The industry dialogue to date on the Department of Labor’s new fiduciary rule has focused primarily on how the rule will affect compensation for retail financial advice. However, this massive regulatory change will also have a sizeable impact in the asset management sector, with significant implications for how third-party asset managers (TPAMs) price their services. Investor dollars had already been flowing out of actively managed funds and into ETFs before the DOL finalized its rule; with the regulation set to take effect next April, regulatory scrutiny of costs for end clients will likely accelerate this trend.
For financial advisors using a third-party asset management platform, the transition to a post-DOL world raises a host of new potential anxieties. While the right TPAM partner can bring a heightened level of efficiency and investing expertise to a practice, some of these providers may not survive the transition. And, as Curian Capital's abrupt exit from the industry a year ago reminds us, the sudden loss of a key partner can be disruptive—even devastating—to an advisory practice.
The following criteria can help gauge your TPAM’s DOL readiness:
1. Can they justify their cost structure?
The DOL rule signals a new environment of heightened scrutiny over investor costs, so advisors will be challenged to justify recommendations that come with a higher price tag. Even if funds don’t get direct attention from regulators, market forces will push them to reduce fees or lose assets. This will extend to TPAM models, as well.
Regulators view higher fees as the primary evidence of conflicts of interest, and their goal is to eliminate such conflicts. As any advisor knows, however, investors may be happy to pay slightly higher costs as long as they can see that they are receiving added value for the money.
Managers whose holdings resemble the same baskets of stocks that investors can purchase through a low-cost ETF, or who simply track a benchmark, will likely not be able to justify a higher fee structure going forward. Those who bring truly differentiated strategies and investing skills, however, will have a better shot. Such strategies include stronger risk management capabilities.
2. Risk Management: Going Beyond the Random Walk
Sophisticated risk management that goes beyond traditional approaches to asset allocation and their reliance on simple diversification will also represent a key point of differentiation between TPAMs that thrive in the post-DOL world and those that struggle or fail.
This means identifying managers who are not constrained by rules of thumb, such as a 60/40 split between stocks and bonds for pre-retirement investors, which can artificially constrain a portfolio and lead managers to duplicate the mistakes of other market participants. Instead, advisors should look for TPAM managers who are able to assess and capture appropriate opportunities—while avoiding inappropriate risks—by adding or reducing exposures in various markets according to their own quantitative analysis.
It also means seeking out managers with clearly defined investing parameters rather than those that hold to general styles. Successful TPAMs will be those who have the flexibility and wherewithal to map out specific responses to changing market conditions and then follow through on them. For example, if a manager is focused on opportunities in a particular market but sees a sudden uptick in risk in that sector, can they shift quickly to capture opportunities elsewhere, or even go 100 percent to cash if necessary?
Finally, TPAMs can differentiate themselves on risk management grounds by sticking to pre-determined exit points for individual assets. Advisors should seek out managers who have a quantitative process for determining when a particular asset is no longer appropriate for a portfolio, and then consistently follow through in order to avoid undue risk.
3. Mass Personalization of Models for Clients
Managing accounts separately takes tremendous time and resources, while providing one-size-fits-all models reduces the value to the investor. Fortunately, technology now allows managers to provide robust personalization on a scalable basis to clients on the same platform at low cost.
Even with a limited number of disciplined investment models, skilled managers can precisely tailor a client’s holdings to suit their needs by adjusting the combinations and proportions of the models used for each investor. Executed correctly, this approach allows a TPAM to focus on optimizing performance across a limited number of investment models while providing a customized and easily adjustable portfolio for each individual client.
Standing the Test of Time
Financial advisors are currently bracing for a radically different operating environment post-DOL, and asset managers will face a comparable level of change soon after. This shift will extend to third-party asset managers, as well, who will come under increasing pressure to show value, cut costs and differentiate themselves as both investing experts and risk managers. Unfortunately, some TPAMs will not survive the transition.
In order to avoid the inevitable disruption a failing investment management partner could cause, advisors, RIAs and independent financial services firms should work to educate themselves on the key factors that will help their TPAMs survive in the unfamiliar landscape of the post-DOL world.
Greg Luken is founder and CEO of Luken Investment Analytics, a turnkey quantitative research and asset management firm. He can be reached at [email protected].