Wealth managers face a challenge of ensuring they deliver value for money to clients yet still generate a profit, Andrew Hutton, director of AJ Hutton and a PAM Awards Judge, told the PAM Annual Dinner last night.
“There is a constant and ubiquitous tension between doing right by the client and making a fair profit,” he said. He argued that it is a “professional duty” for wealth managers to review how they offer value for money.
Mr Hutton said that discretionary wealth management entails a lot of costs to a firm. These include staffing, technology, compliance, distribution and many more.
Diners heard that these costs can be broken down into four areas. Firstly, there is the “basic operating cost”. This is made up of crucial elements such as custody, settlement, trading, client service etc. The second is the basic cost of investing. This is the cost of investing in simple products. Thirdly there is a more complex cost of investing. This is made up of such elements as the intellectual property behind investment convictions and more complex investment products. Finally, there is the profit margin, “to which you are entitled”.
To illustrate this further, Mr Hutton put forward two hypothetical portfolio types – the “dumb” portfolio and the “smart” portfolio. Although, he stressed, this is not about the on-going debate on passive and active investment. Instead it is about measuring the “known costs against expected benefits.”
The “dumb portfolio” is made up of a mix of index funds, cash and gilts. It automatically rebalances and uses just simple products. It will produce “pure beta,” he said.
The “smart” portfolio is based on a firm’s “best thinking” and uses active management. It is “rebalanced all the time” and uses more complex investments.
The costs of investing for both types can be calculated and compared easily. The “smart” is made up of the wealth manager’s fees and third party investment costs. The “basic” is the cost of investing in basic products and the cost of running the portfolio and a fair profit margin. The latter should not have a cost associated with trying to outperform the market.
“If you are delivering the latter, you must believe that is right thing for the client,” Mr Hutton said. However, how can you justify that it bring value.
In this example, the “dumb” portfolio has a TER of 0.5 percent and the “smart” of 1.2 percent. So how can this extra cost be justified? This comes down to what Mr Hutton called “Additional Reward To Incremental Cost,” or ARTIC. He said this provides a framework that can be used to help measure and demonstrate value for money.
They are just three valid justifications that the incremental cost is still value for money, he said. It could be that the “smart” portfolio delivers a significantly higher return, or that it still delivers good returns but with less volatility. The third reason can be “anything else that the firm offers that has value to the client”, such as customised reporting, lines of credit, next generation seminars etc.
The problem with the third justification is that it “can only be quantified to a limited degree but is valued by many clients.” He added: “It is a legitimate piece of the value proposition.”
Mr Hutton said being able to demonstrate value for money does not necessarily mean reducing fees. It is to ensure firms can “place the expected value in plain sight.”
“Long on costs but short on justification is a first class route to a second class conversation,” Mr Hutton said.
The 2017 PAM Annual Dinner for wealth manager CEOs (or the like) was held at The Dorchester Hotel in London on Tuesday 12 September 2017. The Dinner was attended by 39 chief executives, three speakers, one chair and the founder of PAM Insight, James Anderson. The evening was kindly supported by Pershing, a BNY Mellon company, Deloitte, Invest Cloud and Wealth Dynamix. It was chaired by Elizabeth Canning, chief service officer at Pershing.