Originally published in Financial Advisor

By Mark Hurley

One of the more absurd tendencies in the wealth management profession is to equate assets under management with the quality of a firm. Nearly every industry survey that purports to help prospective clients find “the best wealth managers” is, in reality, largely a listing of firms based on their AUM.  There also seems to be some sort of social pecking order among firms — whether at industry conferences or even in terms of eligibility for membership in study groups — that is based on how much money each firm manages.

This is nuts. In fact, there probably has never been such a widely used statistic in any industry that says so little about the quality of its participants.

Sure, sure, sure. In a business with fees largely tied to assets under management, if you don’t have any AUM, you are probably not in business. But as a prospective investor who looks at one hundred or so different wealth managers every year, I have found that for several reasons there is a very low correlation between AUM and whether you would ever consider investing in a firm, much less referring a family member to it.

First off, it tells you next to nothing about the firm’s economics – i.e., its revenue and/or profitability. For example, a few years ago, I ran into a wealth manager that has more than $3 billion under management but generates less than$3M of annual revenue and makes no money.

How is this possible? Well, it had one extremely large client – with a low capped retainer fee – and a bunch of small clients. And net of paying the owners a market level salary, it made no money.

This kind of low-revenue-vs.-AUM ratio is more common in this industry than many may believe. Easily more than a third of the 200 or so firms that currently report in excess of $1 billion of AUM fall into this category; this is particularly true of those firms that have large institutional as well as individual clients.

Even firms that have lots of AUM and lots of revenue are sometimes very poorly run businesses. For example, my partners and I recently ran into a wealth manager with more than $3 billion of assets and that had more than $15 million of annual revenue but somehow still managed to lose about $5 million per year.

Again, how is that possible? Well, the firm had five different lines of business and lost lots of money in four of them (you know the “we lose money but make up for it in volume” strategy).

Unfortunately, this too is fairly common. We have encountered many firms that have more than $1 billion of assets and at least $7 million of annual revenue but, after paying market-level salaries to their owners, make no money, zip, nada. They are effectively labor-cooperatives – you know, jobs more than businesses. Communes. And if you take this group of firms and add them with those that have lots of AUM but not much revenue, combined they probably make up about half of wealth managers that today have $1 billion or more of AUM. Yes, half!

More important, AUM tells nothing about the sustainability of a firm. When clients are looking for a wealth manager, they are looking for an advisor they can count on for the next 30 years. Unfortunately, numerous firms with lots of AUM have no more sustainability than a $50 million one-person-shop down the street.

Why? Their ownership is concentrated in the hands of the founders and there is no mechanism for transferring it to its successors over time. In reality, these firms are glorified sole proprietorships that are unlikely to survive (at least in their current form) the departure of their founders.

Finally and most important, AUM tells nothing about the quality, expertise, depth and breadth of the firm’s staff. If you look closely at several of the “best wealth managers” listed in these surveys, you will find that more than a few are overwhelmingly dependent on the expertise of a handful of individuals – typically the founders – and that many of the firms’ other “professionals” are often (effectively) administrative staff who just service existing clients.

To be sure, it is easy to understand why those poor souls who are tasked by various publications to prepare lists of the best wealth managers almost always invariably default to AUM as the key admission criterion: It is the easiest statistic to get because every firm is required to disclose their AUM as part of their Part I Form ADV.

At the same time, it is likewise understandable why one’s social standing within the industry has historically been based on AUM. When the industry first started, everyone was tiny and trying to find a way to signal to prospective clients that their firms were a safe choice for getting competent advice. By trumpeting one’s AUM (in particular if the firm had one or two big clients) it was easier to sound like a much bigger and badder organization when marketing. And old habits are hard to change.

Please allow me to propose an alternative three-factor model that, while it involves a little more work, is probably a more accurate depiction of the “best” firms and that anyone can use to study the industry. The first factor is sustainability as measured by ownership. If a firm’s equity is concentrated in very few hands (which can also be found on a firm’s ADV), it almost by definition is unsustainable and should be disqualified from any “best” list, regardless of AUM.

The second factor involves the breadth and depth of expertise of a firm’s professionals, which can easily be found on its Web site. Any wealth manager that wants to be considered as one of the “best” should have a deep team (excluding the founders) of professional staff – many, if not most, of whom are also owners – all with numerous years of experience and possessing professional credentials (i.e., CFP, CFA, etc.) and, most important, who are young enough to be around at the firm for at least the next 15 to 20 years.

The third factor – a firm’s likely profitability – may at first seem unimportant in the grand scheme of things. However, any business that does not make money does not last over the long term, and as noted above, clients are signing up for long-term advice. How can a wealth manager be one of the “best” if it does not make much money as a business?

Estimating profitability is a bit more art than science, but still is very doable even with just public information. One should first compare a firm’s number of clients with its AUM and thus, estimate average client size (both sets of data are on its ADV). You can then take average client size and apply it to the firm’s fee schedule (which is disclosed on its Part II Form ADV) and come up with a round-number estimate for its revenue. To be sure, more than a handful of firms regularly discount their stated fees, so at best, you are getting only an estimate of revenues.

Estimating a firm’s costs is also not that hard, given that most firms list all of their employees (including credentials and experience) on their Web sites and there are numerous industry surveys that one can use to estimate their compensation. Add to that about 20 percent to 25 percent of revenue for overhead costs. Compare the firm’s aggregate costs to revenue and one has a ballpark estimate of a firm’s gross profitability.

This combination of long-term sustainability, breadth and depth of expertise and ongoing profitability provides a much better picture of which wealth managers are actually competent, sustainable businesses — and by any measure is far more accurate than a list largely tied to AUM. It also should be a much better guide for those study groups trying to figure out which other firms are, in reality, their peers.

All of this said, I don’t expect a rush away from using AUM as the defining criteria of greatness. It is much easier to simply brag about AUM than it is to run a good, sustainable business.

So the next time you are at some industry event and some owners start to brag about their firms’ AUM, remind them that only Bernie Madoff spends assets.

Mark Hurley, founder and CEO of Fiduciary Network, which has invested in many advisory firms.