Don't be fooled by the numbers — the industry is in a dangerously vulnerable state

If one were to look at the financial advice industry solely by the numbers, it would look pretty good. Median assets grew a whopping 16.8% last year, while median revenue grew by 11.7%, according to the 2018 InvestmentNews Study of Pricing & Profitability. The revenue number was substantially higher than the 5% growth recorded in 2016 and marks a return to a double-digit rate of growth not seen since 2014. The research also shows that average pre-tax income of advisory firm owners reached a new high of $623,000, up 11.8% from $557,000 the year before; and average operating profit margins hit a new high of 24.9%.

But a deeper look into the positive snapshot reveals an industry that is dangerously vulnerable to financial market fluctuations, potentially ignoring important business development and organic growth fundamentals that would help firms weather a market downturn. The InvestmentNews research and survey of 385 advisory firms, compiled in conjunction with Pershing Advisor Solutions and The Ensemble Practice, shows that the biggest contributor of asset growth in 2017, by far, was market performance. The S&P 500 stock index returned 21% last year. More than 8 percentage points — or about half — of the average growth in assets under management among advisory firms was attributed to market gains. "The positive markets have camouflaged a lot of sins, because for the majority of firms, growth is tied to assets under management," said Mark Tibergien, chief executive of Pershing Advisor Solutions.

Averages being what they are, Mr. Tibergien said advisory firms that see their numbers falling behind those of their peers should strip out the market performance and pay attention to things like asset decumulation and a lack of capacity to take on new clients. "The adviser's value proposition has to be greater than just investment management," Mr. Tibergien said. "Those advisers who hold on to investment performance as a unique proposition will inevitably disappoint their clients." As the increased focus on fiduciary duty and fee-based advice continues to lead the financial services industry on its steady migration toward the independent advice channel, financial success is increasingly tied to investment performance. (More: The 2018 InvestmentNews Compensation & Staffing Study Update) According to Matthew Sirinides, senior research analyst at InvestmentNews Research, this year's study revealed that 88% of advisory firm revenue is from asset-based fees. "The majority of firms we talked to said it was all about market appreciation, so it's not a mystery to them why they're doing well," he said. "But because that's not necessarily sustainable, when the markets fall they will need to make sure their relationships with clients are sticky enough."

Client loyalty

The data, however, does not bode well for client loyalty. While advisory firms report that nearly 35% of new clients are coming from the traditional brokerage industry and about the same percentage are coming from the self-directed-investor ranks, more than a third are coming from competing independent advisory firms. By comparison, in 2015, firms reported that less than 10% of new clients were coming from competing advisory firms. Some practitioners attribute client movement among RIAs to a recognition of fiduciary status and holistic planning. "I started my practice in 2008 and I didn't have any problems getting clients because a market downturn is when people want help the most," said Lazetta Rainey Braxton, founder and chief executive of Financial Fountains.

"It's not just about the money in the portfolio," she said. "It's about how you're living, what's going to happen with your job, living expenses. All of those are financial planning questions that people need help with." Sidney Divine has been in the financial planning business for eight years, but started his own firm, Divine Wealth Strategies, in September. From his perspective, if clients are leaving one RIA for another, they are likely looking for more than just commoditized asset management services. "There are more aspects of planning, ancillary services, that aren't necessarily being provided by all advisers," said Mr. Divine. "When I meet with clients we go deeper than just financials and talk about life stuff. We don't talk about investing until the third meeting." Brian Jones, who launched NextGen Financial Advice in March after spending eight years at a wirehouse, said smaller firms have the advantage of being nimble both in terms of products and services. "Where I used to work there would have been pressure to keep clients invested during a market downturn, but now that I'm independent I can be more flexible and put clients into CDs if they're really nervous," he said. "Being a fiduciary is a big deal with clients, and that's something they don't have at the big brokerage firms."

Largest firms grow fastest

Despite the perceived virtues of smaller firms, the InvestmentNews study shows that the largest firms are growing the fastest and are the best performers, benefiting from a balanced blend of organic growth, inorganic growth, strategic hiring and the growing presence of private-equity capital. Fidelity Investments counts 697 advisory firms with at least $1 billion under management, which is up from 360 firms in 2013. Financial advisers are splitting into quantifiable blocks that show revenue growth moving in stride with assets under management, enhancing the focus on size and scale. For example, the largest firms in the InvestmentNews study, those with at least $10 million in annual revenue, increased assets by an average 17.5% and revenue by 12.8% last year. At the other end of the spectrum, solo practitioners increased assets by an average 14.4% and revenue by 6.3%. The biggest firms might be pulling away from the pack by bellying up to a table set for industry consolidation. The impact of mergers and acquisitions, which have been heavily influenced by the growing appetite of private-equity investor capital, last year contributed an average 3.4% in asset growth at the largest firms studied by InvestmentNews.

Private equity still hot

Marty Bicknell, chief executive at Mariner Wealth Advisors, which has $25 billion in assets, believes "the private-equity craze will be here for a while." "I can't see past five years, but I don't see (PE investing) slowing down in that time frame," he said. "There's just too much of it. I recently had a conversation with a PE firm that missed out on a $20 billion firm, and their comment to me was, 'No worries, we will be here to buy them in three to five years when the PE investor that won is ready to sell them.' Just think about that mentality."

One development that could derail it would be a prolonged market decline, according to one M&A consultant. "A stock market decline is a boogie man that will have a significant impact on M&A, because valuations will get hammered, and it pulls advisers away from the negotiating table to deal with nervous clients," said David DeVoe, managing director at the investment bank DeVoe & Co. Another industry expert believes some firms are concentrating on M&A activity because it is the easiest path to asset growth. "Asset growth is what drives most of what happens in this industry, and firms can get overly focused on that because doing mergers and acquisitions is sexier than growing organically," said Drew Taylor, founder of consulting firm DTaylor Group. "Organic growth requires having the right sales and business practices, and leveraging stories and strategies," he said. "It's the basics of blocking and tackling, and it's easy to ignore it when the M&A market is booming and there are a good number of deals out there." Mr. Tibergien also has noticed a lack of organic growth among firms. "Because we've been in such a positive market environment for the past decade, advisers can grow assets and business without doing a lot of business development, so their sales muscles have atrophied," he said. "Why make an effort when everything is going up? Particularly for owners, whose business is getting bigger, they kind of feel like king of the hill." The InvestmentNews report shows that as firms ramped up hiring to build capacity, the average revenue per professional remained about where it was in 2015. "The rate of growth at the average firm has been disappointing relative to the size of the opportunity in the U.S. and the number of new millionaires out there," Mr. Tibergien said. "Right now, 90% to 95% of revenue is coming from existing clients. In this environment, more should come from new business."