portfolios best placed to meet each client’s needs? The legislation requires advice providers to act in the best interests of their clients (section 961B) and provide appropriate advice (section 961G). Last year’s Royal Commission was littered with examples of advisers and practices which failed to do this.

Although many advice practices have an in-house compliance resource, investment compliance is quite different to that associated with providing advice; you would need to ensure your resources have the time and skills to perform both roles.

Consider:

Do you have the time and expertise to monitor compliance with the applicable ASIC requirements and legislation?

Bringing portfolio construction and management in-house can provide you with several benefits. It can be a way to differentiate your business from the advisory firm down the road and add value to your clients. On the other hand, it can potentially be a drain on resources, create potential conflicts of interest and be an added compliance burden. Once you embark on this path, it’s difficult and costly to unwind, and could do untold damage to your brand. It’s not a decision to be taken lightly.

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