Originally published in Financial Advisor

By Mark Hurley

Wealth managers are not in the “business” of giving advice. Rather they are in the business of getting paid to give advice. Consequently, in the long run, the business depends on cost effectively capturing new clients.

Today, a number of firms across the country are dedicating significant resources to capturing a portion of the flood of clients now being referred out of the branch networks of the large custodians. One wealth manager even managed to generate nearly $1 billion of new assets last year from custodian referrals.

But the economics of the custodial channel will soon change. What will happen isn’t shocking; to the contrary, it’s entirely predictable and following a well-worn pattern of market maturity. That pattern goes more or less like this: Product or service innovations create significant opportunity, and in the early part of the life cycle, the rewards flow to those innovators. Over time, however, as the pace of innovation and change slows and competition increases, rewards increasingly flow to those with the best distribution.

What does this mean to firms relying on branch networks for new assets? Costs are about to go up big time. More important, the evolution of the channel will provide a preview of what’s to come in the business of acquiring clients generally.

To get a sense for how this story will end, it’s instructive to review how the economics of client acquisition in an earlier financial services market—the mutual fund business—evolved as the industry matured through the early 1990s. The real innovators— firms like Franklin Templeton and Invesco—powered the steep portion of their growth curve by working with the wirehouses for distribution of their funds. In the early days of that relationship, the funds typically retained both their stated management fees plus as much as half of the upfront sales loads collected by the brokerages.

Not so today. Firms that want to distribute in that channel receive none of the sales load and must directly or indirectly rebate as much as 80% of their management fee in order to feed at the trough. The mutual fund companies directly pay fees to be part of various programs at the wirehouses, and then indirectly rebate a portion of their fees by sponsoring various events and services for the firms and their individual producers. And while certain sponsorship activities are nominally “voluntary,” failing to engage in them will quickly make a firm non-competitive in the channel.

All that is in addition to the fact that the fund managers also now need large, expensive, licensed wholesaling forces. With all the rebates and associated costs, one large asset-management firm calculated that today their breakeven from the wirehouse channel was roughly $40 billion of assets. These more mature markets require increasing amounts of sales infrastructure and overhead to stay competitive, and that in turn makes it harder and harder for small firms to even get out on the playing field, much less win.

So even when it starts out as a free lunch, the bill eventually comes, and the easy, excess returns to capital and effort are competed away. That’s capitalism for you.

There are now the first signs that the custodial channel is beginning to undergo a similar evolution. In the beginning, the custodians didn’t charge wealth managers for participation in the referral programs. Now, the standard fee is the greater of 0.25% of client assets or 25% of the management fees (both in perpetuity). Additionally, due to increased competition among wealth managers for a slice of the referral pie, success in the channel increasingly depends on hiring dedicated teams of marketers to call on the branches.

But a more significant version of the proverbial “canary in the coal mine” has recently come to light: One wealth manager has been able to capture extraordinary volumes of custodian referrals by waiving the entire first-year fee payable by the client while still paying the full amount due to the custodian.
Is the firm nuts? Not if you look at the math. Given that client turnover averages 1% to 3% per year (implying relationships of 33+ years), the firm is forgoing one year of fees in exchange for a few decades of fees. That’s a pretty modest price to pay for a lot of future value.

More important, the strategy points to a broader trend within the channel. Given the immense economic value generated by individual clients, it makes sense for wealth managers to spend more than they do today to accelerate the pace of referrals. Thus, it would not be surprising soon to see wealth managers using new and creative ways to encourage the custodial branches to send more clients their way.

Some wealth managers may offer to sponsor events to help the custodians capture more clients or to reward their top employees. (Yes, advisors will actually start paying for custodial events and not vice versa, as shocking as this may sound.) Others may offer to underwrite some of the continuing education costs of branch employees or even the development of new technology. Of course, any such activities will be completely “voluntary.”

After netting out increased “marketing” and referral costs, profits margins on clients referred from custodians will be squeezed to a fraction of current levels.
To be sure, markets don’t mature overnight. It could be five years in our industry before we start to see net pricing in this channel start to completely collapse, but you read it here: Collapse it will.

Moreover, the cost of acquiring clients will be so high that working the custodial channel will increasingly be profitable only for those who get large volumes from doing so. In the money management world, about a dozen firms capture 90% of the wirehouse assets available. If you’re not playing at scale, you simply can’t compete with the companies that are.

Those who self-select to compete long term will seek scaling opportunities and then take advantage of their size to build organizations that can compete in the long term.

Finally, it should also be noted that these trends shouldn’t be attributed to bad behavior or even greed on the part of the custodians. Custodians send clients to wealth managers because it is in their best interests to do so. The evolution of the economics of the relationship is simply a function of markets at work.
A warning for those firms that are not currently trying to gather clients from the custodial channel: You would be smart to pay attention because the same pricing trends will reoccur in every client-gathering channel over time. In fact, to some extent, the cost of acquiring clients is already beginning to increase.
Many wealth managers are developing separate, sophisticated—and expensive—marketing forces. With increased competition for referrals from accountants and lawyers, firms are spending increasing amounts on ways to endear themselves to these centers of influence. Some firms are also developing sub-specialties and are planning to make substantial investments to brand and communicate this expertise to prospective clients.

For anyone who started in the industry in the early ’90s, these changes can seem like madness. Marketing was largely a pie-eating contest for them. But of course, what’s to come is really quite rational and inevitable. A quarter of a loaf is better than none, even if you need to work a lot harder and dedicate more resources to ensuring you can retain your quarter loaves.

The question is not whether the economics of acquiring clients are going to change, but rather how quickly. The most successful firms will accept this inevitability and view these coming changes as an opportunity to build potential competitive advantages over their less nimble counterparts.

Mark Hurley is the Founder & Chief Executive Officer of Fiduciary Network LLC. He can be reached at hurleym@fiduciarynetwork.net.