Advisor Investment Platforms on Cusp of Major Transformation

But how then, given their inherent disadvantages, did mutual funds and ETFs become so popular? There were two primary reasons the industry saw widespread adoption of mutual funds by investors. Actively managed mutual funds promised investors the prospect of alpha (market outperformance). Second, all mutual funds, regardless of style or asset class, offered investors relatively low-cost diversification. However, we now know, thanks to empirical and academic research, that there is no alpha; managers routinely fail to outperform their asset class benchmarks over time. Second, the recent elimination of trading fees for equities means investors can achieve similar levels of diversification as any mutual fund or ETF – and at zero cost.

With rare exception, mutual funds and ETFs no longer offer investors any meaningful advantage over individual securities.

Game changer: The race to zero

The recent price war, initiated by Charles Schwab, resulted in the industry’s three largest custodians – Schwab, TD Ameritrade, and Fidelity – eliminating fees for trading stocks and ETFs. Mutual funds were noticeably absent from this race to zero, putting those vehicles at a serious competitive disadvantage relative to ETFs and stocks. Investors can purchase a globally diversified portfolio of individual equities at no cost. Why purchase a Vanguard S&P 500 Index fund at a one-time transaction cost of $10 or $20 and an annual fee of 3 basis points when you can effectively purchase all 500 stocks for free while retaining all the flexibility, tax benefits, and transparency that comes with owning individual equities?

The big winner: UMA technology and separate account strategies (SMAs)

Many RIAs historically avoided using separate accounts due to concerns over excessive trading fees. For example, a typical U.S. large-cap equity strategy owns about 150 stocks. With an account minimum of $100,000, an investor paying $5.95 per trade annual trading fees equates to about 0.90% in year one and about 0.45% per year thereafter in trading-related fees; this doesn’t include advisor or manager fees. Many RIAs historically solved this problem by using asset-based pricing programs at their custodians, which typically charged anywhere from 0.10% to 0.25% annually.

But those fees are now zero. Separate account managers suddenly find themselves with a competitive advantage since the race to zero has leveled the playing field.

The immediate beneficiaries of this brave new world are separate account managers who provide model-traded individual security portfolios to RIAs. But not all separate account managers are created equal. Compressing margins and advisors’ need to scale their practices requires the use of more advanced unified managed account technology to minimize account paperwork and 1099s. Only those separate account managers who are UMA-compatible will thrive in the new world. And only RIAs with robust UMA technology will be able to compete in the years ahead; gone are the days of opening five different accounts with the same registration to invest in five different separate account strategies.

The rise of the new RIA

Just as ETFs challenged the market dominance of mutual funds, UMA-compatible SMAs are now poised to challenge the market dominance of mutual funds, ETFs, and non-UMA compatible SMAs. But this victory for UMA-compatible SMAs might be short-lived. New index replication technology will soon challenge incumbent SMA providers by providing RIAs the tools they need to efficiently remove the middle man in the supply chain.

With index replication technology, RIAs can directly add value to client portfolios through portfolio construction, trading, tax management, and custom ESG solutions – without the use of a separate account manager. Technology increasingly empowers advisors to replicate broad, popular indexes like the S&P 500 Index with the click of a mouse. It’s like buying an index fund without the wrapper and tax headaches; and without the expense ratio or, in the case of SMAs, manager fees. RIAs can set tracking error constraints, rebalancing logic, position limits, capital gain budgets and more. They can build custom, tax-managed index portfolios for clients – none of which would have been cost efficient without the elimination of trading fees, the rise of new index replication technology, and increasing demands by investors for more custom portfolio solutions.

Conclusion

The advisor space is on the cusp of unprecedented change. Nowhere is this more obvious than in the realm of investment management. The days of managing client wealth exclusively through the use of mutual fund and ETF portfolios are gone. This is a good thing; these developments continue to push supply chain fees lower, resulting in better portfolios for clients.

For the RIA profession, these developments, perhaps ironically, provide the opportunity to demonstrate value beyond investment management; advisors can more surgically harvest tax-related alpha, partner with clients to build truly personalized portfolios, and, by pushing fees lower, are in a better place to deliver on and defend their own value proposition.

Donald Calcagni is chief investment officer of Mercer Advisors. Mercer Advisors Inc. is the parent company of Mercer Global Advisors Inc. and is not involved with investment services. Mercer Global Advisors Inc. (“Mercer Advisors”) is registered as an investment advisor with the SEC. Content, research, tools, and stock or option symbols are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. Past performance may not be indicative of future results.

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