Repairing the distribution system

Many of us will take time in the new year to reflect what’s in front of us and the year just past – and I suspect a common refrain will be “thank heavens that’s behind us.”

It’s human nature to minimize uncomfortable events and instead look forward with optimism to better times. But, in 2010, naive optimism could test your swimming skills.

The events of the last two years have had a profound effect on the wealth management profession. Wealth managers worldwide were caught seemingly ill prepared for the once in a life time events that took markets down. If you listen to the pundits, active management, modern portfolio theory, asset allocation and even diversification have all been discredited. We haven’t seen enough evidence to suggest the pundits are right, but we do believe the ripples of the past 12 months extend well beyond their apparent epicenter.

By itself, the great recession has given us more than sufficient reason to look hard at our profession as financial planners, and the value our services deliver. Upon reflection, we’re convinced the traditional approach to wealth management in Canada displays all of the hallmarks of a Red Ocean as described by Harvard professors Kim and Mauborgne in their 2005 best seller “Blue Ocean Strategy.” The authors would recognize the downside of their hypothesis in looking at our industry, where players use business models built in the 1980s to pound on each other in the vain hope that momentum, mass and gravity will help them overcome their competitors.

The question confronting us is: Can the traditional approach still work in the years to come? Emphatically, no. Under the surface, there are dangerous forces at play that represent game-changing challenges for the traditional approach to wealth management and financial planning in the Canadian market.

These tidal forces include:

• An addiction to cash – Industry players continue to consolidate in order to build scale and, as a result, need to feed a voracious thirst for cash flow. However, aggressive product tactics and growing marketing budgets mean the market share being chased is measured in decimals. In the first ten months of 2009, the largest gain in market share for IFIC members (net assets) was 0.66% in an industry where almost half the players don’t command a share of 1%. And yet, in the midst of all the thrashing, on a global scale the entire Canadian mutual fund industry would only garner a 2% share amongst global mutual fund companies. Now, add into the mix the fact penetration of mutual fund investments into Canadian households peaked 10 years ago, that five players garnered 95% of net cash flows amongst long term funds in 2009, and that Canada ranks 16th amongst the 20 members of the OECD in terms of household savings.
• Investment commoditization – Investment product proliferation has led to commoditization, complexity and confusion. There are currently more than 2,000 mutual funds sold in Canada (more than 6,000 if you include fund series), over 20 segregated fund complexes and 60 plus ETF’s. All of them are swimming in a pond (the TSX) which only has 3,900 listed companies. Globefund lists over 1,100 funds in its miscellaneous asset category alone. So, at two years the average shelf life of a new fund product isn’t dissimilar to that of a new food entree at your favourite supermarket. And yet, in a survey of industry executives we conducted in the fall of 2009, 88% indicated they view product development as a key focus for 2010. The industry is busy polishing the chrome and the boat’s drifting into the rocks.

Wealth management isn’t bubble gum

In their October 2009 survey, the CSA noted that “While 64% (of Canadians) said that it is important to have a formal written financial plan, only 25% had one.” Most Canadians (80%) agreed it’s their responsibility to acquire investing skills, yet only 32% actually took the necessary steps.

But we can’t blame the investor alone for being casual about financial planning. In our 2008 and 2009 survey of dealership best practices, financial planning ranked dead last amongst the value propositions pursued by mutual fund dealers in providing services to financial planners. We appear to have gravitated to marketing tactics based on traditional retail concepts, but retail marketing misses the point. Wealth management isn’t a point of sale event, it’s a life long adventure, with profound implications if we get it wrong.

Shrinking and distracted distribution

In the midst of the increasingly complex and volatile market, Canadians still rely on advisors to help them make sense of the chaos. However, the overall pool of licensed advisors is shrinking – even with aggressive licensing by the banks – and the deflationary pressures will accelerate when baby boom advisors act on their exit strategies.

If financial advisors follow the same demographic trends as the general population, 30% of our advisors will be eligible to retire by 2020. It’s hard to bail the boat when the crew has already jumped ship.

And the timing couldn’t be worse. Just as Canadians are reaching out for advice, financial planners are increasingly distracted. With distributors, manufacturers and regulators focused on the competition, financial planners have been left to guide investors through a fog. Fluctuating compensation grids, downloaded costs, mountains of paper work, shiny new products, crashing markets and behavioral economics have all served to distract planners from an already daunting responsibility.

Compliance isn’t helping

Rules-based compliance administered by insular, Balkanized bureaucracies is killing trees, distracting management, fostering dysfunctional, arbitrage behavior and adding to costs.

In our survey last fall, 94% of the senior executives who responded indicated compliance “seems to be a part of everything we do and every decision we make.”

While the fundamental principles governing our regulators are valid, the execution and enforcement has too often been dysfunctional. And it sacrifices advice for the sake of rules. If the fundamental principle of acting in the clients’ best interests is embraced by everyone in the industry, why has it been so hard to implement?

Rusty infrastructure

Legacy systems and processes, built around old world paradigms and red ocean tactics, focus management attention on last year’s issues, instead of tomorrow’s imperatives.

In his 2008 book “Six Pixels of Separation,” author Mitch Joel talks about new technologies creating clear lines of sight from producer to consumer. In Canada, the line of sight between investor and investment manager is too often clouded by reams of performance data and market metrics but little that answers the client’s primary question, “Will I be alright?.”

With investments as commodities, what happens when Google becomes the investors’ primary advisor?

Meanwhile, those infrastructures are maintained and financed with economic paradigms created when double-digit organic growth disguised structural inefficiencies. The fundamental economic model guiding investment fund organizations today remains some variation on the 5% commission and 0.5% trailer – a model created more than 20 years ago. In 2010, investors, advisors, distributors and manufacturers alike, all claim to be struggling to meet expectations. Better grab a paddle, the boat may be out of gas.

Never forget, “if you’re running in the wrong direction, gathering momentum isn’t a good thing.”

It is often easier to think of market corrections as periodic anomalies in the march of compounding growth. After all, as soon as the economy regains its lost traction we can set the sails and get back on tack. Right?

Wrong! In the Canadian market, there are serious systemic tidal forces at work and while you’re putting your feet up to reflect on the year ahead it may be a good time to add one more item to your 2010 to do list: Check the boat for leaks.

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Chuck Grace, consultant for Fusion Consulting in London, Ont.

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Chuck Grace