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A Simple Way To Think About Moat

By Quan Hoang A moat is really about protecting a company’s profit as Warren Buffett said: “You give me a billion dollars and tell me to go into the chewing gum business and try to make a real dent in Wrigley’s. I can’t do it. That is how I think about businesses. I say to myself, give me a billion dollars and how much can I hurt the guy? Give me $10 billion dollars and how much can I hurt Coca-Cola around the world? I can’t do it. Those are good businesses.” A business may make less profit because of lower sales, lower margin, or both. So, there are two sides of a moat: the sales side and the margin side. The sales side can be broken down into customer retention and customer acquisition. Customer Retention There are many factors that lead to high retention, including customer behavior, price insensitivity, switching cost, etc. Customer behavior is subtle. Sometimes customers just don’t think about switching. I used to wonder how small banks can compete with big banks. I realized that a bank’s moat doesn’t come from low funding cost or low operating cost but actually from customer habit. Customers rarely change their primary banking account. So, a small bank may have a low ROE because of its high costs but it can still have stable local market share. Despite their big scale to sell many financial products, big banks can’t steal business from small banks very easily. Similarly, car owners rarely shop for a new insurer unless there’s a bad experience, there’s a major event in their life (move or marriage) or there’s a spike in the price of their premiums. In fact, insurers like State Farm and Allstate (NYSE: ALL ) have greater retention rate than Progressive (NYSE: PGR ) and Geico because they sell bundled products. So, even though Progressive and Geico have a huge cost advantage, they have only low double-digit market share after decades of gaining market share. There are simply not many people shopping for new car insurance policies each year. Price insensitivity helps retain customers in the face of price competition. Customers may pay little attention to price when it’s a tiny part of their total spending. Switching from Coca-Cola (NYSE: KO ) to a private label cola simply doesn’t save much. Even better, some customers are willing to pay more for convenience, tailored solutions, product quality, or customer services. I find it interesting that Frost often pays less than one-tenth of the Federal Funds Rate for its interest-checking deposits. For example, Frost paid only 0.47% on its interest-checking deposits in 2007 while many other banks paid about 1.50%. I’m not sure why but perhaps Frost’s customer service is so good that customers simply don’t care about getting interest income on their deposits. Customer Acquisition Strong customer acquisition can be achieved through distribution, mind share, product superiority, or price. The best example of distribution power is perhaps big food companies. By owning key brands, they have the power to convince retailers to carry new brands. Similarly, journal publishers like John Wiley have distribution power by selling bundles of journals to university libraries. Mind share also benefits customer acquisition. Mind share can be created by advertising, word of mouth or simply positive experience. If a customer decides to buy car insurance directly, he’ll pick either Geico or Progressive. Price comparison is actually much less common in the direct channel than in the agency channel. Direct customers know they’ll get a good price from Geico or Progressive. Mind share is particularly strong when a purchase is infrequent. The classic example is See’s Candies. People shop on only one or two occasions a year so there’s no incentive to look for other brands. To a lesser extent, some furniture brands in the U.S. spend a lot in advertising so that people think of Tempur-Pedic when they want to buy a memory foam mattress, think of Select Comfort (NASDAQ: SCSS ) when they want to buy an air-adjustable mattress, or think of La-Z-Boy (NYSE: LZB ) when they want to buy a recliner. Product superiority usually results from investment in R&D or service. It is strongest when there’s a network effect, which makes a popular product more valuable to customers. People join Facebook (NASDAQ: FB ) because many of their friends are there. People go to Amazon (NASDAQ: AMZN ) or eBay (NASDAQ: EBAY ) because that’s where they can find the most sellers and thus the best price. Finally, low price is always a powerful customer acquisition tool. Margin Protection Margin can be protected by maintaining the gap between price and costs. To analyze the margin side of moat, the key questions are: Does the company have lower costs than competitors? Does the company have higher asset turnover than competitors? Does the company have higher customer willingness to pay than competitors? Is the power of suppliers and buyers low? Low cost, high asset turnover, and high customer’s willingness to pay provide a cushion against price competition in the industry. Low power of buyers and suppliers keeps profits from leaking out of the industry. Increasing concentration of buyers or suppliers is a big threat to future profits. Better organized buyers or suppliers may demand better pricing or they threaten to sell or source directly. Moat Evaluation To evaluate moat, we should look at 3 things: Barrier to entry Potential damage of new entrants Rivalry among existing firms Barrier to Entry In this step, we should try to detect all advantages of a company in customer retention, customer acquisition, and margin protection. Barrier to entry is high when several factors are required at once so that entrants need not only money but also time to compete well. Let’s look at Hunter Douglas ( OTC:HDUGF ) . Customer retention isn’t very important for Hunter Douglas because purchases are infrequent. That said, Hunter Douglas’s customers are highly satisfied. Hunter Douglas’s focus on product innovation and services raise a customer’s willingness to pay. Customers rarely downgrade to a lower quality product unless they move to a rental home. Hunter Douglas’s greatest strength is in customer acquisition, specifically distribution. Independent dealers choose Hunter Douglas because the product quality is higher and they can sell the brand more easily. In fact, it’s usually the brand that draws traffic to dealers rather than dealers getting the traffic themselves. Hunter Douglas advertises more than anyone else in the window coverings industry. It also enjoys great word of mouth. Hunter Douglas’s margin is sustainable. Thanks to its huge relative market share, Hunter Douglas benefits from economies of scale in advertising, in R&D, and in fixed investments in its integrated and highly automated manufacturing facilities. Customer’s willingness to pay is higher than competitors because of product quality, advertising, and dealer service. Finally, the power of suppliers and buyers is low. Hunter Douglas is an integrated manufacturer so its inputs are mostly commodities. Dealers have little power because they’re individual mom-and-pop operations. A competitor needs brand recognition and low cost to recruit dealers. But it needs wide distribution to have low cost and to justify advertising investment. So, this is a chicken and egg problem. The best chance to compete with Hunter Douglas is through the online channel or through the big box channel. The only weakness in Hunter Douglas’s moat is the possibility of a market share shift between channels. It’s worth noting that customer power is very strong in the big box channel, which Hunter Douglas avoids. Home Depot (NYSE: HD ) or Lowe’s (NYSE: LOW ) usually demand a low price. Hunter Douglas’s competitors sell through big boxes and make little profit to reinvest in marketing or product innovation. And they tend to cut product quality to meet the low-price demand from big boxes. So, end-customers can be segmented by channels. A weak example is Weight Watchers (NYSE: WTW ) . WTW’s customer retention is weak because its members come and go. People don’t take responsibility for their failure so they’re always eager to try new weight loss programs. WTW’s customer acquisition is a bit better. It has no distribution advantage because fads can pick up easily in health and fitness. However, it has strong mindshare. Many people know what it is and know its effectiveness. In fact, its members re-enroll in the program on average three more times during their lives. All WTW needs to do is to give people a reason to join right now instead of putting off joining indefinitely. WTW’s margin is great. Customer willingness to pay is high thanks to the social value of weight loss. The power of suppliers and customers is low. So, it’ll make a lot of profits as long as it gets enough customers. So, WTW doesn’t have moat but it has some strength in customer acquisition. Its former customer base, about 20 million in the U.S., grows over time. The overweight population grows over time. So, it just needs the right program news and the right marketing buzz. In the past, Weight Watchers has always made record profits after each cycle. Potential Damage from New Entrants Sometimes a business can be good despite a low barrier to entry. I think WTW is a good example. So, it’s useful to make some attempts to judge the potential damage of new entrants. The best tool in this step is to look at history. I unfortunately underestimated WTW’s risk in the recent cycle. The problem is that I only had WTW’s financial data back to 2001. I would have been more cautious if I had financial data back to 1990 to see how WTW performed in its previous crisis in early 1990s. Without financial data, we only know that WTW has always been able to reinvent its program during each crisis. I think there’s some similarity between WTW and restaurant chains. The market is huge. Each chain has a different concept and few have a big market share. But barrier to entry is low and customers are willing to try new restaurants. New entrants actually don’t do as much damage to existing chains as people think. There are not many new successful stories like Chipotle (NYSE: CMG ) . And it took Chipotle 20 years to seize just a 2% market share. A rate of two percent is less than the restaurant industry grows in a single year. Moreover, new restaurants don’t always open in a brand new location. Often, they open in or near a location another restaurant concept had occupied before. So, the total supply of fast food restaurants doesn’t necessarily increase more than population growth despite the industry’s low barrier to entry. So, the biggest competition in fast food chains is actually among existing chains. Recently, Value and Opportunity argued that Fossil (NASDAQ: FOSL ) has no moat because “…wholesale distribution network seems to be quite open for newcomers like Daniel Wellington.” It’s true that department stores always have store space to test new suppliers. Retailers care about gross profit per square foot so they often switch suppliers in that area of their stores. Sometimes a new entrant may succeed. But how much will the success of a new watch brand actually hurt Fossil? Customer’s willingness to pay is high in this category so it won’t hurt margin. It may hurt volume, thus reducing gross profit per square foot of Fossil’s licensed watches. But cannibalization might not be as high as most people expect. Revenue of Michael Kors (NYSE: KORS ) watches went from $100 million to $900 million in 5 years but it didn’t hurt Fossil’s other brands. And Fossil’s other brands didn’t benefit from the recent fall in Michael Kors either. Perhaps not many people wear watches today so Michael Kors helped bring more consumers to the category. Or it simply induced people to buy more often. Also, can Daniel Wellington build on its early success and keep its brand relevant? It’s a big challenge for any newly successful entrant. So, I think it’s safe to bet that a (growing) diversified portfolio of strong licensed brands can help Fossil gain market share over time. Rivalry Among Existing Firms This step is similar to the Barrier to Entry step. However, we compare a company’s strengths in customer retention, customer acquisition, and margin with its competitors. We want to see some durable competitive advantages that allow a firm to gain market share over time. And we want to make sure that the moat is widened over time. In our bank example, every American bank has a pretty good retention rate. However, some regional banks such as Commerce Bancshares (NASDAQ: CBSH ) and BOK Financial (NASDAQ: BOKF ) have the scale to sell other products like wealth management or payment systems service. Selling more products to a customer creates a closer relationship and improves retention. More products also mean more touch points to acquire new customers. Finally, more products result in more fee income, reducing net operating cost and creating a cost advantage. A cost advantage may allow for more reinvestment in products and services. So, these banks will possibly gain market share from tiny local competitors over time. Conclusion There’s nothing innovative in this framework. But I think it can help us connect different competitive advantages and see a clearer picture of moat. It’s a simple way to think about moat. But the most important question is always the one Warren Buffett asks: “I say to myself, give me a billion dollars and how much can I hurt the guy?”

What Should ‘Risk On’ Mean For You?

Summary Evidence suggests that in many quarters, a “risk on” phase of investing sentiment is afoot. The kinds of risks being taken suggest to me that we are in the later stages of a favorable stock market environment. Nevertheless, the U.S. economy seems to me to be basically sound, which makes a negative market event in the near future relatively unlikely. Still, there are enough ways that a negative market event could be triggered that a level of caution – rather than throwing oneself into the risk-on fever – is advisable. On November 2, 2015, The Wall Street Journal brought us flashing signs that the markets have entered a new “risk on” phase. Cam Hui predicted this a few of weeks ago, and now the mainstream press is confirming the trend. Here is one of Cam’s excellent slides focusing on the markets in 2011 and how fear and greed come and go: (click to enlarge) Cam’s slide shows sentiment in the market yees and yaws has little relation to fundamentals. The Wall Street Journal shows risk on The WSJ’s November 2 risk on coverage included these three Page One articles (Note: The headlines here are from The Journal ‘s print edition): In my opinion, these all are signs that financial markets are taking on increased risks. And usually they would be signs that trouble is ahead. Of course trouble always is ahead-somewhere, some time. To say that trouble is ahead helps very little. The problem for investors is whether the time is proximate and the place is wherever they are invested. But before we get to the ‘when and where” hard part, let’s be sure we understand how risk builds up and how certain kinds of institutions react to the forces that impel risk-taking. The role of international funds flows External debt almost always is involved in the build-up of asset values that crash. Robert Aliber, Chicago Booth School professor emeritus, explains how this works in the sixth and seventh editions of Charles Kindelberger’s classic Manias, Crashes and Panics , of which he is the author. Even if you have read Kindelberger’s earlier editions, Professor Aliber’s opening chapters are worth your time. We can trace external buying of debt, often in currencies that are different from the currency of the country whose entities are incurring the debt, as important parts of the crises in, for example, Latin American debt in the 1980s, the Mexican peso crisis of 1994, the Asian contagion crises of 1997, and the U.S., Ireland, Iceland, Spain and Greece problems beginning in 2007. I ascribe this phenomenon in part due to foreigners’ unfamiliarity with local markets. The foreign money is dumb money, I say. And it goes abroad when it is seeking better yields (and is unable to evaluate the risks properly) or simply has too much cash that it cannot invest at home (Eurodollar recycling by U.S. banks in the late 1970s, for example). I have not convinced Professor Aliber that my “dumb foreign money” theory is correct. He thinks macroeconomic forces are more likely the origin of the international capital flows. Maybe both forces are at work. Whichever (or whatever) the origins, the historical record suggests that we should be wary when we see large international capital flows, especially when the borrower cannot print and does not naturally trade in the currency borrowed. Foreign adventures by domestic players We also know that when certain kinds of institutions that have little international experience open offices and make investments in unfamiliar nations, the jig soon will be up. Within about three years, the flaws in their strategy will begin to appear. The German Landesbanks are perfect subjects for this test because they were established by the state and are owned by the state to serve purposes that became unnecessary decades ago. (I explained this in my book Debt Spiral .) Therefore they are always looking for new ways to make money. The Landesbanks were prominent victims of that tendency in the 2007-2009 market events. They were, if you recall, among the first banks to get into trouble in August 2007 because of their Ireland-based, U.S.-invested SIVs. Punters’ success lauded When the financial press starts lauding the successes that risk-takers are having, such as those that buy out-of-the-money Brazilian and Russian bonds, that is anther sign of trouble ahead because people will emulate the apparent successes at precisely the wrong times. Such games work if you can get out fast enough. But the door is not large, and it closes swiftly. Nevertheless, the WSJ reports that “fund managers are trying to manage those risks by staying nimble, rather than holding positions for an extended period which could be hurt by sudden market downturns.” Good luck. Record bond issuance but not much actual investment The WSJ touts the healthy corporate bond market as a sign of a strong U.S. economy. I do not think the economy is weak, but I do not think the strong bond market is such a good sign. What is the money being used for? It is being used largely for stock buybacks and acquisitions. Using debt for those purposes weakens the U.S. economy over the long term because it makes more companies fragile in downturns. And it tends to support stock market prices at levels that naturally decline when the flood of acquisitions and stock buybacks eases. Debt for productive investment can be a positive, but debt that mostly reduces the float of common stock serves no beneficial purposes that I can see, other than those of management and shorter-term stockholders. It is not something to celebrate as indicative of a strong economy. It is indicative of low interest rates, the reach for yield, and the temptation to replace equity with debt. Deal volume Another sign of a long-in-the-tooth market is deal volume. The deal volume in this case goes hand-in-hand with debt issuance. The deals mostly are designed to reduce competition, which may be good for corporate profits but is bad for the economy as a whole. And it indicates that companies do not see organic growth in their futures, which is not a sign of strength. Most companies do not sell out or pay up to acquire when they see bright futures for their independent selves. But don’t get carried away, please Don’t listen to scare-mongering, however. The FT had a particularly egregious article on November 2, in which the writers explored the possibility of a market meltdown caused by investors fleeing balanced mutual funds because the bond market was going down. That is preposterous stuff foisted by the big banks that want lower capital and the right to trade freely for their own accounts. The FT writers are particularly susceptible to this bilge; I do not know why. Balanced open-end funds are safer than houses, so long as they are not leveraged. The U.S. economy is OK I think the U.S. economy, despite all the negatives that I have listed for the future of capital markets, is OK. Neil Irwin had an interesting piece on The New York Times Upshot site last week in which he said he was undecided about whether the U.S. economy was OK or not. As I read the article, he really came out that the economy, despite all the negative signs, is OK. (If you haven’t read it, it is worth a look.) And that is where I come out. At the end of 2012, I wrote on seekingalpha that I was optimistic about the U.S. economy through 2015. Here we are almost at the end of 2015, and without going into detail here, I remain optimistic for the near future. Continued slow growth seems likely. We seem likely to have neither the great strides in productivity nor the large working population increase that might lead to faster growth. And I do not expect the government to begin any historic spending sprees. But the downside negatives almost all emanate from abroad, and the U.S. economy has been dealing with foreign negatives for the entire time it has slowly recovered since 2009. When, where, how? So much for the easy stuff. When, where, how will a negative market event occur? “Why” is not for us to know. “When where, and how” is hard enough. If I really knew when, where, and how, I would be a very rich man. Since I am not a very rich man, we must presume that I do not know. But thinking about such things concentrates the mind. And if you think about this question along with me, I think you will clarify your own views. The relative status quo could go on for quite a long time. And I do not expect the downside stimulus to come from China in the near future. Even though I think China is in for some rocky times, I think the Chinese government and economy will be able to handle them. I have written about that at nexchange.com, where I publish short pieces weekly. But weak credits have attracted too much money and stock markets are priced high largely because of low interest rates. Both those factors would be quite vulnerable to a material increase in interest rates. But I do not think the Fed is going increase rates significantly. There is no reason to do so. A discursion on monetary policy I do not regard myself as an expert on monetary policy, but so many commentators talk about it without meeting that requirement, why shouldn’t I? I do a lot of reading and even correspond with some macroeconomists. It seems to me that for the Fed to raise rates in order to have room to lower them again when a recession occurs lacks logic. The U.S. economy is in slow-growth mode. If it could stay there for an extended period of time without a recession, that would be a good thing. Therefore monetary policy should encourage continued growth, if possible without encouraging credit bubbles. I take that to suggest a monetary policy that is neutral, by which I mean a policy that permits the market to set rates to the extent possible. If the “natural” rate of interest is about zero, then policy should permit rates to remain near zero. And there is considerable evidence that the natural rate (economists call it the Wicksellian rate) is near (or even below) zero. Why raise the rate artificially, which may cause a recession, merely to have the “firepower” to lower it again? On this subject, let me share an interesting graph from Bill Longbrake’s monthly letter that is published by my friends at the Barnett, Sivon & Natter law firm: (click to enlarge) The chart is hard to read, but the data are important. What they show is that the Fed and some other major forecasters (the BofA and Goldman Sachs forecasters that Bill follows every month) are expecting a Fed Funds rate of 3% or more by 2018. If that is going to happen, then I think bad things are going to happen to the U.S. economy and to the U.S. stock market by 2017. Fortunately, Bill Longbrake disagrees. He forecasts close to a zero Fed funds rate still in 2018, and Bill has a better forecasting record than the Fed. I am sticking with Bill on this, but please recognize that we seem to be in the minority and that our being wrong could have significant negative consequences. What might cause a negative market event? Regardless of what the Fed does, I think we will see is some of the risky bets not paying off, the weak credits being unable to refinance, as well as a rise in bankruptcies and delinquencies that already have been occurring over the last year in the energy sector. Many parts of the global economy have depended on the energy sector to buy their products. They are likely also to experience problems, and it is likely that they, like the energy companies, borrowed heavily to expand their capacity quickly and that their creditors also will suffer. U.S. housing remains expensive. Here is a graph of real house prices through August 2015 from Calculated Risk. (click to enlarge) As you can see, house prices are almost back where they were at the top of the boom in 2005-6, with middle class incomes having barely budged since 1999. As I wrote in a lengthy article back in February 2012, housing cannot lead the economy until house prices are affordable for the middle class. In that article, I saw 1997 as a benchmark year when house prices were still affordable in terms of incomes. But house prices now are even more above the 1997 level than they were in 2012, with barely any progress in middle class incomes. Houses are more affordable than they otherwise would be because interest rates are low and heating oil costs have declined. But house prices remain a problem, and household formation and the healthy consumer expenditures that follow that are deterred by the high prices of houses, as well as by student loan balances, a lower marriage rate, and several other economic and social forces. Some respected forecasters say household formation is picking up. So far, I do not see it. A decline in house prices therefore would be a mixed event. It might stir household formation, but it also might cause another round of foreclosures, particularly on properties that have little equity (which means just about everything financed by the FHA), and it might have a negative “wealth effect”. A big change from my thinking a couple of years ago is that whereas in February 2013 I saw rising capital flows propelling global stock prices higher, I now think global capital flows are reversing. That means liquidity most likely will not continue its upward thrust. These various cautions suggest that the U.S. stock market will not produce large returns over the next year or two. But will something cause a major disruption in the next year or two? I am starting to think that is not likely. I have no better crystal ball than anyone else, but I do not see a catalyst on the horizon. The major suspects would be politically or geopolitically unsettling. For example, both parties in the U.S. have enough dumb ideas that, if adopted, one of them could have negative economic consequences sufficient to cause a recession. Or a trigger-happy president could find reasons to do foolish things. Or the Fed could raise rates at a pace that would knock the value foundation out from under the stock market. I am hopeful that American public officials will see the difficulties and not score an “own goal”. A few days ago, I published A Portfolio for the Next Market Crash-Revisited . In that article, I discussed my February 2013 prediction that a negative market event likely would occur in the next five years and that we are now half way through that period. I concluded that I had not changed my investment strategy as a result of events over the last two and a half years. Even though I am suggesting today that I do not think a market event is likely in the next two years, I remain convinced that, at least for investors over, say, age 50, prudent portfolio management indicates being somewhat protective even while maintaining an optimistic outlook. “Risk-on” may be fine for traders. For longer-term investors, it is best not to be tempted at this point in the cycle. Of course, if you’ve really gotta have that new Porsche Panamera, and you only have a spare $40,000…

What Trends Are Influencing The Future Of Wealth Management?

By Ed McCarthy The practice of private wealth management continues to change as quickly as it grows. For insight on key business trends that will influence wealth management over the next three to five years, CFA Institute Magazine invited three experts to share their views in a roundtable discussion: Stephen Horan, CFA, CIPM , managing director of credentialing at CFA Institute; Mark Tibergien , CEO and managing director at Pershing Advisor Solutions, LLC (a BNY Mellon company); and Scott Welch, chief investment officer at Dynasty Financial Partners. The following excerpts were taken from the participants’ remarks. A subsequent column will discuss the impact of technology trends. The Impact of Women and Millennials Stephen Horan (CFA Institute) : One thing that I think is getting some more recognition but is largely unnoticed is the increasing significance of women as clientele. Right now, women control about half of the wealth in the US, but they’re estimated to be in control of two-thirds of the wealth by 2020. That’s stunning. The reasons for that are they’re inheriting wealth, they’re entering the work force at a greater rate, and they have a greater longevity, so they hang on to that wealth and as a result have longer retirements. Women also tend to be better savers than men. So you’ve got this changing face of the investor base along the lines of gender, and I think any adviser would tell you advising a woman is very different from advising a man, which is different from advising a couple. We’ve spent so much time focusing on retirees and retirement needs that we’ve sort of taken our eye off the ball that there is an up-and-coming millennial investor base that is becoming increasingly significant in terms of numbers. It’s not so much about wealth yet, because they have yet to accumulate significant wealth, but they’re partly at the core of this robo-adviser movement. And what’s interesting about them (beyond their obvious penchant for digital solutions) is that they disintermediate investment planning. By that I mean you don’t really need an adviser to do all the things that they currently do; [investors] can interact more directly with financial markets. But millennials are also just very different types of investors; they are far more cautious and risk averse than prior generations. For example, they hold about half their savings in cash, compared with less than a quarter for all other age groups. They hold more than twice as much cash. What’s interesting about these things taken together is that we have an investor base that increasingly looks less and less like the adviser base, which is middle-aged men – and that perhaps could be generous on the age side [for the adviser base]. That’s going to continue to create challenges for advisers who are trying to serve clients who don’t share the same perspectives and life experiences, [who have a] penchant for digital solutions and things like that. Talent Shortage Mark Tibergien (Pershing Advisor Solutions): There is an acute talent shortage facing all the financial services. Since 2008, there are 50,000 fewer financial professionals in all. I think the average age for principals is around 61, but the average age for all advisers is about 50. Only 10% of the adviser population is under the age of 35. In fact, the CFP Board [Certified Financial Planner Board of Standards, Inc.] says they have more CFPs over the age of 70 than they do under the age of 30. Whatever you use as your data point, the face of the advisory business is gray and wrinkled, and that is a challenge because we as an industry have not done a good job of making this a compelling industry to work in. We [Pershing Advisor Solutions] asked our Millennial Advisory Board to casually inquire among their friends who are not in this business why they chose not to come into finance. There were three reasons cited: (1) I never studied it in high school and didn’t know it was a career choice; (2) everything I know about the industry is bad; it’s corrupt; it’s not a place that profoundly helps the lives of other people; and (3) it’s just a sales job, and I don’t want to be in sales. So, as a profession, we have a lot of work to do to demonstrate that it’s actually a helpful career; it’s not a sales job. If people are not learning personal economics in high school, that probably explains why people make a lot of bad financial decisions. Fluctuating Prices and Margins Mark Tibergien (Pershing Advisor Solutions): This is the only profession where clients pay for the value they bring rather than the value the professional brings – meaning that, the richer I am, the more that I pay. It’s kind of a classic Marxist sort of approach to pricing when you think about it. What’s happening is that firms do continue to charge basis points on assets, but in many cases, they’re also charging a retainer or a project fee for other services. But it’s not uncommon in the high-net-worth space to actually see a 5-10 basis-point increase in the asset management fee. There are six levers of profitability in a wealth management firm. Pricing is one of them and perhaps the most controllable, but the others relate to volume, meaning that many firms are not growing at a rate fast enough to keep up with withdrawals. Productivity is becoming a real issue, because [firms are] not managing workflow well, and that’s a function of capacity. Third, the service mix may not be well defined, and one reason it’s not well defined is because of the fourth lever, a poor client mix, where the firms don’t have enough clients within their sweet spot. The fifth lever relates to cost control. Finally, bull markets camouflage a lot of sins, and in some respects, we’ve seen this persistent growth in the equity markets, which has allowed for creeper costs to come into a number of advisory firms. If you look at those six levers [pricing, productivity, service mix, client mix, cost control, and creeper costs], you have to say it isn’t just pricing that determines my margins; it’s “How do I manage the rest of the ship in order to produce an optimal bottom line?” Evolving Investment Management Scott Welch (Dynasty Financial Partners): One trend on the investment side is the democratization of the investment solution set that’s available to clients. A second is simply what I call the “race to zero” in terms of active asset management fees. One aspect of the democratization trend is the explosion in the number of liquid alternatives, or alternative investment mutual funds, that are now available. Both the quantity and quality of those strategies continue to improve, and that will make accessible to a wider audience of investors the kinds of strategies that historically have only been available to qualified purchasers or accredited investors. This is not to suggest, by the way, that hedge funds or LPs (limited partnerships) are doomed for the graveyard. I think the good ones will continue to thrive and prosper. But the door is now open to a much wider set of investors to build far more diversified and sophisticated portfolios beyond simply stocks and bonds. A second trend is the explosion of exchange-traded funds (ETFs), so-called factor-based ETFs, and other low-cost structures now available to investors. I don’t like the phrase “smart beta,” but that is the industry shorthand for factor-based ETFs. As a simple example, Eaton Vance got approval not too long ago for a new kind of structure called an ETMF (exchange-traded mutual fund), which is an actively managed ETF. It has the daily liquidity of an ETF, but the fund company doesn’t have to disclose the underlying positions within that ETF on a daily basis like it does with a traditional ETF. Its disclosure is based more on the mutual fund standard of every six months, which will allow that ETF provider to more actively manage the strategy without daily transparency into it. I don’t know if it will be a good product or a bad product, but I do know it will work to drive down the price of active management. When you combine all the different lower-cost investment products that have and will continue to come out, I think it’s undeniable that there will be a deep impact on active managers. Premium managers will always be able to charge a premium price, but many active managers are going to have to change the way that they manage their books in order to justify their higher fees. That’s why I refer to this trend as the race to zero, and it’s happening both at the product level and at the advisory level because of digital platforms. I think we will see a similar impact in the LP and hedge fund space in the sense that the truly brilliant investors will survive and thrive, and they’ll continue to be able to charge premium prices for premium performance. Clients will still be willing to give up liquidity and pay a higher fee in order to get access to that performance. So, I suspect that “star managers” and things like private equity and other illiquid investments will continue to be very popular. But these pricing pressures pose a distinct competitive threat for the folks who aren’t premium providers. The bottom line from an investment perspective is that an end investor now can build a very sophisticated, very globally diversified portfolio at a far lower cost and with far better liquidity terms than that same client could have built even five years ago. Asset managers and wealth managers are going to have to respond to all of these trends. In an era of commoditization of services, they will need a differentiated business model and clear articulation of their value proposition to justify their higher fees. And in the wake of downward pricing pressure, they will need to focus on core competencies and increase their use of outsourcing to drive profitability. Ed McCarthy is a freelance finance writer in Pascoag, Rhode Island. This article originally ran in the September/October 2015 issue of CFA Institute Magazine . Disclaimer: Please note that the content of this article should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.