Sustainability Pillar #2: Product inventory control
- The evolution of investment philosophy and corresponding asset class fragmentation. As capital markets have evolved over time, new asset classes have been identified as providing diversification benefits. For example, in the early 1990s, emerging market equities became a viable asset class as a diversifier to international developed equities. When a new asset class is “validated,” the advisor community typically responds by adding the new asset class to client portfolios, thereby increasing the number of CUSIPs the advisor tracks.
- Proliferation of products. According to a recent Investment Company Institute report, there were 7,923 mutual funds available to investors in 2015. That was up from 6,248 mutual funds 20 years ago and drastically up from 1,835 mutual funds available 30 years ago. Within just a six-year period in the early 1990s the total number of funds doubled.1 As product availability has increased, some advisors may find that they hold several funds from various fund families targeting the same mandate in an asset class.
- Advisor tenure in the industry. According to Cerulli,2 the average advisor has 19.4 years of experience in the industry. Without a disciplined, rigorous approach to inventory management, an advisor can easily find themselves as a “collector” of CUSIPs over time. Some of these CUSIPs may have been intentionally selected while others may have transferred in with a client. Regardless of the manner in which the CUSIPs found their way into the advisor’s book, the advisor is responsible for appropriate oversight of the CUSIP henceforth.
What’s the problem with attempting to manage a lot of CUSIPs?
- Compromised efficiency.
A significant variable in the quest for advisor scale is product inventory control. More CUSIPs require more time and resources to manage. This is especially true when you consider the amount of time required to effectively manage a CUSIP, which we estimate at eight hours per CUSIP per year (based on our own observations). The eight hours encompass the time required for:
- Objective research: Independent research by the advisor focused on multiple variables, including security selection, category drift, pricing, and performance.
- Subjective research: Quarterly meetings with a representative from the CUSIP provider (wholesaler/portfolio manage/CEO) to gain insight into the decision-making of the most recent quarter.
- Client education: The advisor must translate both the objective and subjective research into relevant information for client communications.
Increased liabilityMany advisors are familiar with the 80/20 “rule” that describes the relationship between Revenues and Households in a typical advisor’s book: often 80% of revenue is driven by 20% of households. We have observed that in many cases the 80/20 “rule” also applies to the relationship between AUM and number of CUSIPs: 80% of a book’s assets are concentrated within just 20% of the CUSIPs; and only 20% of assets are invested across 80% of the CUSIPs.
For example, an advisor who has $100 million AUM and follows 250 CUSIPs, would have $80 million of those assets concentrated within 50 CUSIPs; the remaining $20 million of AUM would be invested across 200 CUSIPs. Sometimes there are CUSIPs that are only used in a single client account with a very small amount of AUM.This raises the question, if it requires eight hours to effectively manage a CUSIP, and there is little AUM/Revenue tied to that CUSIP, then what incentive does the advisor have to dedicate the appropriate eight hours? Either the advisor is inefficiently spending time by focusing the appropriate eight hours on a CUSIP with little client AUM representation in the book, or the advisor is exposing the business to enterprise liability by neglecting to spend the proper eight hours of oversight.
The impactThe hypothetical advisor following 250 CUSIPs would have to dedicate 2,000 hours per year simply to effectively manage the product inventory. However, 2,000 is also the average number of work hours in a year. In theory, attempting to stay abreast of that number of products leaves little time for other business activities and also potentially opens the advisor up to litigation, particularly in this post-DOL rule world. Advisors who make the conscious decision to narrow their product lineup see a number of key benefits, including, but not limited to, increased scale of the ongoing research necessary to effectively manage the client portfolios, as well as a decrease in the enterprise risk because of an effective reduction in the variability.
The solutionReview your product inventory to determine whether you have an 80/20 dynamic in your book. Are you maintaining any CUSIPs that are used by only a very small portion of your book? Is there opportunity to consolidate your smaller positions into more focused weightings that will then carry the AUM to justify eight hours per year? Even better, the more concentrated CUSIP inventory will allow for greater efficiency and scale in the portfolio management side of the business, thereby creating capacity for COI relationships, prospecting, and deeper client relationships. Finally, consider the enterprise valuation benefits of consolidating your product inventory: a book with fewer CUSIPs typically translates to a higher valuation.
What’s nextBe sure to check back over the next several weeks as we discuss the next pillar of a sustainable advisory business:
- Manageable number of client households
- Product inventory control
- Documentation of key processes
- Optimized client experience and portfolios
The bottom lineSuccessfully managing the product inventory in your business is the second step toward building a sustainable practice. By conducting a product inventory audit, you’re taking an important step to focus your time and resources while limiting your liability within this dramatically shifting environment.
1 Source: 2015 Investment Company Fact Book.
2 The Cerulli Report, Advisor Metrics 2015.