Journal of INVESTMENT ADVISORY SOLUTIONS...Jour INVESTMENT ADVISORY SOLUTIONS 2 CONNECT NOW GRO...

InsideINVESTMENT ADVISORY SOLUTIONS DATA AND INSIGHTSbroad trends in market segments and product development and usage

ACTIVE AND PASSIVEbalanced perspective on the appropriate use of active and passive strategies

BUSINESS MODEL EVOLUTIONhow distributor, asset manager and advisor business models are changing

Journal of

INVESTMENT ADVISORY SOLUTIONSVolume 1 n Number 1 n Fourth Quarter 2017

Mon

ey M

anagement Institute20 TH

Mon

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Management Institute20TH

ANNIVERSARY

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ADVANCING THE FUTURE OF INVESTMENT ADVISORY SOLUTIONS

http://www.mminst.org

Journal of

INVESTMENT ADVISORY SOLUTIONS

2

C O N N E C T K N O W G R O W

BOARD OF GOVERNORS

MMI JOURNAL OF INVESTMENT ADVISORY SOLUTIONSVolume 1 n Number 1 n Fourth Quarter 2017

©2017 Money Management Institute. All rights reserved. Articles may be reprinted only with the permission of the Money Management Institute (MMI) and the respective author(s).

The MMI Journal of Investment Advisory Solutions is published by MMI for the use of its members. The publication focuses on thought leadership, including reports, articles, and commentary, from respected subject matter experts and authorities, on topics critical to the ongoing evolution of investment advisory solutions. The publication is intended to provide accurate and informed information on the topics covered. The commentary provided by the authors who appear in the Journal does not necessarily represent the opinions of MMI, its staff, Board of Governors, or members. Neither MMI nor its staff, Board of Governors, or members is responsible for facts and opinions contained in the reports, articles, and commentary herein.

Article submissions and questions about the Journal can be directed to Joan Lensing at [email protected] or (646) 868-8500.

Roger ParadisoChairperson, MMI Board of Governors, Legg Mason

Jennifer Abate Lazard Asset Management

David BerkowitzLincoln Financial Network

Yanni Bousnakis Cetera Financial Group

John Brett Pershing LLC

Marc Brookman Morgan Stanley Wealth Management

John Coyne Brinker Capital

Jeffrey Cusack Nuveen Investments

Jeff Dowdle Raymond James Financial

Marilee FeroneUBS Financial Services

Keith GlenfieldBank of America Merrill Lynch

Matthew JohnsonBrandes Investment Partners

Carl Katerndahl Nuveen Investments

Scott KilgallenNeuberger Berman

Eric KoestnerEdward Jones

Michael Lewers BlackRock

David Lindenbaum Charles Schwab & Co.

Andrea LisherJ.P. Morgan

Patty LoepkerWells Fargo Advisors

Thomas MaloneLord Abbett

John Moninger Eaton Vance

Cheryl NashFiserv Investment Services

Greg NordmeyerAmeriprise Financial Services

Daniel O’Lear Franklin Templeton Investments

Kevin OsbornEnvestnet

Stuart ParkerPGIM Investments

Craig PfeifferMoney Management Institute

Joseph SchultzAmerican Century Investments

Ram SubramaniamFidelity Brokerage Services

Eric Sutherland PIMCO

Pete ThatchCapital Group

Troy ThorntonGoldman Sachs

William Turchyn Mariner Investment Group

Jake TuzzaVoya Investment Management

Burton WhiteLPL Financial

Bebe WilkinsonMassMutual

William GoldenMMI Board Advisor

John SweeneyMMI Board Advisor

Volume 1 n Number 1 n Fourth Quarter 2017

ADVANCING THE FUTURE OF INVESTMENT ADVISORY SOLUTIONS 3


TABLE OF CONTENTS

Letter to Members 4

Investment Advisory Solutions Data and Insights 5 broad trends in market segments and product development and usage

Calculating Upside/Downside Capture Ratios for Equity Hedge and Tactical Managers 6Ricardo L. Cortez, CIMA, Broadmark Asset Management LLC

Discovering Phi: Motivation as the Hidden Variable of Performance 13The Center for Applied Research (State Street Corporation) | CFA Institute

Blockchain Innovation in Wealth and Asset Management: Benefits and Key Challenges to Adopting this Technology 69EY (Ernst & Young)

Sustainable Investing: Investor’s Guide to Corporate Governance 85Stephen Freedman, CFA and Renato Grandmont, UBS

Active AND Passive 100 balanced perspective on the appropriate use of active and passive strategies

Active Versus Passive Investing: Our Perspective 101Lockwood Advisors | BNY Mellon

The Death of Active Management Has Been Greatly Exaggerated: Active investing will never die, but it’s being forced to evolve. 105Ben Johnson, CFA, Morningstar

Business Model Evolution 108 how distributor, asset manager and advisor business models are changing

Links in the Chain: Why Asset Managers Must Embrace the Digital Revolution 109Artivest

Behavioral Alpha: An Advisor’s Greatest Value 113Dr. Daniel Crosby, The Center for Outcomes | Brinker Capital

TAMP Market Overview 120FUSE Research Network

Why Advisors Have Never Been So Valuable: 2017 Value of an Advisor Study 126Russell Investments

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4


LETTER TO MEMBERS

December 2017

To MMI Members and Friends,

As MMI concludes its 20th anniversary celebration, we are pleased to introduce you to a new MMI publication—the MMI Journal of Investment Advisory Solutions—a compendium of original research reports and articles by industry thought leaders and subject matter experts. In launching the Journal, our goal is to collect and present to members informed perspective on topics critical to the ongoing evolution of investment advisory solutions.

For this inaugural Journal, we called for submissions addressing three specific topics:

• Investment Advisory Solutions Data and Insights—broad trends in market segments and product development and usage,

• Active AND Passive—balanced perspective on the appropriate use of active and passive strategies, and

• Business Model Evolution—how distributor, asset manager and advisor business models are changing.

We were extremely pleased by the strong response and the quality of the submissions received, and we extend our special thanks to those industry partners whose work appears in this first edition. Our plan is to publish the Journal on a biannual basis. We trust you will find this new resource valuable and look forward to your feedback.

Roger ParadisoMMI Chairman Legg Mason

Patty LoepkerMMI Chair Elect Wells Fargo Advisors

Craig PfeifferPresident & CEO Money Management Institute


ADVANCING THE FUTURE OF INVESTMENT ADVISORY SOLUTIONS 5


INVESTMENT ADVISORY SOLUTIONS DATA AND INSIGHTSbroad trends in market segments and product development and usage

Journal of


6 Calculating Upside/Downside Capture Ratios for Equity Hedge and Tactical Managers

SummaryThe upside/downside capture ratio is an important analytical tool for the investment management consultant. While they may be calculated for managers in all asset classes, in this paper we focus on upside/downside capture ratio calculations for equity hedge and tactical managers. We believe that the time period used with the ratio is significant when evaluating each of these types of managers.

For the purposes of this paper, we define those managers who are generally hedged (usually long and short at all times) as “equity hedge.” This designation includes market neutral, relative value and long/short managers. We define managers who are directional and not necessarily hedged at all times as “tactical,” including global macro, managed futures and tactical managers.

The traditional upside/downside capture ratio, which is usually calculated using a monthly time series, is best at evaluating an equity hedge manager’s security selection and portfolio construction expertise. As the equity hedge portfolio fluctuates versus its benchmark, the investment consultant is able to assess an equity hedge manager’s performance versus the benchmark during the up and down periods.

Tactical strategies, on the other hand, often make extensive use of broad market indexes through ETFs, futures contracts and derivatives rather than individual

Calculating Upside/Downside Capture Ratios for Equity Hedge and Tactical ManagersRicardo L. Cortez, CIMABroadmark Asset Management LLC

securities. This approach is used because the goal of these managers is primarily to regulate the exposure of the portfolio to the market rather than the selection of individual long and short securities. Tactical strategies are more directional in nature.

Upside/downside capture ratios for tactical managers should provide insight into their ability to manage systemic risk and preserve capital during down market cycles. We suggest that the best way to achieve this goal is to use a time period that is related to the overall market environment—e.g., up, down, flat, volatile cyclical markets—which may be longer than their monthly variance versus a benchmark. While the investment management consultant is able to use the same mathematical formula for both calculations, we believe that the selection of the measurement period is important in evaluating the manager’s particular skill in their area of expertise.

Why Is Upside/Downside Capture Analysis Important Now?The rush to passive investing has accelerated in recent years. In 2016, there was a record net new cash inflow in domestic equity index funds (including ETFs) of over $250 billion. At the same time, there was a record net outflow in domestic equity active funds of over $300 billion. Many market participants have asked if this is the new model for investment management. Figure 1 seems to suggest that this trend is secular in nature, having persisted for 25 years, rather than merely a cyclical phenomenon. It leaves many wondering: why should an investor hire an active manager if active management returns have not exceeded that of unmanaged market indices? Is active management dead?


7Broadmark Asset Management LLC

We believe that a good way to manage risks in a passive portfolio is to allocate a significant portion of the portfolio to tactical strategies that are designed to manage portfolio risks. We believe this active management allocation is essential to portfolio management, particularly now.

At the current point in the economic and stock market cycle, after the U.S. stock market has produced continuous positive returns every year since 2009, it is prudent to ask at what point the market will undergo the type of correction to the uptrend that typically occurs after economic expansions. This question is particularly important for those investors whose time horizon is less than 10 years. Remember that if an investment portfolio declines 50%, as it did during the last recession, it must subsequently double in value just to get back even, which begs the question: does the portfolio have sufficient time to recover? Another consideration when looking

FIGURE 1. RECORD FLOWS INTO PASSIVE FUNDS AND OUT OF ACTIVE FUNDS

YEARLY DATA, DECEMBER 31, 1993—DECEMBER 31, 2016

Sources: Ned Davis Research, Investment Company Institute, as of 12/31/16

at passive versus active investing is that the market advance since 2009 has been indiscriminate in driving up stocks; high-quality and low-quality securities alike have been buoyed upward by the rising stock market tide. Active investment managers that discern higher quality from lesser quality securities have been at a disadvantage because the stock market has not rewarded this distinction.

“The essence of portfolio management is the management of risks, not the management of returns.”

—Benjamin Graham

Net New Cash Flow Into Domestic Equity Index Funds, Including ETFs

Net New Cash Flow Into Domestic Equity Active Funds

252.79

-320.43

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Calculation of the Upside/Downside Capture RatioUpside/downside capture ratios show how much a manager has gained or lost compared to a broad market benchmark over a specified time period. The ratios are usually calculated using monthly data, but any time period can be used. The investment consultant might want use daily or weekly data to examine the manager’s sensitivity to very short-term market movements or extend the time period under review to one year or more to measure a manager’s risk capabilities during a large market decline (2008, for instance) and ability to participate in the subsequent market advance.

Monthly upside/downside capture ratios are calculated by taking the manager’s monthly return during months when the benchmark had a positive return and dividing it by the benchmark return during that same month. Downside capture ratios are calculated by taking the manager’s monthly return during the periods of negative benchmark performance and dividing it by the benchmark return. Generally, upside/downside capture ratios are calculated over one-, three-, five-, 10- and 15-year periods by calculating the geometric average for both the manager’s returns and index returns during the up and down months, respectively, over each time period.

According to Morningstar, “An upside capture ratio over 100 indicates that the manager has outperformed the benchmark during periods of positive returns for the benchmark. A downside capture ratio of less than 100 indicates that the manager has declined less than its benchmark in periods when the benchmark has

been negative. In the case where a manager registers positive returns when the benchmark declines, the fund’s downside capture ratio will be negative (meaning it has moved in the opposite direction of the benchmark). The selection of a particular benchmark is important and is usually the stated benchmark for the manager.”1

Upside/Downside Capture Ratio Measurements for Equity Hedge ManagersUpside/downside capture ratios are commonly calculated using monthly return data. Monthly calculation is an appropriate measure for those managers who employ security selection as their focus, as this analysis captures how well their positions contribute to the overall portfolio movement versus the benchmark without regard to the market environment, as measured monthly. The goal for an equity hedge portfolio is to select both long and short positions they believe will contribute positively to returns.

Upside/Downside Capture Ratio Measurements for Tactical ManagersA tactical manager’s goal is often to capture upward moves during up market cycles and to avoid losses during down market cycles. The traditional method of calculating upside/downside capture ratios using monthly data does not address the tactical manager’s use of risk management techniques through portfolio exposure in different market environments because one month doesn’t capture the full range of a market cycle. By using only monthly data without regard to the market environment, the traditional method does not provide insight into a manager’s timing ability and success at mitigating systemic risk over a full market cycle.

1 See www.morningstar.com/InvGlossary/upside-downside-capture-ratio.aspx



Evaluating Equity Hedge and Tactical Managers Using the Upside/Downside Capture RatioThe CFA Institute has stated that “At the manager level, we can think of a benchmark as a passive representation of the manager’s investment style, incorporating the salient investment features (such as significant exposures to particular sources of systematic risk) that consistently appear in the manager’s portfolios. A manager’s benchmark encompasses the manager’s ‘area of expertise.’”2 Investment consultants evaluate a manager’s capability versus a benchmark by identifying the relevant features of that manager’s strategy. The appropriate benchmark should encompass the manager’s “area of expertise.” The investment consultant should therefore determine how best to measure this expertise in relation to the benchmark.

We suggest that the investment consultant consider four factors when evaluating a manager’s performance versus a benchmark when using the upside/downside capture ratio:

1. The investment time horizon. Tactical managers often take a top-down macroeconomic or a quantitative approach to the markets, or use a combination of the two. The time horizon targeted by these managers might be longer and encompass more of an intermediate- or long-term economic and stock market cycle—from three months to a year or more. The traditional monthly calculations used may be not be helpful in measuring a tactical manager’s success or failure over a longer market cycle.

2. The securities used reflect the different investment approaches. Equity hedge managers generally have long and short individual securities positions in the portfolio. The upside/downside capture ratio as calculated monthly gives the investment consultant a good idea of how the long and short positions have contributed to the performance of the overall equity hedge portfolio, which in turn offers insight into the manager’s stock selection capabilities.

However, tactical managers often use broad market indexes and derivatives rather than individual securities. The evaluation of tactical managers is not based upon stock selection, but rather upon the portfolio’s performance during up- and down-market cycles. By extending the time period to encompass a market cycle or a specific time period within a market cycle, the investment consultant can better evaluate the correlation of investment returns compared to the benchmark with respect to systemic risk.

3. The types of risks being measured. Upside/downside capture ratios using monthly data do a good job of assessing a manager’s ability to construct and manage security-specific risks. The tactical manager’s primary goal is often to capture the larger market upward moves and protect the portfolio from systemic, or market, risk. By adjusting the time period used in the calculation, the investment consultant can make sure to measure the manager’s skill at managing each type of risk—specific risk and systemic risk.

2 2014 CFA Program Curriculum, Level III, “Portfolio: Execution, Evaluation and Attribution, and Global Investment Performance Standards,” page 136

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4. The stock market environment. If the stock market environment in the next five years is similar to the last five years of rising stock prices, then the traditional monthly upside/downside capture ratio calculation may be the best way to assess a manager because it demonstrates the stock picking and portfolio construction ability of the manager. However, if the approaching stock market environment has more economic contractions, declining stock prices or increased volatility, then we suggest that a better way to assess risk management may be to evaluate how a manager performed during longer periods of time compared to the benchmark. Adjusting the time horizon to reflect the anticipated market environment may enhance an investment consultant’s ability to evaluate each manager’s particular area of expertise.

ConclusionThe upside/downside capture ratio can be a powerful tool in evaluating both equity hedge and tactical managers. However, adjusting the time horizon for each of these types of managers can better evaluate each manager’s area of expertise and management of specific risk versus systemic risk.

The commonly used method of calculating upside/downside capture ratios using monthly data is an excellent method for assessing an equity hedge manager’s area of expertise, namely individual security selection and portfolio construction. However, when evaluating the area of expertise of tactical managers, we suggest broadening the time period under investigation to include various market environments. By expanding the time period used in the calculation, a consultant can better evaluate the tactical manager’s expertise at managing risk and return during rising, flat, declining or higher volatility market environments. We believe that examining performance over various time periods and market environments may give the consultant a more robust assessment of the skills of equity hedge and tactical investment managers.



Ricardo L. Cortez, CIMA Co-CEO

As Co-Chief Executive Officer, Mr. Cortez is responsible for the management of Broadmark’s day-to-day business activities as well as the oversight of the firm’s sales and marketing efforts. In

addition, he is a member of the Investment Team and serves as the firm’s Chief Risk Officer. Mr. Cortez joined Broadmark in September 2009 as President, Global Distribution and was named Co-CEO in June 2013. Before Broadmark, he was President of the Private Client Group for Torrey Associates, LLC. Additional prior roles include Vice President at Goldman Sachs serving as Product Manager of the firm’s Global Multi-Manager Strategies program, and Senior Vice President with Prudential Investments overseeing product development and sales for the Investment Management Services Division. Mr. Cortez graduated cum laude from Queens College, City University of New York with a B.A. and is former Chairman of its Business Advisory Board. He is also an adjunct faculty member at Harvard University and has been a guest lecturer on Investment Policy and Hedge Funds at the Wharton School, University of Pennsylvania. Mr. Cortez was awarded the Certified Investment Management Analyst® designation in 1993 and is the author of numerous published articles on hedge funds.

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Broadmark Asset Management LLCInvesting involves risk, including a possible loss of principal. Past performance does not guarantee future results. Portfolio holdings are subject to change at any time.

Broadmark Asset Management (“Broadmark”) is a registered investment advisor. The views expressed contain certain forward-looking statements Broadmark believes these forward-looking statements to be reasonable, although they are forecasts and actual results may be meaningfully different. This material represents an assessment of the market at a particular time and is not a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding any particular security.

Prices, quotes and other statistics have been obtained from sources we believe to be reliable, but Broadmark cannot guarantee their accuracy or completeness. All expressions of opinion are subject to change without notice.

Indexes shown for illustrative purposes only. It is not possible to invest directly in an index.

The specific securities identified and described do not represent all of the securities purchased, sold, or recommended for advisory clients, and the reader should not assume that investments in the securities identified and discussed were or will be profitable.

Not FDIC Insured | No Bank Guarantee | May Lose Value©2017 Broadmark Asset Management LLC. All rights reserved.

All other registered trademarks or copyrights are the property of their respective organizations.

Motivation as the Hidden Variable of Performance

Discovering Phi

13The Center for Applied Research (State Street Corporation) | CFA Institute

After 18 months of research,

we’ve made an important discovery...

Discovering Phi: Motivation as the Hidden Variable of Performance14



...that has widespread implications for

the future of the investment management industry.


We have discovered a hidden variable of performance –


we have quantifi ed it, and we have named it...


Phi.

20 Discovering Phi: Motivation as the Hidden Variable of Performance

�e hidden variable of performance.


As in quantum mechanics, where a “hidden variable” is an element missing from a model that leaves the system incomplete, we find the same situation in investment management.


Short-term thinking has disconnected us from our shared purpose: achieving clients’ long- term goals and in turn contributing to economic growth. Organizations that are able to go back to basics and rediscover their purpose – their raison d’être – should be able to perform better in any return environment. We need to embed in our habits and incentives the connection to purpose. �e �rst step toward accomplishing this is to understand what motivates us and how our motivations work. Our motivations lead to action and our actions drive outcomes.

Based on 18 months of research from May 2015 to October 2016, through in-depth interviews with more than 200 global industry leaders, the State Street Center for Applied Research and project partner CFA Institute set out to answer one fundamental question: How can we leverage motivation to achieve better �nancial outcomes?

We combined the qualitative statements from these interviews with the �ndings from a survey of nearly 7,000 respondents: 3,600 individual investors and more than 3,300 investment professionals across 20 countries.

�rough this e�ort, we discovered a previously hidden variable with a statistically signi�cant relationship

to long-term organizational performance, client satisfaction and employee engagement. As in quantum mechanics, where a “hidden variable” is an element missing from a model that leaves the system incomplete, we �nd the same situation in investment management, i.e., there seems to be an intangible factor that has not previously been quanti�ed.

We call this variable “phi” — derived from the motivational forces of purpose, habits and incentives that govern our behaviors and actions.

�e phi motivation is distinctly di�erent from the short-term outperformance motivation or asset-gathering focus of our industry.1

�e results of our analysis were exceptional. A one point increase in phi is associated with:

28% greater odds of excellent organizational performance

55% greater odds of excellent client satisfaction

57% greater odds of excellent employee engagement. (For a detailed explanation of phi, please see the appendix.)

Discovering Phi

MOTIVATION AS THE HIDDENVARIABLE OF PERFORMANCE


When the phi of the investment professional, the investment �rm and their clients are aligned, this represents the greatest potential for sustainable organizational performance – across market cycles – as all are focused on the long-term goals of the client. Furthermore, phi drives the behaviors and attitudes individual investors must develop to reach higher levels of engagement and progress toward long-term goals.

While secular trends in alpha and beta are largely beyond our control, phi is not. Increasingly, our industry is looking for ways to measure value-add to clients that goes signi�cantly beyond benchmark-relative performance. In the consulting and �nancial advisory space, Morningstar introduced the concept of gamma to highlight the fact that, while advisors were not able to consistently identify which asset managers were likely to perform best, they could add signi�cant quanti�able value to clients through activities such as: liability-driven investing; dynamic withdrawal strategy; annuity allocation; total wealth asset allocation; and asset location and withdrawal sourcing.2 Similarly, phi can measure investment managers’ ability to produce performance driven by purpose.

To maximize phi, we must �rst understand the basics of motivational theory and how this theory applies to today’s investment management industry. We will initially look at those professionals working in the �eld, and then turn to their clients.


New Industry Skills Needed for Success

Research based on Self Determination Theory has found the best

work climates generate the additional skills our industry needs to

fully realize individual performance potential: cognitive flexibility,

creativity, ownership and citizenship. In the context of finance, these

sound rather esoteric, but given the disruptions occurring in today’s

environment, this is precisely the time when these new skills will

separate the winners from the losers. Here is their definition and why

they matter:

Cognitive flexibility: The ability to adapt to disruptive forces in the

industry (and therefore in organizations) is an important advantage.

Creativity: Not just the domain of art classes anymore or the negative

“creative accounting” types, creativity is needed by investment

professionals to find value in an environment that is increasingly

competitive.

Ownership: In this context we mean a sense of joint ownership of the

organization’s successes and failures – a feeling that one is an integral

part of the future of the firm

Citizenship: Corporate citizenship is characterized by employees who

do extra tasks for the overall health of the organization, beyond what

their role would require.


Why motivation?

At �rst glance, the investment profession is hardly one you could call unmotivated. It is full of intelligent and hard-working people, so we might be inclined to think this is an issue for a di�erent sector.

But when we look more closely, we can see that it is the type of motivation that dominates this industry that is precisely what may be working against it.

Motivation matters because it is “the psychological process that initiates and determines direction, intensity and persistence of voluntary and goal-directed actions.”3 Motivation is the engine that drives behavior. We have become more attuned to behavioral biases in �nance in recent years, but at times are frustrated by a feeling that biases can’t be mitigated. Motivation, however, goes one layer deeper to describe what sparks behavior, and may be strong enough to counteract biases.

As there is interplay among individuals with di�ering motivations, we must consider the potential of phi in terms of the complex adaptive system of interactions between providers and clients. Looking at just one participant in isolation does not tell the full story.


Motivation is the enginethat drives behavior.


53%

40%

28%

5%

of investment professionals said they pursued a career in investment management because they were passionate about financial markets.

of investment professionals report that it is an important reason they remain in the industry.

of our respondents said they remain in the investment management industry for the purpose of helping clients in achieving financial goals.

suggest they remain to contribute to economic growth.

The Good News:

The Bad News:


In order to understand (and ultimately improve) the behaviors in our industry, we must �rst understand the type of motivation behind them.

�e good news for our industry is that 53% of the investment professionals surveyed (asset managers, asset owners and other intermediaries) said they pursued a career in investment management because they were passionate about �nancial markets; and 40% of investment professionals report that it is an important reason they remain in the industry.4

�e bad news is that despite this passion, the industry appears disconnected from its purpose. Just 28% of investment professionals said they remain in the investment management industry for the purpose of helping clients achieve �nancial goals, and only 5% suggest they remain to contribute to economic growth.5 As the CEO of one asset owner describes it, “People in this industry do not get motivated by creating a better world…they are interested in returns and competing — nothing else.”6

What’s driving this disconnect? Quite simply, the environment we’ve created to support our passion limits our connection to purpose.

In the workplace, this environment is largely a function of corporate culture and leadership. To examine motivation in the context of culture and leadership, we used Self-Determination �eory (SDT),7 which identi�es three innate needs that, when satis�ed, allow optimal function and growth: competence, relatedness and autonomy. In other words, one must have:

1) �e capability and knowledge to work e�ectively

2) A close-knit environment where peopleunderstand how their work �ts togetherto bene�t from collaboration

3) Delegated authority (versus micromanagement).

The Current State of Motivation

PASSION WITHOUT PURPOSE


For a better understanding of this, we surveyed the following items, asking respondents to rate whether their leaders do the following:

• Articulate a compelling vision of the future

• Have a preparedness to challenge assumptionsand adapt their vision over time

• Talk to their employees about their mostimportant values and beliefs

• Spend time teaching and coaching employees

Unfortunately, we found that a majority of professional investors gave their �rm low ratings in every one of these categories. �e item with the lowest scores was about teaching and coaching, indicating a lack of commitment to the long-term health of the organization. Furthermore, only 15% of professional investors strongly believe their leaders articulate a compelling vision. �e most e�ective leaders make the linkage between these external motivators that they drive and the employees’ motivators that they are internally wired to use.

In fact, this lack of articulated and shared purpose is driving demotivation and stress: 92% of investment professionals in our survey report being demotivated in some way.

To attribute this lack of purpose to shortfalls in leadership and vision would be a major simpli�cation. As described below, investment professionals face a wide variety of other economic and emotional pressures that in�uence their motivations and behaviors.

Compensation

Conventional wisdom dictates that compensation is an e�ective tool for motivation. However, academic research shows that while compensation is indeed a factor that prevents dissatisfaction, it does not necessarily increase long-term motivation.8 Indeed, only 20% of our respondents indicated that compensation is the reason they remain in the industry.

Studies suggest that monetary incentives may create an atmosphere in which an individual feels greater external pressures, making it di�cult for them to process information and make decisions.9 �is can be mitigated if the compensation structure is perceived as fair, controllable and transparent.10 However, only 44% of respondents in our study believe their compensation structure is fair, 40% believe it is transparent and 34% believe it is controllable.


Fear, Stress and Career Risk

Asset owners, asset managers and wealth managers all report various short-term pressures that aect their decision making.

Among asset owners, most of that pressure came from the board (37%), management team (30%) and the investment consultants they have hired (17%). Just as important, however, was perceived career risk: About half of all industry professionals worry about this, and among this group 52% believe they would be �red after 18 months of underperformance.

Among asset managers and wealth managers, 36% report that acting in the best interest of their client actually implied taking on career risk. �is is because performance assessments of managers tend to be carried out over shorter time periods versus the longer-term investing horizon of clients. �is means that short-term losses could drive an investor to terminate a relationship with a manager, even if the investor bene�ts from the investment in the long run.12 Similarly, 24% feel organizational pressure to take too little risk on behalf of their clients, and 25% feel pressure to replicate exposures in their benchmark — even when they believe they are suboptimal investments.

Clearly, the environment in our industry measures success through competition, comparison and the contingent rewards that result.

44%of investment professionals believe their leaders articulate a compelling vision.

41%of investment professionals agree that leaders talk to employees about their most important values and beliefs.

33%of investment professionals believe that their leaders are spending time teaching and coaching employees.

40%think their leaders re-examine critical assumptions and beliefs.


“�e industry claims it is switching over to longer-term systems, but in fact I think [we] are still very reliant on shorter-term bonus structures… Managers are facing a lot of short-term external pressures, like money �owing out if they do not perform in the short run.”

ceo of an asset owner



In turn, self-interest tends to prevail — nearly two-thirds (62%) of investment professionals believe that their organization is acting in its own best interest rather than the client’s. In the words of one asset owner CEO, “It is an industry in which it is OK to behave badly if you are smart enough.”

We asked the same question of retail investors, and they agreed — more than half (54%) of respondents believe that �nancial institutions are most likely to o�er products and services in the �rm’s own best interest versus that of the client. As a result, less than one third (32%) of retail investors surveyed attribute their long-term �nancial planning success to an advisor or other investment provider. �ey were more likely to credit themselves (55%) or friends or family (38%).13

�is is the current state of motivation and performance in our industry: Our current environment “misdirects” our passion for beating the market toward behaviors that inhibit our performance and undermine the legitimacy and credibility of the industry.

Furthermore, there is a disparity between the purpose we say we have on our websites and corporate messaging (helping clients meet their goals), and the purpose evident in our actions (competition and outperformance for its own sake).

We will never be able to compel people to buy into a particular vision or values, but fortunately we do not have to. By implementing changes in our work environment, through the force of culture and leadership, the passion for beating the market that drives so many industry professionals can be channeled into a more sustainable and valuable motivation.


Motivation from Peer Performance

A reasonable skeptic could ask, “Who cares what motivates you, as

long as you get the job done?” Perhaps the desire for a university

endowment to beat a rival school’s returns will motivate staff in the

short run, but will it drive good decision making over the next 20 years?

In one study, researchers found that university endowment allocations

to alternative assets are linked to the allocation policies of their

nearest competitors, specifically, to the single closest competitor.11

Retail investors face a similar desire to “beat” their friends and

neighbors when it comes to investment returns and financial well-

being, often to their detriment. Only a sense of purpose beyond

comparison, competition and contingent rewards will deliver strong,

sustainable performance over the longterm.


By implementing changes in our work environment, through the force of culture and leadership,


the passion for beating the market that drives so many industry professionals can be channeled into a more sustainable and valuable motivation.



�at sustainable motivation is phi: a mindset to deliver performance that’s driven by purpose, and embedded by habits and incentives.

Individuals with high phi are driven by a belief that they are working in the service of something larger than themselves. �eir personal goals and values are aligned with those of their organization and their end clients. �ey are more likely to view their work as a calling rather than just a job.

Leadership must constantly remind investment managers of �duciary duty. �is requires a sense of stewardship and a true understanding of client goals beyond investment returns: generating retirement income, paying for higher education or buying a home for example.

However, only 17% of investment professionals scored high in phi, and 53% scored either low or having no phi.

We calculated phi scores from our survey respondents using three cornerstone questions based on academic theory:

Purpose. What motivates you to perform?

Habits. Why do you continue to work in the investment management industry?

Incentives. Do you think of your work as a job, a career or a calling?

The Future State of Motivation

THE HIDDEN VARIABLE OF PERFORMANCE



16.62%

3 (high phi)

13.19%

0 (no phi)

40.31%1 (low phi)

29.88%

2 (moderate phi)

Phi Distribution Scores for Investment Professionals

N=1,486

In each answer set there were options related to compensation, status, duty, fun and purpose.14 �e maximum score possible was three. �e distribution of calculated phi scores is below and additional details can be found in the appendix.

How does the investment management industry’s phi compare to other industries? While we didn’t measure phi within other industries in this study, a prior survey by State Street Global Advisors asked professionals to what degree their work re ects their values and mission in life. Financial services ranked 12th out of 13 industries, further indicating a signi�cant opportunity to improve.

Materials

Construction

Government / Non-profit

Utilities

Financial Services Consumer Goods

Retail

In a prior survey, State Street Global Advisors asked professionalsto what degree their work reflects their values and mission in life.

State Street Global Advisors’ January 2016 Biannual DC Investor Survey.Data were collected in October 2015 using a panel of 1,500 U.S. workers, aged 22-50,

employed on at least a part-time basis and offered a DC plan by their employer.

Industrial Production Services

Infrastructure / Technology

Telecom

Network Health Care

Manufacturing

Transportation

Energy


Understanding Client Motivations

We are also interested in how individual retail investors can be motivated to be better investors, that is, more focused on behaviors that will support their long-term goals. Phi is by no means limited to investment professionals, though a di�erent methodology is appropriate for individual clients given their di�erent role in the system. We therefore designed our analysis of retail investors using the Biopsychological �eory of Personality. �is theory describes two motivational systems that represent individual sensitivities to the environment around us.

�e �rst of these systems is the Behavioral Inhibition System (BIS), which represents motivation from fear and negative consequences. �e second is the Behavioral Activation System (BAS), which represents motivation from goal setting and attainment.

A one-point increase in BAS sensitivity is associated with: 22% greater odds that an investor believes the industry acts in its clients' best interests, 42% greater odds an investor knows what they pay in fees, 37% greater odds that an investor does not reject using a �nancial advisor, 38% greater odds that an investor considers ESG factors, 79% greater odds that an investor avoids potentially excessive trading (i.e., more than quarterly).

�ese investing habits are clearly driven by purpose and goals, not by fear of loss. �is encourages a sense of commitment and ultimately, a sense of purpose — therefore we have equated BAS sensitivities to phi for retail investors.

As we consider the �nancial system and the important interactions between clients and professionals, the level of demotivation in the industry and the lack of articulated purpose from the top also impacts retail investors.

In the most extreme case, the lack of purpose in investing manifests as individuals avoiding risk and return. �e average asset allocation to cash among both our Generation X and Generation Y respondents is exceptionally high at 36%, which implies that younger investors are not taking an appropriate level of risk. For high-BIS respondents — who are more motivated by fear of negative consequences than goal-setting — regression analysis suggests they are more likely to buy something over saving, more likely to buy an investment after it has gained signi�cant value, and more likely to sell an investment after a signi�cant loss.

Research shows that individuals with retirement anxiety are less likely to save and plan for the future, and exhibit a general pattern of avoidance toward thinking about and engaging in long-term investment activities.15 Studies show that anxiety is created by the feeling of lagging signi�cantly behind your peers and your own goals, promoting a sense of defeat and resulting in “throwing in the towel” reactions.16 �is environment triggers investors’ BIS sensitivities, feeding fear, anxiety, and frustration; ultimately leading to sub-optimal outcomes.

Successful organizations in our industry should be able to increase the average level of phi among their employees and clients, in turn leading to more sustainable results.


greater odds that an investor believes the industry acts in clients’ best interests22%

greater odds that an investor does not reject using a financial advisor37%

greater odds that an investor considers ESG factors 38%

greater odds that an investor knows what they pay in fees42%

greater odds that an investor avoids potentially excessive trading (i.e., more than quarterly)79%

The Influence of BAS Sensitivity

A one point increase in Behavioral Activation System (BAS) sensitivity is associated with:


“The motivational tools we’ve implemented through-out recent quarters are the tools for the future (autonomy, flexibility, empowerment). Competition surrounds us and we all know that the current competition, plus low interest rates, will lead to greater concentration in the industry. What is important today is to be prepared to absorb and not to be absorbed. You have to be flexible; size is key for future sustainability of your company. However, working in a large company is not as motivating, so it is key for these organizations to make the organization work as a boutique.”

ceo of an asset management firm


Both Self-Determination � eory and BIS/BAS assert that the environment is a critical factor in our motivation. Fortunately, it is also the one over which we have the most control.

By creating an environment that supports autonomy and ownership, you create phi. � e right environment includes vision, goals,

values and beliefs, teaching and coaching, and re-examination of critical assumptions; as well as fair, controllable and transparent rewards.

We o� er three simple recommendations for investment leaders to create the environment to maximize phi.

Leaders Need to Cultivate

Recommendations

PUTTING THE ‘PHI’ IN FINANCE

Purpose Habits Incentives


PurposeOur industry has developed two sets of purposes support-

ed by values: the one we say we have, and the one that

actually drives us. How do we create an environment that

eliminates this cognitive (and moral) dissonance, and

aligns our purposes and values with those of the client?


PurposeOur industry has developed two sets of purposes support-

ed by values: the one we say we have, and the one that

actually drives us. How do we create an environment that

eliminates this cognitive (and moral) dissonance, and

aligns our purposes and values with those of the client? One asset manager told us, “Societal good is hard [to internalize] because we’re so many steps removed from the outcome at the consumer level.” In other industries, such as healthcare or construction, professionals are able to see the tangible results of their work.20

Purpose works best when it is visible. When clients are seen as people rather than just an account number, attitudes begin to change. We suggest that organizations createopportunities for investment professionals to understand how their actions impact their clients’ lives.

“Culture is key – you need a set of common values.”

ceo of a foundation


In the 1980s, mission statements became a must-have for �rms in any industry as corporate “machines” aspired to be humanized.18 However, in his paper “Sex, Lies and Mission Statements,” Christopher Bart, professor of business policy at McMaster University in Ontario, found that mission statements have “no in�uence over behavior.” For example, he found that only 5% of managers he surveyed believe their mission statement has a signi�cant positive in�uence on the day-to-day lives of their employees.19 Mission statements remain empty unless leaders spend more time talking about their most important values and beliefs, and questioning assumptions in current practices. �is requires an understanding of how to use values to create new, productive behaviors — a challenging but rewarding process.


In the 1980s, mission statements became a must-have for �rms in any industry as corporate “machines” aspired to be humanized.18 However, in his paper “Sex, Lies and Mission Statements,” Christopher Bart, professor of business policy at McMaster University in Ontario, found that mission statements have “no in�uence over behavior.” For example, he found that only 5% of managers he surveyed believe their mission statement has a signi�cant positive in�uence on the day-to-day lives of their employees.19 Mission statements remain empty unless leaders spend more time talking about their most important values and beliefs, and questioning assumptions in current practices. �is requires an understanding of how to use values to create new, productive behaviors — a challenging but rewarding process.

1

2

3

4

5

VisionCreate a long-term leadership vision that inspires continual progress towards it. This can also create company citizenship and an ownership mindset.17

GoalsArticulate clear goals that tie to your purpose and connect the work individuals do to larger goals that benefit both the client and the organization.

Teaching and CoachingDetermine the time your organization can commit to teaching and coaching employees. This was one of the areas that our researchfound is most lacking in organizations today, and it reinforces short-term thinking about the organization’s future.

Re-examine Critical AssumptionsCreate a culture that regularly re-examines critical assumptions, which conveys that adaptability is more important than tradition — an important quality in a quickly changing profession.

Values and BeliefsLeaders should share their values and beliefs as they relate to the vision,so it is more concrete and personal, and allow time for debate. To the extent a firm wants to change its values, it must change behaviors to reflect them. Over time, these values will become accepted in the organizational culture.

Five Actions �at Will Help Improve Purpose


HabitsDeveloping and internalizing purpose and building

motivation will require the breaking of old habits and

the learning of new ones. Interdisciplinary research on

habit formation21 shows that this process is a function of

the environment around us, requiring effective decision

making and communication.


HabitsDeveloping and internalizing purpose and building

motivation will require the breaking of old habits and

the learning of new ones. Interdisciplinary research on

habit formation21 shows that this process is a function of

the environment around us, requiring effective decision

making and communication.

We need to form a new habit of decision making such that decisions are being driven by phi, with cognitive and emotional behavioral biases kept in check. Breaking habits and forming new ones is a straightforward process, though for those who have tried to break bad habits, it can be extremely di�cult. Why? Because habits by de�nition are largely within our unconscious. �e habit process begins with a cue, then there is a routine, and �nally a reward is received based on this habit. In our industry, we need to break the habit of having fear trigger action. Camelia Kuhnen of the Kellogg School of Management found experimental evidence that we have asymmetric learning when it comes

to gains and losses. Investors that have had losses and negative outcomes are more likely to develop especially pessimistic views and make errors of belief about the investment. We need to replace this habit cycle using phi as the driver — rather than losses. From there, the routine is a process whereby we objectively learn from success or failure, and the reward is an investment decision based on valid information.

�is also presents a product development opportunity. Good habits are only bene�cial if they are easy to adopt. Target-date funds were designed around the idea that a product could make asset allocation choices for clients who

HabitProcess

Cue

RoutineReward


were unable or unwilling to do so themselves, i.e., no habit is even needed! New products that make use of behavioral and event-based data to o�er a personalized advice component could help investors with goal setting and attainment, further stimulating their BAS sensitivity.

Communication between investment providers and clients can be a signal for misaligned incentives and poor relationships, and there is work for the industry to do here. It is worth remembering that communication includes two parts — a content part and a relationship part. �e relationship part can become the most important element of the communication if the relationship itself is not well de ned. When there is a lack of understanding with regard to the di�erent values of the parties communicating, the content part will invariably be misunderstood. A healthy relationship means that you can communicate openly about goals and sincere values to better serve the client’s needs.

E�ective communication in an organizational setting includes delivering and receiving e�ective feedback. Habit formation is impossible without an understanding of one’s own individual tendencies. �erefore, we

propose introducing an assessment of clients’ motivational predispositions using a BIS/BAS-type questionnaire at the outset of the relationship. �ese tests are designed to provide a clearer picture of the psychological forces that drive clients’ nancial decisions, thereby educating clients about their own sensitivities and behavioral biases. Both parties can use this information to build a framework to develop or improve goal-setting habits and communication.

A similar BIS/BAS assessment for professional investors themselves may assist management teams in improving their communication with employees by understanding what drives them, perhaps even encouraging more e�ective feedback among peers. Further, such an assessment could help professional investors recognize their propensity for behavioral biases that harm investment decisions.22 �ese learning and communication components can be used to form and improve goal-setting habits for investment professionals in a similar way to retail investors.

For retail investors, our research shows that simply having access to a de ned contribution plan and other retirement tools can serve as a trigger to increase goal-oriented sensitivity.23


were unable or unwilling to do so themselves, i.e., no habit is even needed! New products that make use of behavioral and event-based data to o�er a personalized advice component could help investors with goal setting and attainment, further stimulating their BAS sensitivity.

Communication between investment providers and clients can be a signal for misaligned incentives and poor relationships, and there is work for the industry to do here. It is worth remembering that communication includes two parts — a content part and a relationship part. �e relationship part can become the most important element of the communication if the relationship itself is not well de ned. When there is a lack of understanding with regard to the di�erent values of the parties communicating, the content part will invariably be misunderstood. A healthy relationship means that you can communicate openly about goals and sincere values to better serve the client’s needs.

E�ective communication in an organizational setting includes delivering and receiving e�ective feedback. Habit formation is impossible without an understanding of one’s own individual tendencies. �erefore, we

propose introducing an assessment of clients’ motivational predispositions using a BIS/BAS-type questionnaire at the outset of the relationship. �ese tests are designed to provide a clearer picture of the psychological forces that drive clients’ nancial decisions, thereby educating clients about their own sensitivities and behavioral biases. Both parties can use this information to build a framework to develop or improve goal-setting habits and communication.

A similar BIS/BAS assessment for professional investors themselves may assist management teams in improving their communication with employees by understanding what drives them, perhaps even encouraging more e�ective feedback among peers. Further, such an assessment could help professional investors recognize their propensity for behavioral biases that harm investment decisions.22 �ese learning and communication components can be used to form and improve goal-setting habits for investment professionals in a similar way to retail investors.

For retail investors, our research shows that simply having access to a de ned contribution plan and other retirement tools can serve as a trigger to increase goal-oriented sensitivity.23

“We have to give and take feedback. We should reward and encourage positive behaviors and celebrate success. We must learn and develop. We judge things on a short-term duration and we should closely look at our behaviors being developed as a result of short term measurement strategies. We should be brave enough to address these behaviors.”

coo of an asset management firm


IncentivesOur data show that industry participants widely perceive

their compensation to be lacking in fairness, transparency

and controllability. With consistent cost pressures and

competition for talent coming from other industries,

re-thinking monetary incentives is necessary to continue

to attract and develop high-performing talent. Equally

important is re-thinking the monetary incentives

necessary to produce the type of cognitive and emotional

functioning we need in this environment.


�e �rst step toward developing an incentive structure that encourages phi is to assess the fairness, controllability and transparency of the existing system. Next, eliminate short-term contingent rewards wherever possible (especially those perceived as most unfair or least transparent). �ese types of incentives are the most likely to depart from the alignment of the individual, organization and clients' goals and values.24

We recommend that �rms experiment with new incentive structures that will facilitate longer-term thinking. In our research, we found that 39% of investment professionals would be pleased to have a performance bonus on a two-to-�ve year cycle versus the typical annual bonus. Some high-functioning teams might wish to adopt this now, and others can follow based on results.

“Remuneration is important, but it is no longer the most important factor. Before, payment was much more important but now autonomy and being a part of something bigger than yourself is becoming even more important.”

cfo of an asset management firm


“�e industry fails to deliver on expected outcomes. We have to be able to justify our fees, salaries and bonuses. �ere is a lot of focus on bonuses and �nancial rewards right now. Compensation has failed. Lower base fees are necessary and more alignment of interest is needed.”

cfo of an asset management firm


Conclusion

QUANTIFYING THE UNQUANTIFIABLE

We see great potential for phi in the investment community because thus far, concepts such as motivation and purpose have not been measurable. In our industry we like numbers, and we have little interest in factors that cannot be measured reliably. Still, we intuitively know there is a cultural difference between firms that are highly regarded and those that are not.

We therefore have been searching for that “secret sauce” or hidden variable that sustains firms through difficult times in the market cycle. With the discovery of phi, we have found a way to measure and describe this difference — and over time, we may even find it has the power to transform our industry into a more respected profession, secure better outcomes for our clients and create greater value for society.


The Center for Applied Research

�e Center for Applied Research (CAR), an independent think tank residing at State Street’s corporate level, comprises a global team of researchers located across the Americas, EMEA (Europe/Middle East/Africa) and the Asia-Paci�c region.

Building on the success of State Street's established Vision thought leadership program, CAR brings together resources within the industry and across State Street to produce timely research on the topics that are most important to investors worldwide. CAR presents at conferences and provides executive brie�ngs for clients and their boards of directors as a value-add service.

If you would like more information about the studies or the Center for Applied Research, you can contact the authors or send an email to [email protected].

CFA Institute

CFA Institute is the global association of investment professionals that sets the standard for professional excellence and credentials. �e organization is a champion for ethical behavior in investment markets and a respected source of knowledge in the global �nancial community. �e end goal: to create an environment where investors’ interests come �rst, markets function at their best, and economies grow.

CFA Institute has more than 148,000 members in 158 countries and territories, including 141,000 CFA charterholders, and 147 member societies. �e CFA Institute Future of Finance initiative is a long-term, global e�ort to shape a trustworthy, forward-thinking investment profession that better serves society.

For more information, visit www.cfainstitute.org.

ABOUT THE TEAM

Authors

Suzanne Duncan Mirtha Kastrapeli Mimmi Kheddache-Jendeby Phil Palanza

Contributors

Rebecca Fender, CFA Paul Smith, CFA Roger Urwin, FSIP


Appendix and Notes


Literature Review

Motivation is a topic that has been studied extensively through time and across dierent academic disciplines. �e application of this wealth of knowledge to the investment management industry, to gain new insights and perspectives, is however conspicuous by its absence.

Motivation theories try to understand the “why” of behavior and throughout time a number of dierent perspectives on motivation have developed. Mechanistic theories view the human as passively being forced to act as a result of the interaction between psychological drives and environmental stimuli.25 Organismic theories on the other hand, view humans as active, initiating behaviors by their own free will. Behavioral theories of motivation have been viewed as mechanistic, focusing on behavior as a response to stimuli and giving choice and intention a secondary role as determinants of behavior (e.g. Freud 26).27 However, over time, motivational theories developed which found the explanatory power of behavioral theories unsatisfactory. �ese theories included the concept of self-direction and choice (e.g. Vroom,28 and Bandura29).30

Another way to fragment motivational theories is to look at content-related motivation theories, that focus on why individuals are motivated (Reiss,31 Herzberg32 and Hackman & Oldham33) and process-related motivation theories, that try to explain how motivation turns into goal-directed behavior (Vroom34 and Locke & Latham35).36

�e Self-Determination �eory (SDT) is in�uenced by both mechanistic and organismic theories, saying that only some intentional behaviors are truly chosen.37

�e theory presents three types of motivation: autonomous motivation, controlled motivation and amotivation. In contrast to amotivation, autonomous and controlled motivations are both intentional, but they are very dierent in nature. Only autonomous motivation makes a person perceive that he/she is acting with a sense of own-will, hence experiencing a choice.38 Moreover, the Self-Determination �eory addresses both the “why” and the direction of behavior. As such, this theory was found well suited to use when answering the problem statement above.

Motivation is aected both by the social environment and by individual dierences. Within the SDT framework these individual dierences are captured by measuring an individual’s causality orientation.39 �is is the degree to which an individual experiences the social context as being controlling or controllable. In previous research40 CAR identi�ed that fear and goals are two very strong drivers of human behavior on an individual investor level. As a result the Biopsychological �eory of Personality41 was identi�ed as a more suitable theory to use within the context of this paper, to measure individual dierences. �e Biopsychological �eory of Personality was developed by Gary42 and states that two motivation systems drive behaviors, the behavioral inhibition system (BIS) and the behavioral activation system (BAS). �e BIS system is sensitive to signals of punishment and avoids behavior that may lead to negative outcomes. As such, the BIS system keeps a person from achieving his/her goals. �e BAS system, on the other hand, is sensitive to signals of reward and non-punishment and makes a person engage in goal-directed behavior.43 �ese two motivation systems are aligned with the behavioral drives identi�ed in CAR’s previous research work.

APPENDIX


Survey Methodology

Primary research for this study includes a survey of 6,938 investors, investment providers, and government o�cials and regulators across 20 countries. �esecountries are: Australia, Brazil, Canada, Chile,China, France, Germany, Hong Kong, India,Italy, Japan, Mexico, �e Netherlands, Singapore,South Africa, Sweden, Switzerland, �e UnitedKingdom, United Arab Emirates, and the UnitedStates. �e retail investor component of the surveyincludes an equal weighting among these countries,while the institutional and regulatory componentre�ects the size of the relative �nancial markets.

Survey data were collected in two rounds. First, CoreData collected information from 3,600 retail investors and 985 professionals on behalf of CAR through an online survey platform in May 2016. Second, CFA Institute conducted a survey to a targeted group of its members in these same countries in June 2016, resulting in 2,353 additional professional responses. Quantitative analysis was then conducted through a partnership with the State Street Center for Data Excellence and CoreData. Note that all percentages are rounded. Data were supplemented by over 200 in-person interviews with executives and government o�cials.44

Participating institutional investors include government pension funds, corporate pension funds, retail pension plans, sovereign wealth funds, central banks, insurance �rms, healthcare institutions, endowments and foundations. Participating retail investors include mass market, mass a�uent and high net-worth individuals. Participating asset managers include institutional-oriented asset

managers, retail-oriented asset managers, blend retail/institutional asset managers (more retail-oriented) and blend retail/institutional asset managers (more institutional-oriented). Participating intermediaries include bank/broker-a�liated advisors, institutional consultants, independent �nancial advisors and insurance-a�liated advisors. Public entities include regulatory bodies and government o�cials, as well as policymakers with a focus on �nancial services-related policy matters.

�e questions used to calculate phi for professionals are listed below, with the option indicating higher phi marked in bold and weighted equally in the phi score.

1. (On purpose) What motivates you to performgenerally and in your current role? (Select topthree):

a) �e hope of receiving a big bonus/salaryincrease.

b) �e fact that everyone can see myperformance and I do not want to look bad.

c) I know it is important to ful ll the end client’s goals.

d) �e feeling of doing something in the service of something larger than myself (e.g. creating a better life situation for the end client, supporting the values of my organization to achieve long-term organizational growth).

e) I just love what I do and would continuedoing it even if I was not paid.


2. (On habits) What is the reason that you arestill working in the investment managementindustry? (Select up to two)

a) I am reasonably satis�ed with my job.

b) It is where the money is, i.e. where I can earnthe most.

c) I like the status that a job in this industrybrings.

d) I am passionate about the markets.

e) I am inspired by a family member/industry�gure.

f) I can help people and organizations achieve their �nancial goals.

g) I like working with very smart people.

h) I help facilitate economic growth and development.

i) It would be too di�cult to change jobs andpursue a new career in another industry.

j) I am thinking about quitting.

3. (On incentives) Which description most closelymatches the way you think about your work?

a) As a job (I work only for the sake of themoney. I am really happy when the weekendcomes and I satisfy my intellectual curiosityand interests via hobbies and not work.)

b) As a career (My work energizes me, andmy aim is to advance and get promoted. Isometimes bring work with me home since Iwant to deliver excellent results. SometimesI do however wonder about the meaning andimportance of what I do.)

c) As a calling (I am devoted to my work. When working I feel that I am part of something larger than myself. �e value my e�orts bring is clear to me, and I never question the meaning of what I do. I would continue to work even if I was independently wealthy.)


Survey respondents were asked to evaluate their organization on a scale of 1-5 on 10-year organizational performance, client satisfaction, and employee engagement. To survey outcomes across a broad range of �rm types and investment strategies, respondents were asked to rate their organizations’ performance in terms of achieving their clients' goals and investment goals over the past 10 years on �ve-point Likert scale.

To relate phi to outcomes, the following odds were modeled:

θ1 = prob(score = 1) / prob(score > 1 )

θ2 = prob(score = 1, 2) / prob(score > 2 )

θ3 = prob(score = 1, 2, 3) / prob(score > 3 )

θ4 = prob(score = 1, 2, 3, 4) / prob(score > 4 )

All odds are of the form θy = prob(score ≤ y) / prob(score > y)

e functional form of the model for each outcome, using phi as an independent variable, is:

ln(θy) = αy – βΦ

using Huber-White standard errors. Incremental percentage improvements in the odds of “excellent” outcomes were derived using an odds-ratio interpretation.


1 Phi is the 21st letter in the Greek alphabet and has been used as a variable in many elds. One of the most common uses is the Golden Ratio, and the concept of balance conveyed in that is a useful reminder of the balance needed between principals and agents in investing.

2 David Blanchett and Paul Kaplan, “Alpha, Beta, and Now…Gamma,” �e Journal of Retirement, 2013.

3 Chmiel, N. (2008), An Introduction To Work and Organizational Psychology: A European Perspective. Oxford, UK, and Malden, Mass.: Blackwell Publishing.

4 N=2417 Respondents were able to select up to two possible responses.

5 N=2417 Respondents were able to select up to two possible responses.

6 It is notable that CFA members had signicantly higher responses to these questions than other investment professionals, with 43% of CFA members saying they are passionate about the markets versus 33% for others, and 30% of CFA members saying their motivation was helping clients achieve their goals, versus 24% for other investment professionals.

7 Deci, E.L. (1975), "Intrinsic Motivation." New York and London: Plenum Press.

8 Herzberg, F., Mausner, B. and Snyderman, B.B. (1959), �e Motivation to Work. New York: Wiley.

9 Robert Eisenberg and Judy Cameron, “Detrimental E¥ects of Reward: Reality or Myth?” American Psychologist, 51:1153-1166, 1996, and Edward L. Deci, Richard Koestner and Richard M. Ryan, “A Meta-Analytic Review of Experiments Examining the E¥ects of Extrinsic Rewards on Intrinsic Motivation,” Psychological Bulletin, 125, 627-68, 1999.

10 Ernst Fehr and Simon Gachter, “Fairness and Retaliation: �e Economics of Reciprocity,” Journal of Economic Perspectives, 14 (3):159-181, 2000, and Deci, E.L. (1975), Intrinsic Motivation. New York and London: Plenum Press.

11 William N. Goetzmann and Sharon Oster, “Competition Among University Endowments,” NBER Working Paper No. 18173, June 2012.

12 Another 20% responded “Neutral” to the question, which is nearly as alarming.

13 Respondents were allowed to choose more than one option, which makes the 32% gure even more disconcerting.

14 �e questions in full can be found in the appendix.

15 Banerjee, Sudipto, 2014 “Take it or leave it? �e Disposition of DC accounts: Who Rolls Over into an IRA? Who Leaves Money in Plan and Who Withdraws Cash?" EBRI Notes May 2014, Vol.35, No. 5; http://www.nber.org/papers/w17345

16 Henk �ierry, “Payment by Results Systems: A Review of Research 1945-1985,” Applied Psychology, 36: 91-108, 1987.

ENDNOTES


17 Doshi, N., and McGregor, L. (2015), Primed to Perform – How to Build the Highest Performing Cultures rough the Science of Total Motivation. New York: HarperCollins.

18 Christopher K. Bart, “Sex, Lies and Mission Statements,” Business Horizons, 9-18, November-December 1997. Web. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=716542 and Jean-Baptiste Michel*, Yuan Kui Shen, Aviva Presser Aiden, Adrian Veres, Matthew K. Gray, William Brockman, �e Google Books Team, Joseph P. Pickett, Dale Hoiberg, Dan Clancy, PeterNorvig, Jon Orwant, Steven Pinker, Martin A.Nowak, and Erez Lieberman Aiden*. QuantitativeAnalysis of Culture Using Millions of DigitizedBooks. Web. https://books.google.com/ngrams/graph?content=Mission+statement&year_start=1800&year_corpus=15&smoothing=3&share=&direct_url=t1%3B%2CMission+statement%3B%2Cc0

19 Christopher K. Bart, “Sex, Lies and Mission Statements,” Business Horizons, 9-18, November-December 1997. Web. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=716542

20 State Street Center for Applied Research 2016 Study Interview: R. Rajan calls this an “arms-length «nancial system.” Rajan notes that this system is particularly problematic for two reasons. First, there is little sense, for the investment professional, of material results of her work (“she is merely a cog in a gigantic machine”). And second, the most direct measure of societal contribution is measured by money, “pro«ts and returns.” He adds that “arms-length transactions do not foster empathy or a long-term focus,” qualities necessary to achieve sustainable performance.

21 Duhigg, C. (2012), e Power of Habit: Why We Do What We Do and How to Change. Great Britain: Random House.

22 Charles S. Carver and Teri L. White, “Behavioral Inhibition, Behavioral Activation, and A¯ective Responses to Impending Reward and Punishment: �e BIS/BAS Scales,” Journal of Personality and Social Psychology, Vol. 67, No. 2. 319-333, 1994.

23 State Street Center for Applied Research survey analysis 2016; Robert Eisenberg and Judy Cameron, “Detrimental E¯ects of Reward: Reality or Myth?” American Psychologist, 51:1153-1166, 1996; and Ernst Fehr and Simon Gachter, “Fairness and Retaliation: �e Economics of Reciprocity,” Journal of Economic Perspectives, 14 (3): 159-181, 2000.

24 Atkinson & Hilgard’s (2009), Introduction to Psychology (15th edition), Cengage Learning.

25 Fahlke, C. & Johansson, M. P. (2007), Personlighetspsykologi, Stockholm: Natur och Kultur.

26 Ryan R and Deci E (1985), Intrinsic Motivation and Self-Determination in Human Behavior, Springer Science + Business Media: New York

27 Vroom, V. H. (1964) Work and Motivation. San Francisco: Jossey-Bass.

28 Zimmerman B., Bandura A. and Martinez-Pons M. (1992) "Self-Motivation for Academic Attainment: �e Role of Self-E´cacy Beliefs and Personal Goal Setting", American Educational Research Journal, Vol. 29, No.3, 663-676

29 Ryan R and Deci E (1985), Intrinsic Motivation and Self-Determination in Human Behavior, Springer Science, Business Media: New York


http://papers.ssrn.com/sol3/papers.cfm?abstract_id=716542

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=716542

https://books.google.com/ngrams/graph?content=Mission+statement&year_start=1800&year_corpus=15&smoothing=3&share=&direct_url=t1%3B%2CMission+statement%3B%2Cc0

https://books.google.com/ngrams/graph?content=Mission+statement&year_start=1800&year_corpus=15&smoothing=3&share=&direct_url=t1%3B%2CMission+statement%3B%2Cc0

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=716542

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=716542

30 Reiss S (2000) Who am I? – �e 16 Basic Desires that Motivate Our Actions and Determine Our Personality, New York:Tarcher/Putnam.

31 Hertzberg F (1966) Work and the Nature of Man, Cleveland: World Publishing.

32 Hackman, J. R., and Oldham, G. R. (1976) "Motivation through the design of work: Test of a theory, Organizational Behavior and Human Performance", 16, 250-79.

33 Vroom, V. H. (1964) Work and Motivation. San Francisco: Jossey-Bass.

34 Locke, E. A. and Latham, G. P. (1990), A �eory of Goal Setting and Task Performance, Englewood Cli�s, NJ: Prentice Hall

35 Chmiel Nik, (2008) An Introduction To Work and Organizational Psychology, A European Perspective, Blackwell Publishing

36 Ryan R and Deci E (1985), Intrinsic Motivation and Self-Determination in Human Behavior, Springer Science, Business Media: New York

37 Gegne M, and Deci E. (2005), "Self-Determination �eory and Work Motivation", Journal of Organizational Behavior, 26: 331-362

38 Autonomy orientation can be measured by using �e General Causality Orientation Scale (GCOS) developed by Deci and Ryan. Deci E. L., Ryan R. M. (1985)

39 "�e General Causality Orientation Scale: Self-determination in personality", Journal of Research in Personality, 19: 119-142.

40 State Street Center for Applied Research, "�e Folklore of Finance: How Beliefs and Behaviors Sabotage Success in the Investment Management Industry", 2014.

41 Charles S. Carver and Teri L. White (1994), "Behavioral Inhibition, Behavioral Activation, and A�ective Responses to Impending Reward and Punishment: �e BIS/BAS Scales", Journal of Personality and Social Psychology, Vol. 67, No. 2. 319-333



44 Retail Investor survey was conducted by CoreData on behalf of the Center for Applied Research. �e sample size for this survey is 3600 (of a total of 82,597 invited, a 4.4% response rate) with a margin of error of 1.6% at 95% con¡dence. One professional investor survey was conducted by CoreData on behalf of the Center for Applied Research. �e sample size for this survey is 985 (of a total of 27,391 invited, a 3.6% response rate) with a margin of error of 3.07% at 95% con¡dence. A second professional investor survey was conducted by the CFA institute of its members. �e sample size for this survey is 2,353 (of a total of 66,159 invited, a 3.6% response rate) with a margin of error of 1.98%.


AcknowledgmentsWe would like to express our deep appreciation to our

200+ interviewees and each of our survey respondents

for participating in our research.

We would also like to thank John Bolton, Anne Cabot-

Alletzhauser, Core Data, Michael Falk, Sean Fullerton,

Samuel Graef, Kunal Gupta, Sam Humbert, Meredith

Kaplan, Michael Morley, MotivIndex, Tim Pollard, the

State Street Center of Data Excellence, Jim Ware and

Tamsen Webster.


Important Information

Investing involves risk including the risk of loss of principal. The views expressed in this material are the views of The Center for Applied Research through the period ending October 2016 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.

The whole or any part of this work may not be reproduced, copied or transmitted, or any of its content disclosed to third parties without State Street’s express written consent.

State Street Corporation State Street Financial Center One Lincoln Street Boston, Massachusetts 02111–2900 +1 617 786 3000www.statestreet.com

© 2016 State Street Corporation All Rights Reserved 16-27864-1016 CORP-2343


69EY (Ernst & Young)

Blockchain innovation in wealth and asset managementBenefits and key challenges to adopting this technology

Contents

Overview ...................................................... 1

What is a blockchain? ..................................... 2

Applications of blockchain to wealth and asset management ................................................. 3

Use case 1: client onboarding and profiling .................................................. 5

Use case 2: model management and trade order generation ............................ 6

What are some challenges to adoption? .......... 8

A practical approach to blockchain .................. 10

Sample opportunity framework approach ....................................................... 11

What to do next? ........................................... 12

Blockchain Innovation in Wealth and Asset Management70

Introduction

OverviewBlockchain, the underlying technology of bitcoin, is drawing significant focus and investments from many financial institutions in the industry. Given the technology’s potential to both disrupt and enhance processes and systems, many firms have recently dedicated resources to understand and integrate blockchain into their businesses.

This article will discuss how wealth and asset management firms are seeking out opportunities to harness the benefits of blockchain as well as key challenges to adopting this technology. Further, the article will highlight near-term practical applications for blockchain and how to approach blockchain innovation.

Evolution of blockchain technologyBlockchain technology as we know it today emerged in January 2009 as the underlying technology of bitcoin. While bitcoin created initial noise in the financial world, blockchain technology gained prominence as a hot topic of discussion by itself.

Continued developmentAs funding from venture capital firms continued to increase, what was considered the next generation of blockchain technology emerged in 2014 to include “smart contracts.” The new programmable blockchains feature conditional logic, allowing contractual scenarios and terms to be coded.

For example, a condition could be designed to release a defined amount of payment to participant A once participant B delivered a specific asset.


What is a blockchain?A blockchain is a shared record of all transactions and related information for a particular entity. This shared record — a distributed ledger or database — is visible by all parties with permission to the record. A blockchain comprises an ever-increasing set of transaction data blocks (see diagram below) that are verified by members of the network, traditionally referred to as “miners.”

Each block is a set of transactions between two or more parties (e.g., counterparty A pays counterparty B in exchange for an asset) and added to the existing chain of blocks, creating a complete history of transactions. With each additional block, the entire distributed ledger is synchronized and agreed upon by all participant nodes. All nodes are continuously validating the transaction history, resulting in a blockchain of immutable data.

Block 355 Block 356 Block 357Inception-to-date

record oftransactions

Inception-to-daterecord of

transactions

Inception-to-daterecord of

transactions

New transactionsNew transactionsNew transactions

2 3 41

72 Blockchain Innovation in Wealth and Asset Management

Applications of blockchain to wealth and asset managementBlockchain technology, also known as distributed ledgers, has a number of potential use cases within the wealth and asset management life cycle. Distributed ledgers are highly flexible; once implemented, they can be used to remove friction from the client onboarding process, streamline management of model portfolios, speed the clearing and settlement of trades, and ease compliance burdens associated with anti-money laundering (AML) and know your customer. The result is elimination of redundant functions, reduced operational expenses and increased opportunities to enhance the client experience. While blockchain technology is unlikely to replace current systems, it may be used to reconcile information across them or enable new infrastructure for new markets and products.

By extension, these concepts can expand to broader applications, such as rollovers, trusts, estates, insurance and other transactions where assets are moved between parties or contracts are executed. A distributed ledger supports the validation and execution of a transaction in near real time. The client experience is enhanced and the process streamlined, and costs are reduced.

Social media

Client portfolio AML

Regulatoryreporting

Financialplanning

Bankingand moneymovement

Portfoliomanagement

Application of blockchain in wealth managementBlockchain can be leveraged to build a client profile in a much more efficient way. Storing client profile data on a blockchain allows for data points — profile data, preferences, net worth, account information, social media profiles — to be shared as needed, with each individual block of data being stored securely, but permissioned for access by the individual (read, write, edit) as needed.



Use case 1: client onboarding and profiling

Benefits

Challenges Approach

• Strict onboarding requirements• Proof of identification• Residency• Marital status• Sources of wealth• Occupation• Business interests• Political ties

• Complying with numerous reporting requirements• Information security procedures• Ongoing monitoring of profiles• Automated clearinghouse (ACH) and automated

customer account transfer (ACAT) systemstake multiple days and involve manual processesusing multiple systems and databases

• Can facilitate many key functions of onboarding:• Client and risk profiling• Financial planning• Anti-money laundering checks and money movement

• Can enhance or possibly replace traditional systems,such as ACH and ACAT

• Enables near-instantaneous transfers of assets betweenfinancial institutions with authenticated provenance of tracked changes

• Profile stored on a blockchain/distributed ledger• Trusted parties are granted access to all or part of

the profile based on cryptography• New relationships would be initiated by profile owner• The system inherently enables an audit trail for tracking

changes to the chain. As a result, processesrequiring fact-checking, such as AML, are simplified

• Integrate blockchain technologies into onboarding andACH and ACAT systems and processes

Key driversBlockchain presents the possibility of revolutionizing client onboarding for wealth managers. In today’s world, potential clients must provide proof of identification, residency, marital status, sources of wealth, occupation, business interests and political ties. Going through this process can take days or weeks to collect and verify the data.


Use case 2: model management and trade order generation

Benefits

Challenges Approach

• A wealth and asset manager using different platformsand data architectures causes difficulties in distributing,monitoring and updating third-party models.

• Firms must support redundant model managementsystems.

• Managers are often required to email models toprogram sponsors or use proprietary portals.

• Will allow other account transactions and trades to beshared more easily

• Can provide near-real-time performance, portfolio riskand drift data, allowing managers to observe moreeasily and have greater insights

• Can reduce the amount of reconciliation needed by moving from the current segregated master ledger to a secure, distributed one

• Reduces the need for some intermediates responsiblefor settling and executing trades

• Investment managers would create and maintain amodel — similar to how they do it today.

• Models could be transmitted through a blockchain tovarious subscribed brokers.

• Individual accounts can be invested according to the model.

• Customization for restrictions and other account-levelconstraints can be stored and applied.

Key driversThe proliferation of open architecture investment offerings and the availability of third-party investment models in separately managed accounts have presented a number of operational challenges for wealth managers. Distributed ledger technology would allow portfolio managers to instantly communicate portfolio changes to all clients “subscribed” to the model, as well as enable real-time views of individual account performance, drift outside of tolerances and cash flows. Also, smart contracts would allow for the management of fees paid by the sponsors — essentially taking a payment every time the model is used or downloaded.


Distributed infrastructure

Allows the move from master ledgers, e.g., clearing houses, banks ...

... to distributed ledgers with no intermediaries

Technology allows the distribution of trusted value transfer and execution, allowing the disintermediation of intermediaries: the network becomes the intermediary.


What are some challenges to adoption?Exploration of blockchain technology and its application to financial services firms is still in the early stages, and many wealth and asset management practitioners are not very familiar with how blockchain actually works or what the benefits might be. Additionally, there are many critics who claim that blockchain technology is “looking for a business problem to solve,” and we agree that business cases should drive technology solutions, not the other way around.

The chart below is based on 2016 EY research and indicates that scalability is expected to be a hurdle to industry-wide adoption for many organizations. To date, blockchain has seen limited deployment in situations requiring large volumes of data, and the linear nature of the technology calls into question its ability to handle such a volume. In addition, firms face product complexity limitations, as initial rollouts of complex products can be difficult to change later on the distributed ledger.

This comes as no surprise when current institutions are able to handle billions of transactions with a high degree of reliability and security. Bitcoin blockchains, for example, can only achieve 7 transactions per second compared to Visa’s VisaNet, which currently achieves 50,000+ transactions per second.1

There are also significant unknowns related to the regulatory and legal hurdles that exist in wealth and asset management, such as the custodial requirements if assets are held on a blockchain network at any point. Other barriers to widespread adoption include data privacy and the high cost of replacing legacy infrastructures. Despite these challenges, EY believes that blockchain technology can be applied to solve business needs for wealth and asset management firms’ middle- and back-office internal processes first, before there can be widespread impacts to industry business models.

Technologystandards

Smart contractstandards

Interoperabilitywith legacy

systems

Successfulproof

of concept

Demonstratedability to

handle volume,resiliency, etc.

Security

70%

30% 30%

60%

80%

50%

Source: 2016 EY Blockchain Capital Markets Roundtable.

Which milestones must blockchain pass before broad adoption would be possible at your organization?

“ Business cases should drive technology solutions, not the other way around.”



A practical approach to blockchainBlockchain is a difficult topic to understand, and determining a good business strategy for using it is even tougher. While many technologists can grasp the concept and the underlying algorithms, many business leaders are unsure of how it can benefit their business in a meaningful way, or where it can disrupt current models. To accomplish this, EY recommends breaking strategy development into three key phases: first, identify the opportunities for the technology; then, focus on developing innovative solutions to capitalize on the opportunities; and, finally, work with your technology partners to successfully implement the solutions.

The first step in developing a strategy is creating an opportunity framework to identify where the emerging benefits might exist and which areas of the business are the most vulnerable to disruption. There are a handful of firms finding some early successes, and the ones that are making headway are taking a strategy-focused approach.

We recommend that as firms examine the opportunities, they look internally first, as it is much easier to develop and gain adoption within your own firm. As smaller internal solutions begin to gain traction, firms should look to expand the solution internally — across functional groups and then across lines of business — to demonstrate efficacy and gain support and momentum. Finally, once internal support is obtained, business cases and development for altering existing revenue-generating business models should be examined.

With so many potential blockchain opportunities, establishing an effective framework to identify real business value is critical. As noted in the previous section, there are use cases that can be developed quickly to drive results. Firms should focus on those use cases that have the greatest opportunity with minimal risk, and use a framework to properly allocate time and resources. In addition to creating blockchain specific use cases, blockchain should be considered an enabling technology to the challenges of business-as-usual operations. To this point, firms should expect blockchain disruptors to emerge where operational overhead and data management issues exist or where potential revenue-generating opportunities are driven by transparency and ease of use.

An opportunity assessment strategy at a minimum should contain the following components:

• The establishment of a framework for identifying the areas of opportunity andthreats and defining relevant use cases for analysis

• A team structure that includes key stakeholders, as well as select subject-matterexperts in the areas of concern (e.g., operations, product management, technology,strategy)

• A communications plan for socializing findings and decision-making

• A prioritization matrix or framework for identifying key use cases for the executionroad map


Sample opportunity framework approach

The next logical step is to focus on developing solutions — first on a small scale internally, but gradually ramping up to larger, more impactful internal and client-facing solutions. Several firms have adopted this approach through an innovation strategy. This strategy is usually defined as the process for assessing the opportunities previously identified in your analysis, determining the impacts to current business models and strategies, and creating solutions to take advantage of those opportunities and impacts.

In several cases, firms have implemented an innovation strategy through an “innovation lab,” where teams can focus on evaluating the opportunities and developing proofs of concept and working prototypes to explore the possibilities of blockchain. While some of these innovation labs start as individual, stand-alone groups, many are developed with the idea that the output will eventually be integrated into the organization’s business lines. Most firms now realize that

working in a vacuum can delay implementation, or possibly result in significant rework to integrate new solutions into existing systems and business processes. The most successful firms define the frameworks for innovation up front and then work within the prioritization set earlier to develop the solutions.

It is also possible that the technology solution may not need to be developed in-house. There are currently dozens of blockchain technology providers, and more are launching on a regular basis. Once the concepts have been detailed during the innovation phase, the next step involves aligning the solution to your technology strategy and competencies. Many firms — even some of the largest players in the wealth and asset management space — are collaborating to implement blockchain solutions; the largest consortiums in the space today (Hyperledger) include many firms that would normally build solutions in-house on their own.

Process

Obj

ecti

ves

Key

act

ivit

ies

Out

put

Business expertise Use case solutioning

• Establish a framework for usecase assessment

• Define business requirementsand document use casesidentified during framework

• Conduct workshops withidentified participants basedon use cases identified fromthe preliminary opportunityreview

• Group and categorize use caseopportunities

• Socialize, review and seekapproval from key stakeholders

• Identify use cases that warrantextended solutioning in the nextphase

• Review and agree upon initial usecase assessment with keystakeholders

• Conduct final workshops withidentified participants

• Further define use cases withkey participants

• Prioritize use case assessmentsand summarize them forleadership

• Identify and confirm with keystakeholders use cases thatwarrant extended solutioning

• Presentation of key findingsto stakeholders

• Detailed use case assessmentdocument

• Review and validate use caseassessment findings with key stakeholders

• List of key use cases/assumptions for stakeholderpresentation

• Define use case catalog• Identify cross–functional team• Perform preliminary review of

use case opportunities• Identify in-house and external

workshop participants• Socialize, review and seek

approval from key stakeholders

• Target requisite workshopparticipants

• List of preliminary use cases/assumptions


What to do next?With so much confusion regarding FinTech and blockchain, many firms are unsure of where to turn next and how to spend their very limited strategic dollars. Given that the success of a blockchain solution rests in its distributed nature and the willingness of the participants in the chain to work together, many firms are shying away from an initial aggressive approach. However, to be successful within an industry such as wealth and asset management, a firm or set of firms must take the lead and begin the innovation process. Ultimately, these are the firms that will stand to benefit the most, as they will reap the initial rewards of the technology.

EY is currently working with its clients on blockchain strategy development and impact assessments, innovation lab build-outs, and proof of concept creation and management. The approach is simple but effective:

• Get the business to understand the basics of blockchain technology

• Determine how it can impact its industry and specific businesses

• Contextualize the concept by identifying specific use cases that can be implemented in a short time frame with minimal risk

• Harness the technology in small, incremental steps (e.g., proofs ofconcept) by first working to develop and use blockchain internally,and then working to expand the solutions internally until they areincorporated into your business model

• Work with a partner to accelerate the process as needed

“ Innovation distinguishes between a leader and a follower.“ – Steve Jobs


Nalika NanayakkaraPrincipal Financial Services OrganizationErnst & Young LLP+1 212 773 [email protected]

Matthew HatchPartnerErnst & Young LLP+1 415 894 [email protected]

Contact us

Charles SmithExecutive Director Financial Services OrganizationErnst & Young LLP+1 212 773 [email protected]

Angus Champion de CrespignyFinancial Services Blockchain and Distributed Infrastructure Strategy LeaderErnst & Young LLP+1 212 773 [email protected]

Zackary NassirSenior Manager Financial Services OrganizationErnst & Young LLP+1 949 437 [email protected]

Ryan HinkisManager Financial Services OrganizationErnst & Young LLP+1 212 773 [email protected]


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EY professionals in our financial services practices worldwide align with key global industry groups, including EY’s Global Wealth & Asset Management Center, Global Banking & Capital Markets Center, Global Insurance Center and Global Private Equity Center, which act as hubs for sharing industry-focused knowledge on current and emerging trends and regulations in order to help our clients address key issues. Our practitioners span many disciplines and provide a well-rounded understanding of business issues and challenges, as well as integrated services to our clients.

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This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice.

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1 “The next big thing,” The Economist website, http://www.economist.com/news/special-report/21650295-or-it-next-big-thing, May 9, 2015.


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http://www.ey.com/

http://www.economist.com/news/special-report/21650295-or-it-next-big-thing

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85UBS

Sustainable investingInvestor's guide to corporate governance

CIO WM Research | 30 March 2017Stephen Freedman, CFA, Strategist, [email protected]; Renato Grandmont, Regional CIO Latin America, [email protected]

• Corporate governance considerations have been gettinggreater attention among investors in recent years. This hasbeen driven by two factors: a) the frustration with the short-term orientation often prevailing in financial markets, withcorporate governance seen as a way to extend investmenttime horizons; and b) the realization that company valueis driven increasingly by factors not available in traditionalcorporate financial reporting, with corporate governanceviewed as a tool to gain a fuller picture of the company.

• Investors focusing on corporate governance should seek tounderstand how a company's board of directors operates,whether its composition is adequate to face the company'schallenges, and whether the board has the necessaryindependence from management or controlling shareholdersto assume its oversight responsibilities. An understandingof management compensation and incentives, possibleconflicts of interest, and the degree of transparency anddisclosure is also vital.

• We look at academic evidence that shows corporategovernance analysis has provided valuable information toinvestors in the past, at times improving performance, and atthe very least has been a powerful risk management tool. Wealso provide four case studies of corporate scandals acrossthe world, which document how corporate governancefailures contributed to the demise of the affected companies.

• Investors can incorporate corporate governanceconsiderations into their investment process, typicallythrough an investment manager, in two ways: 1) makecorporate governance analysis part of the security selectionprocess; and 2) influence corporate governance policiesand behavior through active ownership, such as activelyvoting proxies at shareholder meetings, engagement withmanagement, or filing shareholder proposals (or relying onan asset manager to take these steps on their behalf).

I. Introduction: Why focus on corporategovernance?

In today’s economic model dominated by shareholder capitalism,the owners of most companies are not the key corporate decision-makers; instead, they have to rely on others to be the stewards oftheir invested capital. Shareholders rely on a board of directors tooversee the company's activities and set its broad strategic direction.The board, in turn, relies on an executive management team to runthe business.

Source: UBS

Related Sustainable Investing (SI) research

• Sustainable value creation in emergingmarkets (update report, January 2017)

• Doing well while doing good: impactinvesting (May 2016)

Source: UBS

This report has been prepared by UBS Financial Services Inc. (UBS FS). Please see important disclaimers anddisclosures at the end of the document.

Sustainable investingInvestor's guide to corporate governance

CIO WM Research | 30 March 2017Stephen Freedman, CFA, Strategist, [email protected]; Renato Grandmont, Regional CIO Latin America, [email protected]

• Corporate governance considerations have been gettinggreater attention among investors in recent years. This hasbeen driven by two factors: a) the frustration with the short-term orientation often prevailing in financial markets, withcorporate governance seen as a way to extend investmenttime horizons; and b) the realization that company valueis driven increasingly by factors not available in traditionalcorporate financial reporting, with corporate governanceviewed as a tool to gain a fuller picture of the company.

• Investors focusing on corporate governance should seek tounderstand how a company's board of directors operates,whether its composition is adequate to face the company'schallenges, and whether the board has the necessaryindependence from management or controlling shareholdersto assume its oversight responsibilities. An understandingof management compensation and incentives, possibleconflicts of interest, and the degree of transparency anddisclosure is also vital.

• We look at academic evidence that shows corporategovernance analysis has provided valuable information toinvestors in the past, at times improving performance, and atthe very least has been a powerful risk management tool. Wealso provide four case studies of corporate scandals acrossthe world, which document how corporate governancefailures contributed to the demise of the affected companies.

• Investors can incorporate corporate governanceconsiderations into their investment process, typicallythrough an investment manager, in two ways: 1) makecorporate governance analysis part of the security selectionprocess; and 2) influence corporate governance policiesand behavior through active ownership, such as activelyvoting proxies at shareholder meetings, engagement withmanagement, or filing shareholder proposals (or relying onan asset manager to take these steps on their behalf).

I. Introduction: Why focus on corporategovernance?

In today’s economic model dominated by shareholder capitalism,the owners of most companies are not the key corporate decision-makers; instead, they have to rely on others to be the stewards oftheir invested capital. Shareholders rely on a board of directors tooversee the company's activities and set its broad strategic direction.The board, in turn, relies on an executive management team to runthe business.

Source: UBS

Related Sustainable Investing (SI) research

• Sustainable value creation in emergingmarkets (update report, January 2017)

• Doing well while doing good: impactinvesting (May 2016)

Source: UBS

This report has been prepared by UBS Financial Services Inc. (UBS FS). Please see important disclaimers anddisclosures at the end of the document.

86 Sustainable Investing: Investor’s Guide to Corporate Governance

Fig. 1: Intangible assets comprise the bulk ofmarket valueComponents of S&P market value in %, 2015

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1975 1985 1995 2005 2015

Intangible assets

Tangible assets

Source: Ocean Tomo1, UBS

Given the number of actors involved, investors need to understand what incentives boards and management teams have to act in shareholders' interest rather than follow their own agenda.

Corporate governance is a central concept in this regard. It repre-sents the set of rules and processes that determine how a company is controlled and operated. Some of these rules are based on legal and regulatory norms in particular jurisdictions, and others may arise from listing requirements or voluntary codes of best practice.

Since corporate governance standards vary significantly across firms, there is a solid case for investors to incorporate such factors when selecting companies. They are an important driver of value, and it is therefore critical for investors to distinguish between com-panies with good and bad governance. Yet, we often still find that such considerations typically take a backseat to traditional financial analysis.

There is a growing realization that the standard way of looking at companies as a collection of well-defined assets needs to be questioned. Consider evidence by Ocean Tomo1, a firm focused on intellectual capital, which tracks the percentage of the value of the US stock market that is accounted for by tangible assets (land, buildings, machinery, etc.) versus intangible assets (brand value, goodwill, trademarks, etc.). The intangible share rose from 17% in 1975 to 84% in 2015 (see Fig. 1). This suggests that increasingly sources of information not well-captured in corporate financial dis-closure need to be understood by investors to make informed deci-sions. Understanding corporate governance is one of these areas.

One reason why such factors are often not well considered by investors has to do with the tendency toward short-termism in financial markets. Evidence suggests that excessive short-termism is prevalent in some parts of the investment community and among corporate managers. For example, a 2006 survey of 400 chief financial officers found that a majority of respondents were willing to forgo investing in value enhancing long-term projects in order to meet short-term earnings targets.2 And a recent study by investment consultancy firm Mercer found that portfolio turnover among active investment managers was higher than what could be deemed optimal, suggesting that on average their time horizon was shorter than it should be.3

Fortunately, the need to promote long-term thinking is increas-ingly being recognized among thought leaders in the investment community. For instance, in July 2016, a group of thirteen influ-ential CEOs from the corporate sector and finance released a set of "Commonsense Corporate Governance Principles"4, many of which attempt to extend investors' time horizon (e.g. by de-emphasizing quarterly company guidance).

We will now look at what corporate governance is based on (Section II), what its key features are (Section III), why investors should care (Section IV), and how they can ensure can that its analysis is incor-porated in their portfolios.

87UBS

II. Laws, regulations and codes

A company's corporate governance characteristics should be a matter of concern for investors, as we will illustrate in the following sections. However, in order to assess corporate governance perfor-mance, it is important to understand what gives rise to it. While many corporate governance decisions are at a company's discretion, corporations are embedded in a legal context with norms operating at different levels that vary according to jurisdiction.

Global corporate governance standards vary significantly among countries and have undergone profound changes in recent years. The most basic corporate governance norms are contained in corporate and securities law. For example, in the US, many com-panies are governed by the Delaware General Corporate Law and by norms adopted in the 2002 Sarbanes-Oxley Act. The UK has its 2006 Companies Act and Germany its Aktiengesetz.

Beyond legal norms, corporate governance rules arise from a variety of codes, principles and listing requirements.

The UK was an early adopter of a corporate governance code. In 1992, following various corporate scandals, the Cadbury report made several recommendations, including the separation of the CEO and the chair, the existence of an audit committee and independent directors. Over time, these recommendations were expanded and became part of the listing requirements for the London Stock Exchange. The UK Corporate Governance Code has statutory value. Companies must either comply with it or explain why they are not complying with certain provisions.

Similar codes have since been adopted in many countries based on the "comply or explain" principle, spurred in particular by interna-tional work such as the OECD's Principles of Corporate Governance. An example is the German Corporate Governance Code. It con-tains a number of "shall" provisions subject to comply or explain, as well as "should" provisions without such a requirement. Even in Japan, a country that has traditionally been considered a clear laggard in corporate governance practices, a code was adopted in 2015 as part of the Abenomics structural reform agenda. The code has been adopted by the Tokyo Stock Exchange but is voluntary. This stronger focus on corporate governance has led to a rise in shareholder activism in Japan in recent years.

In the US, while there is no generally accepted code, the listing rules of the New York Stock Exchange include a number of mostly mandatory corporate governance provisions. Various sets of cor-porate governance recommendations without legal implications have been issued in recent years, including two during the last year. The previously mentioned "Commonsense Corporate Governance Principles"4 were issued in July 2016 by corporate and financial sector leaders – including among others Berkshire Hathaway's Warren Buffett, JP Morgan's Jamie Dimon, Blackrock's Larry Fink and GE's Jeff Immelt – and in February 2017 the Investor Stew-ardship Group – backed by another, partially overlapping group of asset owners and asset managers - issued "Corporate Governance Principles for US Listed Companies"5.


1. Board compositionA company's board of directors is the body that is ultimatelyanswerable to shareholders. To assume such responsibility the boardneeds to exhibit the necessary skills, experience and ability tooperate well as a team.

For investors, it can be useful to consider the skills, experience andother relevant attributes of individual board members but also howcomplementary they are. These are some factors to consider whenassessing a board:

• Professional experience, both in terms of its extent and rele-vance for the company (e.g. sector of activity)

• Skills (e.g. finance, marketing, legal)

• The diversity of skills and experience within the board

It is important not to judge a board's composition in isolation, butrather to view it in the company's business context. For example,a board composed of seasoned industry veterans with very similarbackgrounds may be appropriate in a stable sector, but could signalthe risk of strategic errors in a sector facing rapid structural change.

Investors are increasingly focusing on the board's diversity. Thebenefits of more diverse boards in terms of the quality of decision-making has been well documented by a substantial body ofresearch.6,7 A key insight is that diversity of gender, cultural andethnic background, nationality and age (among other dimensions)is a valuable proxy for diversity of skills, experience and perspective.

For example, in the case of gender diversity, research has found thatin the US, more gender diverse boards may exhibit a broader set offunctional expertise8 (see Fig. 2).

Fig. 2: Board gender diversity tends to expandavailable skillsPercentage of US small-cap boards possessing eachexpertise

0% 20% 40% 60% 80% 100%

FinancialOperationsAccounting

InternationalM&A

StrategyLeadership

TechnologyRegulatory

Corporate governanceMarketing

PoliticalSustainability

Risk managementHuman resources

Research & development

Note: Light bars indicate skills the authors foundswomen board members were more likely to possess.Source: Daehyun and Starks (2016)8.

Given the co-existence of binding norms, rules and principles subject to comply-or-explain requirements, and recommendations with an aspirational best practice character, companies have degrees of freedom in determining their corporate governance framework and further leeway in behaving according to it, or even going above and beyond. For investors, assessing corporate gov-ernance practices at individual companies in light of the relevant regulatory framework and best practices among peers can be chal-lenging. However, as suggested in the following sections, it can also be rewarding. Investors also need to understand the corporate governance characteristics of each equity market. This is not only helpful in making asset allocation decisions, it also serves as a basis to understand market dynamics within the respective equity markets, especially in times of crisis.

III. Key aspects of Corporate Governance

For analysts and investors, corporate governance can appear to be a vast and at times intractable topic. Corporate governance cannot be fully appreciated with a standard checklist of issues. A number of substantive questions must be asked about the company's values, management and corporate structure, policies and the treatment of shareholders. Combined insights from all these dimensions of analysis help to gain a fuller picture. Still, it helps to divide the issues around key topic clusters.

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2. Board independenceThe board exists to set strategic direction and to oversee thecompany's management and ensure that it is behaving in theinterest of all shareholders. As such, a critical question is whetherthe board is independent of executive management, in particularthe CEO. Factors to consider include the following:

• Are the positions of CEO and Chair of the board separate?An increasingly widespread view is that separation of the rolesleads to better oversight and accountability. A number of coun-tries actively recommend this principle in norms and codes (e.g.the UK, Australia, Switzerland, Hong Kong). Even in the US,where this is not the case, there has been a shift in that directionamong companies in recent years. According to Spender Stuart,the fraction of US companies with dual chair/CEO roles fell from67% in 2006 to 52% in 2016.9 One should note that there arealso arguments against separation, particularly concerning thegreater knowledge of the company that a CEO/chair will have.

• What is the position of independent directors? In caseswhere the CEO and the chair are the same person, is there anindependent lead director in the board to counterbalance thechair? What proportion of board members is independent com-pared to mandatory thresholds? Is turnover of board membersencouraged, e.g. through term limits or a mandatory retirementage, to help prevent the board from becoming too cozy withmanagement?

• What is the committee structure within the board? In par-ticular, is there an audit committee with sufficient independentboard members? Are senior executives of the firm allowed tojoin board committee, in particular the compensation com-mittee? Are the committee chairs independent directors? Isthere a governance committee?

3. Compensation and incentivesFinancial incentives are a very powerful instrument in guidingbehavior. Company management is no exception. It is thereforeessential for investors to ascertain whether executive compensationprovides an appropriate alignment of interest between senior exec-utives and shareholders. Aspects to consider include:

• Is the CEO and senior management compensation commen-surate with their contribution to shareholder value creation?What performance metrics are used to this effect and are theyappropriate?

Fig. 3: Improving US corporate governancetrends% of S&P 500 companies

0% 20% 40% 60% 80% 100%

% of independent directors

Women as a % of all directors

Boards with at least one woman

% of CEOs serving on anoutside board

Boards where CEO is theonly non-independent

Independent chairman

CEO is also chairman

% of audit committee chairs who areactive CEO, chair, president or vice chair

Boards offering stockoption program

2016

2011

2006

Source: Copyright © 2016 Spencer Stuart9, UBS

Specifically, the authors found that between 2011 and 2013, new female directors among US small-cap companies brought on average more additional skills into the board than their male coun-terparts, i.e. women brought expertise into the mix that otherwise tended to be missing.

Apart from the skills and experience of directors, another relevant factor is whether directors have enough time to devote to their mandates or whether they are over-committed. The presence of directors who sit on an excessive number of other boards (over-boarding) can reduce their focus and effectiveness.


• Does senior management compensation provide incentives tofocus on delivering sustainable value over the long run or isit based on relatively short-term results? For instance, how longis the vesting period for incentive compensation and are thereclaw-back provisions under certain circumstances?

• Are severance payments for senior executives within a rea-sonable range?

4. Conflicts of interest / treatment of shareholdersThe overall commitment of a company's CEO and board to treatingminority shareholders fairly is a key concept of corporate gover-nance. Accordingly, important elements of corporate governanceare related to the alignment or misalignment of incentives betweenthe shareholders on one side and the board and executive team onthe other. These are some aspects to consider:

• Is the market for corporate control allowed to functionand discipline corporate leadership? For instance, are thereexcessive takeover defenses in place that could perpetuateboard and management entrenchment against shareholderinterests?

• Are there multiple share classes with different voting rights?This can allow company insiders (for example, the founder) tocontrol the company, without the need to provide a majorityof the firm's capital.

• Do shareholders have enough input on key corporate deci-sions? For example, are they consulted on compensationpackages?

5. Transparency and disclosureA final aspect of corporate governance is the amount and thequality of transparency and disclosure that companies provide totheir investors. The quality of financial disclosure is a critical factorhere. For instance, analysts spend time and effort evaluating howconservative the assumptions embedded in earnings reports are.This helps them determine whether current results can be repeatedin the future. Disclosure of contingent liabilities, expensing ofoptions, related party transactions, executive use of corporate assetsand cash, and political donations are additional examples of bestpractice disclosure.

IV. Benefits of focusing on corporate governancefor investors

Empirical evidenceOver the last several decades, numerous studies have been done onthe effects of corporate governance on performance across largesets of companies. The general conclusion is that corporate gover-nance can be valuable as a risk mitigation tool.

Research on the US stock market in the 1990s found that aninvestment strategy that bought firms with the strongest share-holder rights and sold firms with the weakest rights would havesignificantly outperformed.

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Fig. 4: Comparison of corporate governance indicators across select countries

USA UK France Germany Italy Spain Switzer. Russia

Combined chairman and CEO 52.0% 0.7% 55.0% 0.0% 18.0% 66.0% 0.0% 2.2%

% independent board members 84.0% 61.1% 69.0% 60.0% 50.1% 43.0% 88.0% 32.0%

% female board directors 21.3% 24.4% 38.8% n.a. 26.4% 16.0% 20.5% 7.0%

% boards with at least one female director 98% 98% 100% 93% 99% 83% 95% 40%

% new board members 7% 15% 14% 17% 17% 15% 11% 18%

Average number of boards per director (total) 2.1 1.9 2.3 - 3.3 1.1 2.1 1.7

% companies with a mandatory retirement age 73.0% n.a. 33.0% 67.2% 4.0% 23.0% 55.0% n.a.

Average tenure in years (chairman and non- executives) 4 4.9 6.3 5.7 5.5 6.4 6.6 3.4

Source: Copyright © 2016 Spencer Stuart10, UBS

Firms with stronger shareholder rights were also found to havehigher firm value, higher profits, higher sales growth, lower capitalexpenditures, and make fewer corporate acquisitions.11

Researchers found that US companies whose boards or audit com-mittees had an independent director with financial expertise wereless likely to face an accounting scandal in which they had to restatetheir earnings.12

Another study of the US market found that between mid-2001 andmid-2003, companies with above average corporate governancescores and positive momentum in the score outperformed com-panies with below average score and negative momentum, withmost of the effect arising from the momentum (i.e. corporate gov-ernance improvement).13 The same study also found that for UKstocks, market both positive scores and momentum led to outper-formance between 2001 and 2003.

The insight that a relatively straightforward measure of corporategovernance could be relied on to add value to portfolios seemsto have been recognized by analysts and integrated into theinvestment decision. As a result, more recent evidence (since 2000)reveals that such strategies no longer exhibit a clear pattern of out-performance.14, 15

This doesn't mean that corporate governance information can nowbe ignored. It just suggests that it requires more thoughtful analysisthan simply using a governance score to eliminate companies fromportfolios. Evidence still shows that corporate governance infor-mation can be very useful for the investment decision, particularlywhen managing a portfolio's risk. For example, a recent study foundthat firms ranking higher across a variety of corporate governanceindicators had a lower probability of experiencing a stock price crashover the following year.16 There is also evidence that a focus on cor-porate governance can be a source of value through shareholderengagement (more in Section V).


Fig. 5: Corporate governance failures illus-trated in case studies

Parmalat SatyamHIH

InsuranceEnron

CEO /Chair duality

No Not really

Independentboard

No No No

Auditcommittee

Notindependent

Notqualified

Notindependent

Short-termperformanceorientation

Yes

Auditorindependence

No No

Soundmanagementincentives

No

Source: Endnotes 20-23, UBS

CalPERS, the California Public Employees' Retirement System, had its engagement activities analyzed by Wilshire. They found that the 188 companies that were on their Engagement Focus List Program between 1999 and fall 2013 outperformed the broad US market.17

Therefore, while simple investment strategies relying on corporate governance scores may no longer be as effective, there remain plenty of opportunities to add value through corporate gover-nance considerations. Corporate governance information can prove valuable when it is used to paint a fuller picture of companies within a process of fundamental analysis. It can help prevent investors from being blindsided by risks and to extend their investment time horizon. Finally, it can serve as a basis for shareholder engagement strategies.

Case studies: Insights for corporate governance failures While corporate governance matters under business-as-usual cir-cumstances, its implications are perhaps best illustrated by relying on cases of corporate failures where poor governance was a central factor.

In recent decades, many instances of corporate abuse have occurred when the controlling shareholders sought to take advantage of minority shareholders. Entrenched management teams and boards have also often played a big role in abusing company assets and shareholder trust. In most cases, even those where financial fraud was at work, a closer look reveals that poor corporate gover-nance principles and practices such a perverse incentives, weak oversight and poor accountability and transparency were at least partly responsible for the ensuing collapse and shareholder value destruction.

In the appendix below, we illustrate how corporate governance failures contributed to the demise of various companies by high-lighting several case studies from across the world. Fig. 5 summa-rizes the takeaways from these cases.

V. Implications for investors

The evidence provided so far strongly suggests that investors can benefit from making corporate governance analysis an integral part of their investment process. Corporate governance is a component of equity risk. Yet, most of the time, investors react to corporate governance risks, rather than anticipate them. Corporate gover-nance is difficult and it takes time to assess properly. However, when corporate governance becomes an issue at a company, it probably becomes such an important driver of performance (for good or for bad) that it can dominate everything else.

For individual investors who are delegating portfolio management responsibility to some degree, the key insight is to ensure that the right capabilities are in place at the wealth and asset management firms they work with. An investor or investment manager can con-sider corporate governance at the level of security selection and of shareholder engagement.

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• Actively and independently voting through proxy at share-holder meeting: ESG topics are increasingly making they wayonto the ballot at annual meetings. The easiest way for aninvestment manager to try to induce change at a company is byindependently assessing what preferable outcomes are ratherthan automatically following management recommendations.

• Conducting informal discussions with companies: asset man-agers often have access to company boards or managementteams. They can use these interactions to raise concerns aboutESG topics. This is often a first step in addressing issues. Suchinteractions can often help change company behavior, espe-cially when the investment manager is large, persistent or theconcerns are shared by other investors.

• Filing shareholder resolutions: this is the most activeapproach and involves submitting a proposal for a vote at theannual shareholders' meeting. This is often viewed as a lastresort after attempts to sway company management fail.

Florida's State Board of Administration (SBA), the agency respon-sible for investing the assets of Florida's retirement system, con-ducted a study in 2015 to evaluate the value of its proxy votingpractices.19

Fig. 6: Percentage of US shareholder proposalsBy type, 2006-15 and 2016

Corporate Governance

Executive Compensation

Social Policy

2006-15

2016*

Source: ProxyMonitor.org.18 250 largest publicly tradedAmerican companies, by revenues, as determined byFortune. magazine.(*) In 2016, based on 231 com-panies holding annual meetings by August 31.

Fig. 7: Deeper look at US shareholder proposalsShareholder proposals per 100 companies

0 5 10 15 20 25 30

Employment Rights

Human Rights

Special Meetings / Written

Proxy Access

Voting Rules

Separate Chairman / CEO

Political Spending or Lobbying

Environmental Concerns

2015

2016*

Source: ProxyMonitor.org.18 250 largest publicly tradedAmerican companies, by revenues, as determined byFortune. magazine.(*) In 2016, based on 231 com-panies holding annual meetings by August 31.

ESG integration: Make corporate governance analysis a part of your security selectionIf, as documented above, corporate governance influences a company's risk and valuation, analysts would be expected to incor-porate such information when assessing the attractiveness of a company. Yet, a look at investment research across the industry reveals that this is often not the case, suggesting such insights are not fully reflected in securities prices.

Governance analysis is part of the broader field of environmental, social and governance (ESG) analysis, which seeks to incorporate insights from a broader range of non-financial, but financially rel-evant, factors into investment decisions. ESG factors become rel-evant over a time horizon that is somewhat longer than those of most analysts. A sound understanding of these factors requires an appreciation of how corporate activities affect a broad range of stakeholders and how these interactions ultimately determine value creation for shareholders in the longer term. As a result of these commonalities, investment managers who emphasize cor-porate governance often also incorporate relevant environmental and social factors into their investment process.

Shareholder engagement: Influence through active own-ershipIncorporating governance analysis into security selection is only one lever that investors have available. A second, equally potent lever is shareholder engagement. This covers a range of measures that investors can take to be more active owners of the underlying companies in their portfolios. The purpose is to promote better corporate governance practices, including greater disclosure, more diverse board composition and other aspects discussed in Section III. Such efforts are typically undertaken at the investment manager level.

Shareholder engagement includes:


• The board did not fulfill its fiduciary duty, failing to critically andindependently supervise the company's activities. Many boardmembers had a long tenure – more than 20 years in severalinstances.

• Financial incentives further reduced their independence asboard members were receiving stock compensation as wellas fees for consultancy. There is little evidence that Enron'sproblems were concealed from the board, and much indicatingthat it failed to act.

• There were significant problems with management compen-sation. First, the board approved excessive amounts of compen-sation for company executives, while failing to monitor the cashdrain caused by these compensation plans. Second, there wasa heavy reliance on stock options as an instrument of seniormanagement compensation, which may have provided incen-tives that exacerbated short-term profit seeking.

• Enron’s auditor Arthur Andersen lacked independence as it wasreceiving considerable fees for consultancy services.

Parmalat: Italian dairy and food producerThe Italian multinational company Parmalat was a world leader inthe food and dairy industry, which went into bankruptcy in late2003 following revelations of accounting fraud.

The study analyzed 107 votes between 2006 and 2014 and clas-sified them according to whether the SBA supported at least one dissident nominee for the board of directors, i.e. one not sup-ported by the company's management, or not. The findings showed that the best five-year performance following the proxy vote was achieved in cases when the SBA voted for a dissident and the dis-sident was elected.

VI. Appendix: Case studies

Enron: A corporate scandalEnron's collapse in 2001 is perhaps the best known corporate scandal in recent history. Created in the mid-1980s by Kenneth Lay from the merger of natural gas pipeline companies, Enron rapidly diversified away from the traditional energy business. As US energy markets were deregulated in the 1980s and electricity markets fol-lowed suit in the 1990s, Enron became a market maker in these markets and developed innovative financial instruments to help energy market participants better manage risks in these evolving energy markets. While the firm was seeking to maintain an ambi-tious growth trajectory, it adopted accounting practices that proved controversial. The first was mark-to-market accounting for its posi-tions in derivatives, many of which were thinly traded. The other was the creation of a large number of special purpose entities, which were used for off-balance sheet financing purposes and over time contributed to painting an increasingly misleading picture of the company's financial strength. At the end of 2001, the company announced that its reported financial conditions had been inflated by accounting fraud. There were multiple causes that led to Enron's demise. However, a few stand out from a corporate governance standpoint.20

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• The chair and the CEO were the same person, which was notcommon in Italy at that time.

• The board of directors included a minority of non-executivedirectors, and among them few could be considered inde-pendent.

• The internal control committee (audit committee) had no inde-pendent members in violation of the Italian corporate gover-nance code. Two members were on the executive committeeand the third member was the Tanzi family's accountant, andtherefore hardly independent.

These corporate governance features at Parmalat made controlfunctions highly ineffective and helped perpetuate the financialabuse by the controlling shareholder.

Satyam: Indian IT companyBy 2008, Satyam had been grown by its chairman and founderRamalinga Raju into a global IT services provider with over 50,000employees globally across sixty seven countries. It had receivednumerous accolades and had been listed on the New York StockExchange since 2001. Yet, it was about to give rise to the biggestcorporate scandal in India at the time. In early 2009, after a lossof investor confidence, a plunge in the share price and allegationsof bribery, Raju admitted to fraudulent financial reporting, resignedand was arrested shortly thereafter.

An analysis of the case by Elisabetta Basilico and her two coauthors22

highlighted a number of financial red flags that should have beenvisible. In addition, significant corporate governance deficiencieshave been identified that contributed to enabling fraud on such alarge scale.

• While the chairman and the CEO positions were nominally sep-arate, the CEO was Raju's brother, with a clear lack of inde-pendence between the two. This was a case of an all-powerfulchairman.

• On the surface, the board of directors did not appear tolack non-executive members and included audit, compen-sation, and investor grievance committees. However, a closerlook actually revealed a lack of independence as most boardmembers came from overlapping social circles with strong tiesto Harvard University (from which Raju had graduated) and theIndian government.

• Internal controls were weak. Audit committee members lackedthe necessary education and experience as none of them wasa financial expert.

Controlled by the Tanzi family through a complex corporate structure, the company had experienced spectacular growth during the preceding decade, relying a lot on debt financing. On the surface, the Parmalat case appears to be a classic story of a financial fraud by a controlling owner at the expense of minority share-holders. In a detailed analysis, Andrea Melis21 has argued that Parmalat’s corporate governance structure failed to comply with some of the key existing Italian corporate governance standards of best practice and that this contributed to the downfall. Consider the following:


• The business strategy favored a short-term performance orien-tation with constant double-digit revenue growth targets.

• Conflicts of interest were prevalent. The Raju brothers had ahistory of investing cash reserves in other family businesses tothe detriment of other shareholders.

Once the dust settled, the Satyam scandal spurred significant cor-porate governance reforms in India.

HIH Insurance: Financial troubles down underHealth International Holdings (HIH) Insurance was Australia'ssecond largest insurance company when it collapsed in 2001. Ithad been on an aggressive expansion course to increase its marketshare for several years. In 1998-1999, HIH purchased FAI InsurancesLimited without proper due diligence or consulting the board andended up overpaying. In the process, it accumulated more debt thanit could handle.23 With its financial position deteriorating, HIH waseventually placed in provisional liquidation in 2001. The HIH RoyalCommission, in its 2003 report, identified key corporate governancefailures that contributed to the collapse:

• The audit committee was deemed ineffective. This is not sur-prising as the chairman of HIH, Geoffrey Cohen, was alsothe chairman of the audit committee. Moreover, he regularlyattended audit committee meetings accompanied by membersof the senior management.

• The auditor, Arthur Andersen, was found to be not inde-pendent enough, particularly concerning non-audit-relatedbusiness with HIH.

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VII. Endnotes / Bibliography1 Ocean Tomo (2015), “2015 Annual Study of Intangible Asset Market Value”.

2 John R. Graham, Campbell R. Harvey, Shiva Rajgopal (2006), " Value Destruction and Financial Reporting Decisions ", Financial Analysts Journal, Volume 62, Number 6, pp. 27-39.

3 Mercer (2017), "The long and winding road: How long-only equity managers turn over their portfolios every 1.7 years", February.(Available at: http://tragedyofthehorizon.com)

4 Warren Buffet et al (2016), "Commonsense Corporate Gover-

nance Principles".

5 Investor Stewardship Group (2017), "Corporate Governance Prin-ciples For US Listed Companies", https://www.isgframework.org/corporate-governance-principles/.

6 Anita Williams Wooley, et al. (2010), “Evidence for a collective intelligence factor in the performance of human groups”, Science, Vol. 330, Issue 6004, October, pp. 686–688.

7 Corinne Post, Kris Byron, (2015), “Women on Boards and Firm Financial Performance: A Meta-analysis,” Academy of Management Journal, Vol. 58 ,Issue 5, October, pp.1546-1571.

8 Daehyun Kim, Laura T. Starks (2016), " Gender Diversity on Cor-porate Boards: Do Women Contribute Unique Skills?", American Economic Review, Vol. 106, no. 5, May, pp. 267-71.

9 Spender Stuart (2016), "2016 Spencer Stuart Board Index: A Per-

spective on U.S. Boards".

10 Spencer Stuart (2016), "2016 UK Board Index".

11 Gompers et al. (2003) "Corporate Governance and Equity Prices", Quarterly Journal of Economics, 118(1), February, pp. 107-155.

12 Anup Agrawal and Sahiba Chadha (2005), "Corporate Gover-nance and Accounting Scandals", The Journal of Law & Economics, Vol. 48, No. 2 (October), pp. 371-406.

13 Grandmont, Renato (2004), "Beyond the Numbers. Corporate Governance: Implications for Investors", Deutsche Bank, Global Equity Research, Strategy Focus, April.

14 Credit Suisse (2016), "How Corporate Governance Matters", Credit Suisse Research Institute, January.

15 Lucian A. Bebchuka, Alma Cohena, Charles C.Y. Wang, (2013), " Learning and the disappearing association between governance and returns", Journal of Financial Economics, Volume 108, Issue 2, May, pp. 323–348.

16 Andreou, P. C., Antoniou, C., Horton, J. and Louca, C. (2016), "Corporate Governance and Firm-specific Stock Price Crashes", European Financial Management, 22, pp. 916–956.

https://www.isgframework.org/corporate-governance-principles/

https://www.isgframework.org/corporate-governance-principles/


17 CalPERS, www.calpers.ca.gov/page/investments/governance/cor-

porate-engagements/focus-list-program, accessed 28 March 2017.

18 The Manhattan Institute (2016), "ProxyMonitor: An Annual Report on Corporate Governance and Shareholder Activism".

19 SBA (2015), "Valuing the Vote: The Impact of Proxy Voting on SBA Portfolio Holdings. Empirical Analysis of Proxy Contests", Florida State Board of Administration, June.

20 Khan, M.A. (2011), "The reasons behind a corporate collapse: A case study of Enron", SSRN Working Paper. Available:https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1923277.

21 Andrea Melis (2005),"Corporate Governance Failures. To What Extent is Parmalat a Particularly Italian Case?", Corporate gover-nance: an international review, Volume 13, Issue 4, July, pp 478–488.

22 Elisabetta Basilico, Hugh Grove, Lorenzo Patelli (2012), "Asia's Enron: Satyam (Sanskrit Word for Truth)", Journal of Forensic & Investigative Accounting, Vol. 4, Issue 2.

23 Mak, T. et al. (2005), "Australia’s major corporate collapse: Health International Holdings (HIH) Insurance 'May the force be with you'”, Journal of American Academy of Business, 6(2), March, pp. 104 –112.

https://www.calpers.ca.gov/page/investments/governance/corporate-engagements/focus-list-program

https://www.calpers.ca.gov/page/investments/governance/corporate-engagements/focus-list-program

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AppendixChief Investment Office (CIO) Wealth Management (WM) Research is published by UBS Wealth Management and UBS Wealth Management Americas, Business Divisions of UBS AG (UBS) or an affiliate thereof. CIO WM Research reports published outside the US are branded as Chief Investment Office WM. In certain countries UBS AG is referred to as UBS SA. This publication is for your information only and is not intended as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. The analysis contained herein does not constitute a personal recommendation or take into account the particular investment objectives, investment strategies, financial situation and needs of any specific recipient. It is based on numerous assumptions. Different assumptions could result in materially different results. We recommend that you obtain financial and/or tax advice as to the implications (including tax) of investing in the manner described or in any of the products mentioned herein. Certain services and products are subject to legal restrictions and cannot be offered worldwide on an unrestricted basis and/or may not be eligible for sale to all investors. All information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to its accuracy or completeness (other than disclosures relating to UBS and its affiliates). All information and opinions as well as any prices indicated are current only as of the date of this report, and are subject to change without notice. Opinions expressed herein may differ or be contrary to those expressed by other business areas or divisions of UBS as a result of using different assumptions and/or criteria. At any time, investment decisions (including whether to buy, sell or hold securities) made by UBS AG, its affiliates, subsidiaries and employees may differ from or be contrary to the opinions expressed in UBS research publications. Some investments may not be readily realizable since the market in the securities is illiquid and therefore valuing the investment and identifying the risk to which you are exposed may be difficult to quantify. UBS relies on information barriers to control the flow of information contained in one or more areas within UBS, into other areas, units, divisions or affiliates of UBS. Futures and options trading is considered risky. Past performance of an investment is no guarantee for its future performance. Some investments may be subject to sudden and large falls in value and on realization you may receive back less than you invested or may be required to pay more. Changes in FX rates may have an adverse effect on the price, value or income of an investment. This report is for distribution only under such circumstances as may be permitted by applicable law. Distributed to US persons by UBS Financial Services Inc. or UBS Securities LLC, subsidiaries of UBS AG. UBS Switzerland AG, UBS Deutschland AG, UBS Bank, S.A., UBS Brasil Administradora de Valores Mobiliarios Ltda, UBS Asesores Mexico, S.A. de C.V., UBS Securities Japan Co., Ltd, UBS Wealth Management Israel Ltd and UBS Menkul Degerler AS are affiliates of UBS AG. UBS Financial Services Incorporated of PuertoRico is a subsidiary of UBS Financial Services Inc. UBS Financial Services Inc. accepts responsibility for the content of a report prepared by a non-US affiliate when it distributes reports to US persons. All transactions by a US person in the securities mentioned in this report should be effected through a US-registered broker dealer affiliated with UBS, and not through a non-US affiliate. The contents of this report have not been and will not be approved by any securities or investment authority in the United States or elsewhere. UBS Financial Services Inc. is not acting as a municipal advisor to any municipal entity or obligated person within the meaning of Section 15B of the Securities Exchange Act (the "Municipal Advisor Rule") and the opinions or views contained herein are not intended to be, and do not constitute, advice within the meaning of the Municipal Advisor Rule.UBS specifically prohibits the redistribution or reproduction of this material in whole or in part without the prior written permission of UBS and UBS accepts no liability whatsoever for the actions of third parties in this respect.Version as per September 2015.© UBS 2017. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved.

Journal of


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ACTIVE AND PASSIVEbalanced perspective on the appropriate use of active and passive strategies

101Lockwood Advisors | BNY Mellon

Capital Markets Insights MAY 2017

Active Versus Passive Investing—Our Perspective

The debate over the merits of active and passive investment management has persisted since the early 1970s, when “indexing,” a form of passive management, came into vogue at many of the nation’s largest pension funds. There are respected experts on both sides of the debate, who argue their positions convincingly and support their conclusions with scholarly research.

In the 1950s and 1960s, a group of economists—Harry Markowitz, Merton Miller, William F. Sharpe and Eugene Fama—first seriously addressed the concept of efficient markets. Much of the work pointed to a conclusion that stock markets are a zero-sum game, and that they efficiently discount, or factor, all news into the price of stocks. The ever-increasing availability of information and the speed of its delivery argue in favor of this theory. Adherents to the efficient markets doctrine would naturally gravitate toward passive management of their equity assets, because there would be virtually no opportunity to use an active management approach to anticipate the effect of news on a stock’s price.

Subsequent studies by behavioral theorists suggest that investors do not always act logically and make rational decisions. These scholars argue that the psychological effects of varying emotions (greed, timidity, procrastination, fear of losing wealth, regret, etc.) are barriers to an objective, logical response to market news. Hence, the researchers contend, markets are not efficient. In an inefficient market, the potential for capitalizing on perceived opportunities and outperforming an index is higher, and therefore, the argument is for active management.

However, since one of these theories is based on the availability of information and the other on its use, it is difficult to make a direct comparison of their merits. By extension, it often becomes difficult to decide whether active or passive management is the better choice.

A review of performance adds another dimension to our analysis. Comparative studies on active and passive management conducted by Standard and Poor’s and Morningstar broadly suggest that active strategies, on average, generally have underperformed passive approaches after fees. However, these broad, high-level studies typically do not take into account risk-adjusted performance or the importance of seeking to provide some protection during market declines—especially protracted market declines. Keep in mind that recouping losses requires a larger percentage gain than the loss itself. In addition, the differences between gains and losses become more dramatic as the losses get larger (i.e., compound).

Another important, and often overlooked, component of the active and passive investing debate is that each style tends to have varying degrees of success based on certain economic conditions, market types and time periods. One such example is market volatility. Market volatility has been relatively low for the last several years, especially by historical standards. In such an environment, there tends be lower return dispersion (or performance spread) between the “best” and “worst” performing stocks. When there are relatively limited differences between the best and worst performing stocks, there tends to be less of a reward (i.e., alpha generating potential) for active managers to pick the “winners” instead of simply holding an index/market-like portfolio. In contrast, market environments with higher volatility typically provide greater performance differences between the best and worst performing stocks. This, in turn, creates more opportunities for an active manager to add value from stock selection.

All investments are subject to risk, including the loss of principal. For additional information, please refer to the Important Disclosures at the end of this report.

LKA-AMS-495-17

102 Active Versus Passive Investing: Our PerspectiveAll investments are subject to risk, including the loss of principal. For additional information, please refer to the Important Disclosures at the end of this report.

LKA-AMS-495-17

The key features and differences of passive and active management are highlighted in Table 1. Passive management, more commonly called indexing, seeks to match performance of an index (before fees). The management style is considered passive because portfolio managers do not make decisions on which investments to buy or sell; they simply seek to mirror the index. Because passive management seeks to track performance of an index, investors must be satisfied with market performance—including market-like performance during market declines—and the corresponding volatility. It is important to note that, over the past several years, additional types of passive investment strategies seeking to track “non-traditional” rules-based indexes have become available within the marketplace. In contrast to the traditional market-capitalization weighted indexes, the “non-traditional” rules-based indexes are designed to capture specific market factors or sources of return—a

sub-set of the broader universe of securities included in traditional indexes. The context of this paper, however, is focused on passive strategies designed to track traditional indexes represented by widely accepted benchmarks.

In contrast to passive management, active management seeks to outperform the market (as measured by a benchmark index) on a risk-adjusted basis. Portfolio managers make decisions on which securities to buy or sell as well as the underlying market exposures (industry, sector, style, size, country, region, etc.) to establish within the portfolios. Active managers typically have flexibility to manage/mitigate risk within the portfolios as well as implement more defensive measures and positioning during market declines. As a result of this decision-making, active managers have the potential to maximize gains and minimize losses—including the potential to minimize losses during market declines.

Table 1

Passive Management/Indexing Features Active Management

Market-driven Investing Style Manager-driven

Inflexible. Seeks to match perfor-mance of the benchmark; no flexibil-ity to vary holdings or exposures

Decision Making Flexibility

Flexible. Seeks to capitalize on perceived opportunities and mitigate risk; flexibility to vary holdings and exposures

Fees tend to be lower than active management

Investment Management FeesFees tend to be higher than passive management

No; seeks market-like performance of its underlying index

Potential for Risk Management Yes


Potential for Down Market Protection

Yes

Seeks to match performance of an index, before fees

Potential for Above-/ Below-Market Returns

Potential for above- and/or below- index returns, before fees

Source: Lockwood Advisors, Inc.


LKA-AMS-495-17

The key features and differences of passive and active management are highlighted in Table 1. Passive management, more commonly called indexing, seeks to match performance of an index (before fees). The management style is considered passive because portfolio managers do not make decisions on which investments to buy or sell; they simply seek to mirror the index. Because passive management seeks to track performance of an index, investors must be satisfied with market performance—including market-like performance during market declines—and the corresponding volatility. It is important to note that, over the past several years, additional types of passive investment strategies seeking to track “non-traditional” rules-based indexes have become available within the marketplace. In contrast to the traditional market-capitalization weighted indexes, the “non-traditional” rules-based indexes are designed to capture specific market factors or sources of return—a

sub-set of the broader universe of securities included in traditional indexes. The context of this paper, however, is focused on passive strategies designed to track traditional indexes represented by widely accepted benchmarks.

In contrast to passive management, active management seeks to outperform the market (as measured by a benchmark index) on a risk-adjusted basis. Portfolio managers make decisions on which securities to buy or sell as well as the underlying market exposures (industry, sector, style, size, country, region, etc.) to establish within the portfolios. Active managers typically have flexibility to manage/mitigate risk within the portfolios as well as implement more defensive measures and positioning during market declines. As a result of this decision-making, active managers have the potential to maximize gains and minimize losses—including the potential to minimize losses during market declines.

Table 1

Passive Management/Indexing Features Active Management

Market-driven Investing Style Manager-driven

Inflexible. Seeks to match perfor-mance of the benchmark; no flexibil-ity to vary holdings or exposures

Decision Making Flexibility

Flexible. Seeks to capitalize on perceived opportunities and mitigate risk; flexibility to vary holdings and exposures

Fees tend to be lower than active management

Investment Management FeesFees tend to be higher than passive management


Potential for Risk Management Yes


Potential for Down Market Protection

Yes

Seeks to match performance of an index, before fees

Potential for Above-/ Below-Market Returns

Potential for above- and/or below- index returns, before fees

Source: Lockwood Advisors, Inc.

103Lockwood Advisors | BNY MellonAll investments are subject to risk, including the loss of principal. For additional information, please refer to the Important Disclosures at the end of this report.

LKA-AMS-495-17

While the theoretical and empirical evidence behind both approaches is useful and make for a lively debate, the relevant issue for most investors is not whether one strategy is better than the other in theory, but rather, how to design the most beneficial approach to managing their particular portfolio. The intelligent management of diversifying assets is a complex process, and a one-word answer to an either-or question (“Active or Passive?”) is probably too simplistic for optimal results.

Lockwood Advisors, Inc. (Lockwood) believes there is merit in both positions of this debate, and that the consultative process for each client should include comparing the characteristics of active and passive management against the client’s investor profile. Indeed, more often than not, we find that a managed blend of active and passive styles of management has tended to produce the highest probability of achieving a long-term investment goal while accommodating the client’s tolerance for risk.

However, as mentioned earlier, several studies indicate that long-term performance in passively managed portfolios tends to be better, on average, than performance in actively managed approaches. The key to portfolio outperformance, then, lies in looking for the active management approaches that have a reasonable expectation of delivering strong risk-adjusted performance, and incorporating them into a blended active-passive portfolio strategy.

As we examine the range of management styles, we can see that, historically, outperformance tends to occur in management styles that function in the less analyzed capital markets (small-cap and international equity styles, for

example). The lighter research coverage of these markets tends to create less efficiency and, therefore, offers an empirical opportunity of outperformance. This level of inefficiency is grounded in the availability of information, and not in the emotional reaction of investors. In addition, active management may also provide additional ability to customize an investor’s portfolio regardless of the market environment. To the extent that active management is used, professional manager selection is a key aspect to success.

For the informed investor, knowing where the “best” opportunities for active management may be for assuming active management risk within each asset class and investment style is crucial for determining the proper mix of active versus passive management styles in a diversified investment portfolio. Constructing portfolios that seek to recognize the strengths and weaknesses of the two styles, as well as combining them in an effort to balance their effects and diversify the risks, reconciles the ongoing debate between the benefits of index and active management. It also provides a more holistic framework that is designed to enable asset allocation decisions to have a higher probability of success, a better potential to mitigate downside risk and a lower cost than a 100% actively managed portfolio.

And finally, Lockwood incorporates a blend of index and active approaches within our discretionary multi-style investment solutions. In addition, Lockwood’s investment approach is designed to emphasize a long-term investment horizon, focus on downside risk management and access the expertise and worldwide resources within BNY Mellon—a trio of key differentiators, in our view.


LKA-AMS-495-17

While the theoretical and empirical evidence behind both approaches is useful and make for a lively debate, the relevant issue for most investors is not whether one strategy is better than the other in theory, but rather, how to design the most beneficial approach to managing their particular portfolio. The intelligent management of diversifying assets is a complex process, and a one-word answer to an either-or question (“Active or Passive?”) is probably too simplistic for optimal results.

Lockwood Advisors, Inc. (Lockwood) believes there is merit in both positions of this debate, and that the consultative process for each client should include comparing the characteristics of active and passive management against the client’s investor profile. Indeed, more often than not, we find that a managed blend of active and passive styles of management has tended to produce the highest probability of achieving a long-term investment goal while accommodating the client’s tolerance for risk.

However, as mentioned earlier, several studies indicate that long-term performance in passively managed portfolios tends to be better, on average, than performance in actively managed approaches. The key to portfolio outperformance, then, lies in looking for the active management approaches that have a reasonable expectation of delivering strong risk-adjusted performance, and incorporating them into a blended active-passive portfolio strategy.

As we examine the range of management styles, we can see that, historically, outperformance tends to occur in management styles that function in the less analyzed capital markets (small-cap and international equity styles, for

example). The lighter research coverage of these markets tends to create less efficiency and, therefore, offers an empirical opportunity of outperformance. This level of inefficiency is grounded in the availability of information, and not in the emotional reaction of investors. In addition, active management may also provide additional ability to customize an investor’s portfolio regardless of the market environment. To the extent that active management is used, professional manager selection is a key aspect to success.

For the informed investor, knowing where the “best” opportunities for active management may be for assuming active management risk within each asset class and investment style is crucial for determining the proper mix of active versus passive management styles in a diversified investment portfolio. Constructing portfolios that seek to recognize the strengths and weaknesses of the two styles, as well as combining them in an effort to balance their effects and diversify the risks, reconciles the ongoing debate between the benefits of index and active management. It also provides a more holistic framework that is designed to enable asset allocation decisions to have a higher probability of success, a better potential to mitigate downside risk and a lower cost than a 100% actively managed portfolio.

And finally, Lockwood incorporates a blend of index and active approaches within our discretionary multi-style investment solutions. In addition, Lockwood’s investment approach is designed to emphasize a long-term investment horizon, focus on downside risk management and access the expertise and worldwide resources within BNY Mellon—a trio of key differentiators, in our view.

104 Active Versus Passive Investing: Our Perspective

Important DisclosuresThe statements contained herein are based upon the opinions of Lockwood Advisors, Inc. (Lockwood) and the data available at the time of publication and are subject to change at any time without notice.

This communication does not constitute investment advice, is for informational purposes only and is not intended to meet the objectives or suitability requirements of any specific individual or account. An investor should assess his or her own investment needs based on his or her own financial circumstances and investment objectives.

The statistical data contained herein has been obtained from third party sources (see below) believed to be reliable; however, Lockwood has not verified, and cannot guarantee, the accuracy of the information provided.

Neither the information nor any opinions expressed herein should be construed as a solicitation or a recommendation by Lockwood or its affiliates to buy or sell any securities or investments.

It is important to remember that there are risks inherent in any investment and that there is no assurance that any money manager, fund, asset class, style, index or strategy will provide positive performance over time. The investment return and principal value of an investment will fluctuate, so that an investor’s assets, when sold, may be worth more or less than their original cost.

Diversification and strategic asset allocation do not guarantee a profit or protect against a loss in declining markets. Past performance is not a guarantee of future results. All investments are subject to risk, including the loss of principal.

Investors should carefully consider the investment objectives, risks, charges, fees and expenses of any portfolio before investing

Statements of future expectations, estimates and other forward-looking statements are based on available information and Lockwood’s view as of the time of these statements. Accordingly, such statements are inherently speculative, as they are based on assumptions that may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements.

Past performance is not a guarantee of future results. Current performance may be lower or higher than the performance data quoted. The investment return and principal value of an investment will fluctuate, so that an investor’s assets, when sold, may be worth more or less than their original cost.

For more information about Lockwood, as well as its products, fees and services, please refer to Lockwood’s Form ADV Part 2, Wrap Fee Brochure for Managed Account Link, Wrap Fee Brochure for Managed Account Advisor, Wrap Fee Brochure for the Lockwood Sponsored Program, Wrap Fee Brochure for Co-Sponsored Programs, Wrap Fee Brochure for the Managed360® Program or the Firm Brochure, as applicable, which may be obtained through your financial advisor or by writing to: Lockwood, Attn: Legal Department (AIM #19K-0203), 760 Moore Road, King of Prussia, PA 19406, or by calling (800) 200-3033, option 3.

Lockwood Advisors, Inc. (Lockwood) is an investment adviser registered in the United States under the Investment Advisers Act of 1940, an affiliate of Pershing LLC and a wholly owned subsidiary of The Bank of New York Mellon Corporation (BNY Mellon). Pershing LLC, member FINRA, NYSE, SIPC. Trademark(s) belong to their respective owners.

©2017 Lockwood Advisors, Inc.

FS-LKA-CMI-5-17

Important DisclosuresThe statements contained herein are based upon the opinions of Lockwood Advisors, Inc. (Lockwood) and the data available at the time of publication and are subject to change at any time without notice.

This communication does not constitute investment advice, is for informational purposes only and is not intended to meet the objectives or suitability requirements of any specific individual or account. An investor should assess his or her own investment needs based on his or her own financial circumstances and investment objectives.

The statistical data contained herein has been obtained from third party sources (see below) believed to be reliable; however, Lockwood has not verified, and cannot guarantee, the accuracy of the information provided.

Neither the information nor any opinions expressed herein should be construed as a solicitation or a recommendation by Lockwood or its affiliates to buy or sell any securities or investments.

It is important to remember that there are risks inherent in any investment and that there is no assurance that any money manager, fund, asset class, style, index or strategy will provide positive performance over time. The investment return and principal value of an investment will fluctuate, so that an investor’s assets, when sold, may be worth more or less than their original cost.

Diversification and strategic asset allocation do not guarantee a profit or protect against a loss in declining markets. Past performance is not a guarantee of future results. All investments are subject to risk, including the loss of principal.

Investors should carefully consider the investment objectives, risks, charges, fees and expenses of any portfolio before investing

Statements of future expectations, estimates and other forward-looking statements are based on available information and Lockwood’s view as of the time of these statements. Accordingly, such statements are inherently speculative, as they are based on assumptions that may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements.

Past performance is not a guarantee of future results. Current performance may be lower or higher than the performance data quoted. The investment return and principal value of an investment will fluctuate, so that an investor’s assets, when sold, may be worth more or less than their original cost.

For more information about Lockwood, as well as its products, fees and services, please refer to Lockwood’s Form ADV Part 2, Wrap Fee Brochure for Managed Account Link, Wrap Fee Brochure for Managed Account Advisor, Wrap Fee Brochure for the Lockwood Sponsored Program, Wrap Fee Brochure for Co-Sponsored Programs, Wrap Fee Brochure for the Managed360® Program or the Firm Brochure, as applicable, which may be obtained through your financial advisor or by writing to: Lockwood, Attn: Legal Department (AIM #19K-0203), 760 Moore Road, King of Prussia, PA 19406, or by calling (800) 200-3033, option 3.

Lockwood Advisors, Inc. (Lockwood) is an investment adviser registered in the United States under the Investment Advisers Act of 1940, an affiliate of Pershing LLC and a wholly owned subsidiary of The Bank of New York Mellon Corporation (BNY Mellon). Pershing LLC, member FINRA, NYSE, SIPC. Trademark(s) belong to their respective owners.

©2017 Lockwood Advisors, Inc.

FS-LKA-CMI-5-17

105Morningstar

It is no secret that actively managed funds are struggling (EXHIBIT 1 ). Over the three-year period ending April 30, U.S.-domiciled actively managed mutual funds and exchange-traded funds witnessed collective outflows of nearly $514 billion. Passively managed mutual funds and ETFs collected nearly $1.57 trillion in net new money during that same span. What began as more discerning culling of positions in underperforming U.S. stock funds has become more widespread. For example, during the 12 months ending Jan. 31, investors pulled $99 billion from funds that beat their Morningstar Category indexes over that same period.1

Are we approaching the End of Days for active management? I don’t believe so. In my opinion, active management will never die. There will always be investors who hope for something better than getting the market’s return net of a small fee—it’s human nature. But active management must continue to evolve. Here, I’ll take a closer look at two ways in which active management has changed in recent years as evidenced by:

1 The growth in the active use of passive funds. 2 The expansion of a class of nominally passive funds that make active bets.

Both phenomena demonstrate that active management is alive and well and that the distinction between active and passive is as blurry as ever.

Investors Are Getting Active With PassiveThe objects of many active managers’ decision-making process are changing. Instead of choosing between Coca-Cola KO and Apple AAPL, many active managers are deciding between U.S. large caps and U.S.-dollar-denominated emerging-markets debt. These active asset-

allocation decisions are increasingly implemented using ETFs and index mutual funds. The managers making these decisions are doing so in a number of different settings and with varying degrees of activity. These range from broadly diversified strategic asset-allocation models that are managed at intermediary platforms’ home offices to so-called robo-advisors and ETFs of ETFs. Among these actors, the preference for passive is strong. In trying to generate alpha by recombining various beta building blocks, many asset allocators want to take ownership of all active decision-making rather than outsource it to a traditional security selector.

The growth of these model-builders is most readily measured by the increase in assets under management of target-date funds, the assets under management or advisement in ETF managed portfolios, and the amount of money managed on digital advice platforms (aka robo-advisors).

Assets in U.S.-domiciled target-date funds stood at $880 billion as of the end of 2016.² Of that sum, 39%, or $343 billion, was invested in target-date series that use passive funds exclusively. These

Ben Johnson

PASSIVE

1 Ptak, J. 2017. “Loveless: Even Winning Funds Are Bleeding Assets” Morningstar. March 28, 2017. http://news.morningstar.com/articlenet/article.aspx?id=798866 2 Holt, J. 2017. Morningstar Target-Date Fund Landscape 2017. https://corporate1.morningstar.com/ResearchLibrary/article/803362/2017-target-date-fund-landscape/

Passive Active+800

USD Bil

+400

Trailing 12-Month Estimated Net Flows

0

–400

01/1994–03/2017

1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

–267.9

+643.7

Assets Under Management

70.0USD Bil

Estimated Net Flows

0.0

600.0USD Bil

52.5450.0

35.0300.0

17.5150.0

0.02000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2011 20132010 2012 2014 2015 2016

Active Is on the Ropes Assets in active strategies are plummeting, while passive thrives.

EXHIBIT 1

Source: Morningstar.

The Death of Active Management Has Been Greatly ExaggeratedActive investing will never die, but it’s being forced to evolve.

Spotlight: The Future of Investing

JUNE/JULY 2017

106 The Death of Active Management Has Been Greatly Exaggerated

series’ share of the target-date market increased from 17% as of 10 years ago. ETF managed portfolios are investment strategies that typically have more than 50% of portfolio assets invested in ETFs. Primarily available as separate accounts in the United States, these portfolios represent one of the fastest-growing segments of the managed-accounts universe. As of Dec. 31, Morningstar was tracking 881 strategies from 162 firms with total assets of $84.8 billion in this space. This is just the tip of the iceberg, as there are tens of billions of dollars invested in similar strategies that are managed by teams at a number of different intermediary platforms, which are not captured in our database. Lastly, there are the robo-advisors. Firms like Vanguard and Charles Schwab SCHW have seen rapid growth in the adoption of their digital-advice platforms. Schwab Intelligent Portfolios were home to $16 billion in investors’ assets as of the end of March. Vanguard’s Personal Advisor Services segment now oversees more than $50 billion.

As individuals and advisors show a growing preference for solutions over products and grow more comfortable with technology, it is likely that these active asset allocators will continue to attract new money from investors.

Actively managed mutual funds are also making greater use of passive funds, and ETFs in particular ( EXHIBIT 2 ). Since 2006, the number of actively managed U.S.-domiciled mutual funds that hold at least one ETF has more than doubled. Meanwhile, the size of the median ETF positions held by these funds has nearly quadrupled. Security selectors are using ETFs to fill gaps in their portfolios. Some have substituted them for futures contracts to equitize cash. Others invest in them to take sector bets when they don’t have expertise to select the most attractively priced stocks in a corner of the market. The growing use of ETFs by active fund managers is a clear example of the increasingly fuzzy distinction between active and passive.

The starkest data demonstrating the active use of passive building blocks is the rate of turnover in many ETFs’ shares. SPDR S&P 500 ETF SPY is the most actively traded security on the planet. According to NYSE, SPY’s average daily turnover in March was $21.4 billion. Over the year ending April 30, the average holding period for SPY was 15.4 days.3 That hardly seems passive. ETFs are being used in countless ways by countless different market participants. For some, they are low-cost, tax-efficient, buy, hold, and rebalance building blocks. For others, they are a substitute for a derivative, a trading tool, or a hedge. Unlike mutual funds, there is no way to trace ETF users or to discern how they are being used. Trying to do so is like a playing a frustrating game of Clue. All we know for certain is that the candlestick was the murder weapon (SPY, in our case). We have no idea who committed the crime, why they did it, nor in what dark corner of the mansion the deed was done. What we can say for certain is that ETFs are being used actively (EXHIBIT 3).

Active Use of Passive More mutual funds are using ETFs, and their ETF positions are growing.

EXHIBIT 2

# of Mutual Funds Holding ETFs

Median Size of ETF Holdings (% of AUM)

2006 595 1.2

2007 711 1.3

2008 964 1.5

2009 785 1.3

2010 850 1.7

2011 862 2.3

2012 1,045 2.0

2013 1,110 3.0

2014 1,216 3.2

2015 1,234 4.3

2016 1,222 4.5


Clues ETFs such as SPY have high turnover rates, an indication that they are being used in an active fashion.

EXHIBIT 3

Average Holding Periods of the 10 Largest ETFsAverage AUM

($Bil)Average Holding Period

(Days)

SPDR S&P 500 ETF SPY 204.40 15.4

iShares Core S&P 500 IVV 82.58 149.6

Vanguard Total Stock Market ETF VTI 65.94 354.2

iShares MSCI EAFE EFA 59.80 70.3

Vanguard S&P 500 ETF VOO 52.44 172.9

Vanguard FTSE Emerging Markets ETF VWO 42.26 111.7

iShares Core US Aggregate Bond AGG 40.19 187.4

PowerShares QQQ ETF QQQ 39.86 22.3

Vanguard FTSE Developed Markets ETF VEA 37.31 185.7

SPDR Gold Shares GLD 35.98 43.7

Source: Morningstar. Data as of 04/30/2017.

3 I calculated ETFs’ average holding periods as follows: Average Holding Period = 365 / (Total Dollar Value of Trades Over Last 12 Months / Average Daily Assets Under Management).

107Morningstar

Passive Itself Is Getting More ActiveNot only are investors making active use of passive funds, but the complexion of passive funds is also changing. Asset managers are looking to marry the best traits of active and passive, pairing active bets with the strict discipline and lower costs of an index approach (EXHIBIT 4). This has given rise to a swelling number of strategic-beta (aka “smart” beta) ETFs and substantial growth in these funds’ assets. From the launch of the first generation of these ETFs in 2000, their collective AUM had grown to $556 billion as of the end of 2016, having

compounded at an annualized rate in excess of 40% during that period ( EXHIBIT 5 ).

These funds make rules-based active bets against the market in a nominally passive manner. Unlike traditional actively managed funds, there is no ongoing research or day-to-day buy, sell, or hold decisions made in response to developments in the markets. As these are active bets, these funds give investors the opportunity for outperformance, less risk, or some combination of the two relative to owning the market at large via a broad-based

market-cap-weighted index fund. It also takes an important risk off the table—manager risk. Omitting the uncertainty associated with the human element of active security selection is an important differentiating feature. Furthermore, because these strategies are delivered via an ETF, they can be more tax efficient than traditional active funds. Most important, however, is the fact that these funds tend to charge lower fees than most of their active peers.

Make no mistake, strategic-beta and other kindred factor-focused approaches to portfolio construction are a form of active management. So, not unlike traditional active funds, not all of them will succeed in generating better risk-adjusted returns relative to plain-vanilla market-cap-weighted index funds over the long haul. And like the best active managers, these funds will experience cycles of performance marked by droughts and market-beating returns. As such, investors’ patience will be tested, and their behavior may be suboptimal. We have already seen examples of all-too-familiar performance-chasing behavior among investors in these funds. The active decisions that matter most are still those made by the end investor.

I’m Not DeadActive management will never die. It will continue to evolve—we hope for the better. Fees will face pressure, and fee arrangements themselves may also evolve. Performance fees and loyalty programs are among the ideas being mulled by fund sponsors. New share-class and product types are also coming to the market.

Active managers may also get more active. The exodus from actively managed funds has disproportionately affected funds that are high- priced benchmark huggers. Taking on more active risk is the only way that many managers can possibly justify their current fee levels. The movement to passive and the growth of strategic-beta and other factor-oriented funds will drive the evolution of active managers and further reinforce the fact that active and passive are becoming more indistinguishable by the day. K

Ben Johnson, CFA, is director of global ETF research with Morningstar Research Services and is editor of Morningstar ETFInvestor. He is a member of the editorial board of Morningstar magazine.

Passive Active+800

USD Bil

+400

Trailing 12-Month Estimated Net Flows

0

–400

01/1994–03/2017

1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

–267.9

+643.7

Assets Under Management

70.0USD Bil

Estimated Net Flows

0.0

600.0USD Bil

52.5450.0

35.0300.0

17.5150.0

0.02000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2011 20132010 2012 2014 2015 2016

Smart Growth Strategic-beta ETFs have grown substantially since the first generation was launched in 2000.

EXHIBIT 5


Best of Both Worlds Strategic beta attempts to marry the best traits of active and passive.

EXHIBIT 4

Rules-Based and/or Discretionary Active

Screening/WeightingActive Implementation Active

Rules-Based Active Screening/Weighting

Passive Implementation Strategic Beta

Market Capitalization Weighting

Passive Implementation Passive


Spotlight: The Future of Investing

Journal of


108


BUSINESS MODEL EVOLUTIONhow distributor, asset manager and advisor business models are changing


109Artivest

The technological innovations of the Digital Revolution have engendered new expectations from individual investors, changing the way advisors, distributors and asset managers demonstrate their value. Digital technologies have transformed “shopping” for everything from groceries to one’s life partner. With consumer-facing technology assuming asset allocation functionality, many financial advisors (FAs) have redefined their value proposition. These changes for advisors have had knock-on effects for distributors and asset managers. In this feature, we will look at the evolving preferences of individual investors, assess the wealth and asset management industry’s response and explore the digital practices that are gaining the most traction.

Meet Today’s ClientShe sizes up her local brick-and-mortar establishments against Amazon for every household purchase, comparing costs and weighing convenience against immediacy and hands-on experience. She tries to be a smart consumer of all products and services, including financial advice.

The financial crisis, though nearly a decade in the rearview mirror, has left her with an enduring sense of cost-consciousness, a heightened aversion to risk, and a skepticism as to the integrity and efficacy of the entire money management industry. After the crisis, she watched a protracted, liquidity-driven bull market favor passive investments in inexpensive ETFs and index funds over the majority of active mutual funds—even before fees. She witnessed hedge funds closing at a record clip as their returns have underwhelmed investors. It is no wonder she expects her FA—and the managers he selects—to justify their fees.

Links in the Chain: Why Asset Managers Must Embrace the Digital RevolutionArtivest

This investor may be a follower of the herd. She may believe that passive strategies will outperform active ones in perpetuity. Or she may be one of the savvy variety. She may understand that bull markets never last forever and that uncorrelated returns come at a premium. But whereas before the crisis she was interested in the advisors and managers with the highest returns, she is now acutely aware of the importance of investment process and risk management protocol as drivers of sustainable returns. Also, although she is bombarded with data from the 24-hour news cycle, she is eager for someone to parse the information and make it relevant to her situation.

Our investor may give an automated portfolio manager (a.k.a. “robo-advisor”) a try for part of her investable assets. But she may also (or instead) value hands-on advice and choose to cultivate a relationship with a financial professional. Either way, however, her online consumer experiences have colored her expectations for the delivery of goods and services. As EY observes in its 2015 publication on money management in the digital age, “Wealth and asset management clients will increasingly demand seamless, coordinated, visually stunning, rich, easy digital access to their providers.”

To satisfy our consumer, traditional money managers must not only go beyond their online counterparts, then, to understand individual situations and make studied, thoughtful recommendations. They must also emulate the “anywhere, anytime” convenience and visual appeal of the best e-commerce sites. Taken together, this is a tall order, especially in light of the pressures that the money management industry has faced.

http://fortune.com/2017/03/24/hedge-fund-eton-park-goldman-sachs-eric-mindich/

https://insight.factset.com/what-ultra-high-net-worth-clients-want-from-wealth-managers

www.ey.com/Publication/vwLUAssets/ey-wealth-and-asset-managers-awake-to-new-digital-age/$FILE/ey-wealth-and-asset-managers-awake-to-new-digital-age.pdf

Journal of


110 Links in the Chain: Why Asset Managers Must Embrace the Digital Revolution

Today’s Wealth and Asset ManagersThe two main currents permeating our investor’s mindspace—fee consciousness and online orientation—impact wealth and asset managers just as profoundly. The rise of passive investing and the growth of fintechs have put pressure on fees. But this only accounts for the squeeze on the revenue side of managers’ income statements. On the cost side, peculiarities of the liquidity-driven post-crisis bull market, including a historic lack of market breadth, have made it increasingly difficult to deliver alpha, raising the price of superior investment talent. The cost of sales talent, meanwhile, has also grown unabated, particularly for managers focused on the more labor-intensive individual investor channel. Last but not least, regulatory costs have risen, from compliance with the Volcker Rule to preparation for the eventual enforcement of the DOL Fiduciary Rule.

All of these factors go a long way in explaining why managers have been slow in adapting their technology to the needs of today’s investor. In his write-up of a worldwide survey of 458 money managers sponsored by Dassault Systemes, Amin Rajan, CEO of CREATE-Research observes two phenomena at work: first, there is the “innovator’s dilemma,” in which thinning margins promote a survivalist rather than forward-thinking orientation with regard to spending on innovation. Second, managers face a “legacy technology problem,” in which IT has been developed in piecemeal fashion, making it hard to integrate with new systems.

Myths: HNWIs and MillennialsThe inertia is also given cover by the persistence of two widely-believed myths about tech adoption in the wealth space: that it is relegated to the “mass affluent” market and to Millennials. Indeed, the mass affluent market—that of investors with less than $1 million of investable assets—has gravitated more quickly to online financial advice than have wealthier segments. However, the consumer we described above does not live within a specific wealth stratum. She has been caught up in a cultural shift that is means-agnostic.

Age has also been tied to digital practice. Much has been written about the coming dominance of the Millennial generation, which stands to inherit $15 trillion dollars and dominate the workforce in the coming decades. Although 78% of younger high-net-worth investors (HNWIs) indicate that they will leave a financial advisor over “lack of channel integration” (i.e. a non-seamless user experience), advisors often discount these data as a weaker indicator than the reality of their practice, which may have a higher average client age or which may feature strong relationships with the Millennial offspring of their longtime clients. However, regardless of whether an FA has rationalized away the Millennial phenomenon, all of her clients—young and otherwise—are living and transacting in an increasingly digital world. In fact, nearly half (48%) of over-40 HNWIs expect all or most of their wealth management relationship(s) to be conducted digitally in next 5 years.

Whatever the cause of money managers’ delayed reaction, the phenomenon pervades the wealth industry. Barry Benjamin, PwC’s global leader for asset and wealth management, has expressed amazement at the industry’s slow response to client demand for digital capabilities. In PwC’s 2016 annual survey, only 10% of CEOs in these industries have reported prioritizing tech investments as a means of growing their business. This low number is especially surprising in light of CREATE-Dassault’s finding that 80 percent of asset managers and 77 percent of wealth managers expect digitization to partially or fully disrupt their industry within ten years.

https://www.novus.com/blog/market-breadth-is-nearing-record-lows/

http://www.asset-management-summit-2015.com/pdf/Searching_for_Profitable_Growth_in_Asset_Management.pdf

https://www.wsj.com/articles/where-millennials-go-for-financial-advice-1450062181

https://www.worldwealthreport.com/uswr

https://www.fnlondon.com/articles/fund-managers-are-analogue-in-a-digital-world-says-pwc-20170220


111Artivest

Wealth Management on the Front Lines On the whole, wealth managers are significantly further along in their adoption of digital technology than asset managers. This is not surprising: the digital revolution is consumer-led, and wealth management is the first point of contact for individual investors. Indeed, wealth managers - via both home offices and financial advisors—often provide the wholesale channel through which asset managers access individual investors.

Another major dynamic within the field of financial advice has also increased the urgency for wealth managers to develop market-leading technology. Wirehouses and private banks have lost significant market share to independent firms including registered investment advisors (RIAs) and independent broker-dealers (IBDs). RIAs and IBDs, in turn, have been avid and nimble consumers of a host of technologies, many provided by enterprising fintechs that opened their doors specifically to serve this rapidly-growing market. To retain their top producers, therefore, traditional wealth managers have surveyed the same field of fintechs and/or developed digital capabilities internally.

Asset Managers, Know Thy Customer Until roughly the past decade, asset managers have focused mainly on serving institutional clients, generally including only the wealthiest individual investors and their family offices among that cohort. To the extent that a given asset manager ran mutual funds, they relied on FAs to provide their entry point to individual investors. Given the often razor-thin performance gap between long-only asset managers, the actual products (with some exceptions) were commoditized. As a result, whether an advisor chose to direct client assets toward one mutual fund family or another depended in large part on wholesaler-FA relationships cemented over boozy steak dinners.

As we recall from our profile of today’s investor, the crisis and the ensuing bull market shifted investor priorities significantly. Specifically, they highlighted the need for alternative return streams, which are complex, alpha-driven and characterized by significant differences in the returns of the best- and worst-performing managers. As alternatives surged in popularity among individual investors, asset managers were pressed to take a hard look at their sales practices. The increasingly important wealth channel demanded not just more resources, but different resources, most notably educational tools to bring advisors quickly up to speed on an entirely new vocabulary and new paradigms for measuring success.

Reaching Through the Value ChainThe most successful asset managers have long prioritized education for FAs, including resources they can use at the point of sale. With clients demanding insight and context around their FA’ recommendations, advisors face a much more pressing ongoing need for relevant, value-added content. Asset managers who want to gain share in the wealth market would be well-served to develop that content, particularly around alternative investments, and to deliver it in an intuitive and appealing digital format. While wealth managers as a population have felt more urgency to evolve their digital practice for their increasingly online-oriented clients, asset managers increasingly perceive how closely they are linked to advisors in the value chain.

https://www.3ds.com/industries/financial-and-business-services/innovation-factory/

www.riainabox.com/hubfs/2017RIATechnologyInfographic.pdf?submissionGuid=a5c203b0-caad-4060-ba72-dec610683c60

Journal of


112 Links in the Chain: Why Asset Managers Must Embrace the Digital Revolution

Finally, education is by no means the sole axis along which there is the imperative to digitize. If asset managers are to take their cue from wealth manager behavior, it is important for them to note that of 8 technology categories surveyed by CREATE, the one with the highest implementation rate (56%) among wealth managers is the use of client-facing digital platforms. Asset managers offering online workflows that communicate seamlessly with these systems, therefore, stand to capture the lion’s share of advisor allocations, all else equal. Those asset managers offering private alternative funds have been particularly hindered by cumbersome, offline distribution processes. Thankfully, technology is bridging the gap, bringing reams of paperwork online for faster, easier and less error-prone completion.

Conclusion The wealth industry’s (albeit slow) embrace of digital best practices and the attendant removal of costs and complexity from the system are a boon for all parties—investors, advisors, distributors, and asset managers. Digitization, moreover, introduces the aggregation of data, facilitating more targeted product development and opportunities for all providers to better educate and inform their clients. The good news for those asset managers who have contemplated or begun leaping the “digital divide” is that they are still in the vanguard. First-mover advantage is theirs to capture.

Artivest149 Fifth Avenue, 16th Floor, New York, NY, 10010 Tel: 212-951-0027 artivest.co

113The Center for Outcomes | Brinker Capital

How advisors can enhance an investor's life by helping improve their decision-making process

How working with an advisor may increase an investor’s sense of confidence and security

In this paper, you will learn:

Authored by: Dr. Daniel Crosby, Executive Director The Center for Outcomes

behavioral alpha:an advisor's greatest value

A discussion of the value financial advisors bring to the wealth management process

Advisor education that changes the conversation

How advisors can enhance an investor's life by helping improve their decision-making process

How working with an advisor may increase an investor’s sense of confidence and security

In this paper, you will learn:

Authored by: Dr. Daniel Crosby, Executive Director The Center for Outcomes

behavioral alpha:an advisor's greatest value

A discussion of the value financial advisors bring to the wealth management process

Advisor education that changes the conversation

Because of this commitment to a game plan, the wealth discrepancies between families who receive advice and those who do not grows over time.

The chart below shows how those who receive four to six years of advice, the multiple attributable to advice is 1.58. Those receiving seven to 14 years of advice nearly double (1.99x) their no-advice peers, and those receiving 15 or more years of advice clocked in at an overwhelming

Research has found that investors who purchase financial advice are more than one and one half times more likely to stick with their long-term investment plan than those who did not.

2.73x multiple. Good financial advice pays in the short run, but the multiplication of those gains over an investing lifetime is truly staggering.

This paper will examine the ways in which working with a financial advisor makes sense. It will also explore the finan-cial advisory activities that add the most value. Finally, it will discuss areas in which the advisor-investor relationship can be enhanced.

3.00x

2.75x

2.50x

2.25x

2.00x

1.75x

1.50x

1.25x

1.00x4-6 Years 7-14 Years 15+ Years

The value of advice multiplies over time

Source: Investment Funds Institute of Canada, “Value of Advice Report" (2012).

1.58x1.99x

2.73x

114 Behavioral Alpha: An Advisor’s Greatest Value

Years ago, brokers and advisors were the guard-ians of financial data, the keeper of the stock quote. Today, investors need only an iPhone and a free online brokerage account to do what just 30 years ago was the exclusive purview of Wall Street. It is worth asking in such an age, “Is my advisor really earning their fee?” An appeal to the research shows that the answer is a resounding “yes”, albeit not for the reasons you might have supposed.

In a seminal paper titled “Advisor’s Alpha,” the famously fee-sensitive folks at Vanguard estimate that the value added by working with a competent financial advisor is roughly 3% per year. The paper is quick to point out that the 3% delta will not be achieved in a smooth, linear fashion. Rather, the benefits of working with an advisor will be “lumpy” and most concentrated during times of profound fear and greed. This uneven distri-bution of advisor value presages a second truth that we will discuss more fully in the next section; that the highest and best use of a financial advisor is as a behavioral coach rather than an asset manager.

Further evidence of advisor efficacy is added by Morningstar in their whitepaper, “Alpha, Beta, and Now…Gamma.” “Gamma” is Morningstar’s shorthand for “the extra income an investor can earn by making better financial decisions" and they cast improving decision-making as the primary benefit of working with a financial advisor. In their attempt at quanti-fying Gamma, Morningstar arrived at a figure of 1.82% per year outperformance for those receiving advice aimed at improving their financial choices. Again, it would seem that advisors are more than earning their fee and that improving decision-making is the primary means by which they improve clients’ lives.

Research conducted by Aon Hewitt and managed accounts provider Financial Engines, also supports the idea that help pays big dividends. Their initial research

was conducted from 2006 to 2008 and compared those receiving “help” in the form of online advice, guidance through target date funds or managed accounts to those who “did it themselves.” Their finding during this time was that those who received help outperformed those who did not by 1.86% per annum, net of fees.

Seeking to examine the impact of help during times of volatility, they subsequently performed a similar analysis of “help vs. no-help” groups that included the uncertain days of 2009 and 2010. They found that the impact of decision-making assistance was height-ened during times of volatility and that the outper-formance of the group receiving assistance grew to 2.92% annually, net of fees. The research suggest that the benefits of advice are disproportionately experi-enced during times when rational decision-making becomes most difficult.

We have now established that financial guidance tends to pay off somewhere in the ballpark of 2% to 3% a year. Although those numbers may seem small at first blush, anyone familiar with the marvel of compounding understands the enormous power of such outperfor-mance. If financial advice really does work, the effect of following good advice over time should be substan-tial and indeed, research suggests that very thing.

In an era of seven-dollar trades and fee compression, some have been quick to dismiss the traditional advisory relationship as a relic of a bygone era.

Financial advice pays

Behavioral alpha can add up to 3% of value each year3.5

3.0

2.5

2.0

1.5

1.0

0.5

0.0Aon HewittMorningstar Vanguard

1.82%1.82%

2.92%to

1.86%

3.00%

valuevalue

value


emergency versus only 22% of those without a plan. Finally, 51% of respondents with a plan felt prepared for retirement against a frightening 18% of those not receiving advice.

Receiving good financial advice pays a dividend that builds both wealth and confidence. The research is unequivocal that a competent financial guide can both help you achieve the returns necessary to arrive at your financial destination while simultaneously improving the quality of your journey.

After all, many people perfectly capable of mowing a lawn, cleaning a home or painting a room will outsource those jobs. While you may have lawn mowing skill equal to that of the person you hire, you may still enjoy peace of mind and increased time with loved ones as a result of your delegation. The research suggests that in addition to the financial rewards that may accrue to those working with an advisor, it also provides increases in confidence and security that are no less valuable.

The Canadian “Value of Advice Report” found that those paying for financial advice reported a greater sense of confidence, more certainty about their ability to retire comfortably and having higher levels of funds for an emergency. A separate study performed by the Financial Planning Standards Council found that 61% of those paying for financial advice answered affirmatively to “I have peace of mind” compared to only 36% of their “no plan” peers. The majority (54%) of those with a plan felt prepared in the event of an

Hopefully at this point, there is little doubt in your mind that the cumulative effects of receiving sound investment counsel are financially impressive. But as we look beyond dollars and cents, it is worth considering whether there are quality of life benefits to be enjoyed by working with a financial professional.

Financial advice improves quality of life

Receiving good advice pays a dividend that builds both wealth and confidence.

Source: Investment Funds Institute of Canada, "Value of Advice Report" (2012). Financial Planning Standards.

"Do you have peace of mind?"

20%0% 60%40% 100%80%

those with an advisor61%

those without36%

"Are you prepared for retirement?"

20%0% 60%40% 100%80%

51%

18%

those with an advisor

those without


The tendency to seek complexity and ignore simplicity has been alive and well for years in invest-ment circles. For far too long, financial advisors have led with proprietary product pitches or the assertion that they can outperform the market through superior investment acumen. This appeal to complexity has rung true to an investing public overwhelmed by the vagaries of financial markets, but is beginning to crumble in the face of popular research that highlights the difficulties in generating investment “alpha.”

Once again, we will appeal to the research to try and determine the sources of outperformance for those receiving professional financial advice. Vanguard’s “Advisor’s Alpha” study quantifies the value added (in basis points, or bps) by many of the common activ-ities performed by an advisor, and the results may surprise you. They include:

Rebalancing: 35 bps

Asset allocation: 0 to 75 bps

Behavioral coaching: 150 bps

What will surprise most investors seeking an appropriate financial guide is that hand-holding provides more added value than any of the activ-ities more directly associated with the manage-ment of money. Based on the above assumption of 3% per year average added value, fully half of that owes to behavioral coaching, or preventing clients from making foolish decisions during times of fear or greed!

Morningstar’s “Gamma” study is also illustrative of the true value added by an advisor and the things inves-tors should seek out when choosing a professional. The study lists the sources of added values as follows:

Asset allocation

Withdrawal strategy

Tax efficiency

Product allocation

Goals-based advice

While some sources of gamma can easily be self-taught (e.g., asset allocation) others remain uniquely powerful in the hands of an outside advisor. Just as anyone can look up a sensible workout regimen, it is not difficult to find instructions on investing in a broadly diversified mix of asset classes. But if knowledge were sufficient to induce appropriate behavior, America would not be the most obese developed country in the world and be staring down the barrel of a looming retirement crisis. While appropriate knowledge is an important starting point, a personal coach that ensures adherence to a plan is demonstrably even more important.

Oftentimes, simple solutions are ignored because of their simplicity. Investors tend to ignore the greatest value provided by a financial advisor by looking beyond the mark to more glamorous pursuits like asset management.

Where do financial advisors add value?

An advisor is adding more value when they manage emotions than when they manage your money.


C. Daniel Crosby, Ph.D.,Educated at Brigham Youngand Emory Universities, Dr.Daniel Crosby is a psychol-ogist, behavioral financeexpert and asset managerwho applies his study ofmarket psychology to every-thing from financial productdesign to security selec-

tion. In the summer of 2016, Dr. Crosby released his latest book, The Laws of Wealth. In this book readers are treated to real, actionable guidance as the promise of behavioral finance is realized and practical applications for everyday investors are delivered.

In 2014, Dr. Crosby co-authored his second book with Chuck Widger, Founder and Executive Chairman of Brinker Capital. The New York Times bestseller, Personal Benchmark: Integrating Behavioral Finance and Investment Management, outlines a highly personalized approach to investing that aligns intention with action while fostering an

So, do financial advisors add value? The research strongly supports that they do, both in terms of improving means and quality of life. But they only add value when we know what to look for when selecting the appropriate wealth management partner. Our natural tendencies will be toward excess complexity and flash, seeking out those who lead with bold claims of esoteric knowledge. But what might add much greater richness is a partner who balances deep knowledge with deep rapport. Someone we will listen to when we are scared and who will save us from ourselves. A simple solution to a complex problem.

Meet the author

The bottom line

investment experience that is both more enjoy-able and more rational.

Dr. Crosby is at the forefront of behavioralizing finance. He constructed the “Irrationality Index,” a sentiment measure that gauges greed and fear in the marketplace from month to month. His ideas have appeared in the Huffington Post, Think Advisor, and Risk Management, as well as his monthly columns for WealthManagement.com and Investment News. Daniel was named one of the “12 Thinkers to Watch” by Monster.com, a “Financial Blogger You Should be Reading” by AARP and in the “Top 40 Under 40” by Investment News. Crosby’s well-reviewed first book, You’re Not That Great (2012) applies elements of behavioral finance such as loss aversion and the availability heuristic to the pursuit of a meaningful life.

When he is not consulting around market psychology, Daniel enjoys living near Atlanta, watching independent films, fanatically following St. Louis Cardinals baseball, and spending time with his wife and three children.


WP_CFO_BEHAVE_ALPHABrinker Capital Inc., a Registered Investment Advisor.

Important InformationViews expressed are those of Dr. Daniel Crosby, a consultant of The Center for Outcomes offered through Brinker Capital Holdings. Content is for informational/educational purposes. Please consult your advisor before investing in any product. Investment decisions should be made based on the investor’s specific financial needs and objectives, goals, time horizon, tax liability, and risk tolerance. When investing in managed accounts and wrap accounts, there may be additional fees and expenses added onto the fees of the underlying investment products.

The Brinker Capital Center for Outcomes brings together experts in education, behavioral finance, business, investments, sales, and communica-tions to provide education that strengthens the advisor-client relationship through conversa-tions that center around outcomes. The Center for Outcomes Model is a repeatable communi-cation model that enables advisors to save time, improve productivity, increase client retention, and enhance their reputation in the investor marketplace.

Who we are

Since 1987, Brinker Capital has provided innovative investment solutions based on creative ideas generated from actively listening to the needs of financial advisors and investors. From being a pioneer of the multi-asset class investment philosophy to using behavioral finance to help investors manage the emotions of investing, our highly strategic, disciplined investment approach is the key to helping advisors and their clients achieve better outcomes.

Advisor education that changes the conversation Great Ideas + Strong Discipline = Better OutcomesTM

BrinkerCapital.com1055 Westlakes Drive, Suite 250

Berwyn, PA 19312 800.333.4573

Connect With Us

Who we are


120 TAMP Market Overview

September 9, 2017 Issue Brief

TAMP Market Overview

Turnkey asset management platforms (TAMPs) are being used by more than 25% of financial advisors and assets have grown tenfold. TAMPs provide back-office support, advanced technology, and third-party asset management, where the investment manager determines the investment models and implements the trades. The popularity of these platforms is directly related to the positive impact on a financial advisor’s business practice—they allow advisors to spend less time on back office activities and more time on financial planning and client-facing responsibilities. However, recently launched Model Marketplaces like TD Ameritrade’s iRebal Model Portfolio Marketplace may unbundle the investment and back-office services TAMPs provide.

According to Tiburon Strategic Advisors, TAMPs have grown from $147 billion in 2011 to nearly $1.8 trillion at the end of 2015. They also assert that one-quarter of advisors work with a TAMP. Others, like Northern Trust, have reported this number to be higher, upwards of 50% of advisors and close to 35 firms control the vast majority of TAMP business. Wealth Advisor’s 2017 America’s Best TAMPs reports that Envestnet is the largest competitor, followed by SEI and AssetMark. These three providers control a major share of the TAMP market.

This FUSE Issue Brief examines the largest TAMPs in the marketplace, assets under advisement vs. assets under management, programs driving asset growth, and corresponding fees. Advisor benefits, the rise of Model Marketplaces, and the future outlook for TAMPs are also included.

121FUSE Research Network

Platform Types: AUA vs. AUM The exhibit below illustrates TAMP asset growth among six major TAMP providers, which control a major market share of the space. Despite the data not being all-inclusive, it is indicative of general industry trends and growth within the space.

During this timeframe, growth has occurred within both scenarios. Assets under management, which is when the TAMP provider is responsible for investment management aspects of the relationship, have grown from $114.8 billion in June 2010 to $448.5 billion as of June 2017. Assets under advisement (TAMP only provides operational and technological capabilities) have swelled from $148.4 billion to $735.8 billion during this period, underscoring the need advisors have for advanced technology, which otherwise would not be as readily available.

TAMP Platform Offering Assets, June 2010 - 2Q2017 ($ Billions)

Sources: Money Management Institute, Dover Financial Research

Program Types: MF Advisory and UMA Display Strong Growth Generally, the following are the account type varieties offered by TAMPs, including high-level definitions. With each account type, the type of investment, associated fees, and the role of the TAMP changes significantly.

• Mutual Fund Wrap Accounts—Also referred to as Mutual Fund Advisory Programs, they are essentially baskets of mutual funds selected from the prescreened professional managers on the TAMP platform.

• Exchange-Traded Funds (ETF) Wrap Accounts—Same as above using ETFs.• Separately Managed Accounts (SMAs)—Professionally managed portfolios comprised of

individual securities. A fee-based SMA program utilizes multiple SMAs. A single SMA can also form a single sleeve within a UMA structure.

• Unified Managed Accounts (UMAs)—All investment types (including mutual funds, individual stocks and bonds, and ETFs) in a single account.

• Unified Managed Households (UMHs)—Similar to a UMA-like relationship but brings together all aspects of a client household’s wealth, not just the wealth of separate individuals.







• Other—Includes Rep as Portfolio Manager (fee-based, managed program that allows the advisorto act as the portfolio manager) and Rep as Advisor (non-discretionary, fee-based, advisoryprogram that enables an investor to hold different types of securities).

Mutual fund advisory and UMA program assets under management dominate the other programs by a fairly significant margin. The due diligence process on managers to ensure they are utilizing a specific investment strategy is just one of the values that help make mutual fund advisory programs so attractive. Also, this program allows advisors to serve the mass affluent in an efficient manner. However, as the preference for lower cost options mounts, we anticipate ETF advisory will gain momentum.

UMA programs have witnessed rapid growth, growing from a mere $18.4 billion in June 2010 to ranking as the second largest program with $267.3 billion in assets as of June 2017. Thanks in part to the financial crisis, advisors turned to UMA programs since they were seeking a flexible and integrated solution that they could control rather than having to deal with existing product platform limitations.

Select Program Asset Growth, June 2010 – June 2017 ($ Billions)

Sources: Money Management Institute, Dover Financial Research

Pricing: A Call for More Transparency 2017 America’s Best TAMPs suggests, “Transparency in pricing will go a long way toward improving the number of clients selecting managed money as the best practice in wealth management.” The report further explains that the industry needs to move beyond a “single, unexplained rate” to at least the following three distinct components:

1. Product fee—The institutional rate charged to the firm for the mutual fund, ETF, or managedportfolio. In the case of the UMA, it should be just the managers’ models without the associatedtrading costs.

2. Firm fee—Reflects the true costs of providing the managed money platform, trading, custody,statement preparation, and other definable costs. It should include both the mark-up to the firmand the advisor’s compensation tied to the account.


3. Other services—These services, such as financial planning, should be billed separately. ETF wrapfee maximums should be less than 150bp for smaller accounts. UMAs that serve larger accountswith more complex portfolios should fee between 100bp and 175bp, dependent on use of modelsand type of overlay services provided.

Regarding program fees, UMAs and SMAs charge higher fees, ranging between 1.5% and 2.5%, than the traditional mutual fund and ETF advisory programs, which charge 0.75% on the lower end to a high of 1.5% and 1.25%, respectively.

Typical TAMP Fee Ranges Account Type

Investment Fees

Management Fees

Total Fees

Mutual Fund Wrap 0.5% - 1.5% 0.5% - 1.5% 0.75% - 1.5% ETF Wrap 0.1% - 0.25% 0.5% - 1.0% 0.75% - 1.25% SMA 0.5% - 1.0% 1.0% - 1.75% 1.5% - 2.5% UMA (using models) 0.4% - 0.6% 0.75% - 1.5% 1.5% - 2.5% UMH Negotiable along lines of UMA, with modest

(0.01% - 0.03%) for held-away assets *For large clients with greater assets, fees are negotiable, and will tend to be near theminimums noted above.Source: Wealth Advisor, 2017 America’s Best TAMPs

The fees paid by the client—which may range from 85bp to 280bp dependent on the type of program and asset classes included as noted in the table above—have to be appropriately divided among the asset manager, the advisor, the sponsor, the platform provider, and the overlay manager (if utilized), generally on a monthly basis. The fee sharing ranges are illustrated in the exhibit below.

Fee Sharing Among Managed Account Participants

Source: The Trust Advisor, America’s Best TAMPs 2014







Advisor Benefits and Opportunities TAMPs first emerged in the 1980s to assist time-strapped financial advisors by offloading their back office functions and portfolio management so they could focus on their core business—gathering assets, deepening client relationships, and acquiring new business. By their very nature, TAMPs provide a host of benefits to advisors so they can seek additional business-building opportunities.

One of the greatest benefits is the access provided to sophisticated strategies/programs that are not offered at the home office. Complicated vehicles like UMAs and UMHs can be easily managed through a TAMP, providing advisors with the opportunity to serve high-net-worth and ultra-high-net-worth clientele. In addition to complex strategies, advisors gain access to open architecture that supports a plethora of investments managed by multiple asset managers. Also, these available investments have been validated through third-party due diligence processes from either the TAMP provider, the advisory firm, or both. Reviewing, analyzing, and, getting products onto recommended lists is a time-consuming endeavor.

Operational support and advanced technology cannot be underscored enough given the time and cost savings passed on to the advisor. As noted in 2017 Americas Best TAMPs, the provider should offer:

• Streamlined asset allocation and trading functionalities• Seamless integration of back-office, money management and client services• System scalability to provide open-ended growth opportunities• Comprehensive data delivery for all parties

Based on FUSE’s recent Advisor Top Trends for 2017 report, done in conjunction with WealthManagement.com, surveyed advisors reported a mounting reliance on third-party built portfolios by TAMPs. Advisors plan to allocate an additional 3% of their client assets toward these portfolios in 2019, with independent broker/dealers reporting on the high end (4.5%) as well as advisors who work alone (4.3%) versus those who work in a team structure.

TAMP Asset Net Increase, 2017 vs. 2019

Sources: FUSE Research and WealthManagement.com

Channel Practice Type


Will the Model Marketplace Disrupt TAMPs?

Three different platforms announced the rollout of a “Model Marketplace” where advisors can use robo trading and rebalancing automation tools to implement third-party-managed models and trades using the advisor’s existing platform and ultimately no longer needing to fully delegate to a TAMP. Although it’s been reported that “Model Marketplaces will threaten both existing ‘marketplace’ incumbents…, and the current paradigm of third-party TAMPs,1” FUSE does not view this as a substantial threat, but rather as a potential development for the two to coexist with unbundling options as well as cost savings.

The first platform, iRebal Model Portfolio Marketplace was announced by TD Ameritrade in early 2017. Advisors will be able to directly access third-party investment management strategies by having their models uploaded directly into the iRebal trading software for the advisor to implement themselves.

Also, Riskalyze announced that its robo-advisor-for-advisors AutoPilot platform was launching a “Partner Store” that would allow advisors to use its new trading and rebalancing tools to directly implement the models from a series of third-party investment managers. As of February 2017, it was reported that the AutoPilot Partner Store already had at least a dozen third-party managers available.

Finally, Orion Advisor Services announced the launch of Eclipse, which is embedded in its own version of a newly launched trading and rebalancing software platform. Another initiative is “Orion Communities,” where advisors can share their investment models for implementation with other advisors and may eventually be used to distribute third-party manager models.

Future of TAMPs As noted above, the emergence of the Model Marketplace will not be a TAMP replacement but may ultimately lead to the unbundling of TAMP offerings, resulting in lower fees attached to these platforms. Total TAMP fees range from a low of 85 basis points to a high of 280 basis points—and we expect these ranges will likely decline. Financial advisors will have the choice to fully outsource to a TAMP, delegating their investment process, its implementation, and back office responsibilities; they may choose to leverage a Model Marketplace, utilizing the trading and rebalancing software; or they may elect a combination of the two by selecting certain offerings from a TAMP and others from a Model Marketplace.

We expect a portion of advisors will elect to use the software, but a considerable number of financial advisors—particularly smaller independent advisors with limited resources—will stay committed to TAMPs like Envestnet or AssetMark for management of the investment process and back office capabilities.

1 The Unbundling of the TAMP and the Rise of the Model Marketplace, kitces.com, February 27, 2017

Will the Model Marketplace Disrupt TAMPs?

Three different platforms announced the rollout of a “Model Marketplace” where advisors can use robo trading and rebalancing automation tools to implement third-party-managed models and trades using the advisor’s existing platform and ultimately no longer needing to fully delegate to a TAMP. Although it’s been reported that “Model Marketplaces will threaten both existing ‘marketplace’ incumbents…, and the current paradigm of third-party TAMPs,1” FUSE does not view this as a substantial threat, but rather as a potential development for the two to coexist with unbundling options as well as cost savings.

The first platform, iRebal Model Portfolio Marketplace was announced by TD Ameritrade in early 2017. Advisors will be able to directly access third-party investment management strategies by having their models uploaded directly into the iRebal trading software for the advisor to implement themselves.

Also, Riskalyze announced that its robo-advisor-for-advisors AutoPilot platform was launching a “Partner Store” that would allow advisors to use its new trading and rebalancing tools to directly implement the models from a series of third-party investment managers. As of February 2017, it was reported that the AutoPilot Partner Store already had at least a dozen third-party managers available.

Finally, Orion Advisor Services announced the launch of Eclipse, which is embedded in its own version of a newly launched trading and rebalancing software platform. Another initiative is “Orion Communities,” where advisors can share their investment models for implementation with other advisors and may eventually be used to distribute third-party manager models.

Future of TAMPs As noted above, the emergence of the Model Marketplace will not be a TAMP replacement but may ultimately lead to the unbundling of TAMP offerings, resulting in lower fees attached to these platforms. Total TAMP fees range from a low of 85 basis points to a high of 280 basis points—and we expect these ranges will likely decline. Financial advisors will have the choice to fully outsource to a TAMP, delegating their investment process, its implementation, and back office responsibilities; they may choose to leverage a Model Marketplace, utilizing the trading and rebalancing software; or they may elect a combination of the two by selecting certain offerings from a TAMP and others from a Model Marketplace.

We expect a portion of advisors will elect to use the software, but a considerable number of financial advisors—particularly smaller independent advisors with limited resources—will stay committed to TAMPs like Envestnet or AssetMark for management of the investment process and back office capabilities.

1 The Unbundling of the TAMP and the Rise of the Model Marketplace, kitces.com, February 27, 2017






THIS MATERIAL IS FOR FINANCIAL PROFESSIONAL USE ONLY AND NOT FOR DISTRIBUTION TO CURRENT OR POTENTIAL INVESTORS.

WHY ADVISORS HAVENEVER BEEN SO VALUABLE2017 VALUE OF AN ADVISOR STUDY

THIS MATERIAL IS FOR FINANCIAL PROFESSIONAL USE ONLY AND NOT FOR DISTRIBUTION TO CURRENT OR POTENTIAL INVESTORS.

NOT FDIC INSURED • MAY LOSE VALUE • NO BANK GUARANTEE126 Why Advisors Have Never Been So Valuable

2 // RUSSELL INVESTMENTS // WHY ADVISORS HAVE NEVER BEEN SO VALUABLETHIS MATERIAL IS FOR FINANCIAL PROFESSIONAL USE ONLY AND NOT FOR DISTRIBUTION TO CURRENT OR POTENTIAL INVESTORS.

EXECUTIVE SUMMARY

As part of Russell Investments’ commitment to powering advisor success, this annual report looks holistically at what advisors do for their clients and the additional value they contribute to an investor’s portfolio.

With growing regulatory attention on advisory fees and natural consumer skepticism about delivered value, given strong U.S. stock performance, today’s advisors may be challenged to articulate the material value they deliver. By looking at the full value equation of an advisor’s services— annual rebalancing, behavior mistakes investors make, the cost of investment-only management, planning and ancillary services, and tax- aware investing— it is clear that the value an advisor delivers to clients materially exceeds the 1% fee they typically charge for their services.

In 2017, the value of an advisor in the U.S. is calculated at 4.08%.

IntroductionIn recent months, the DOL fiduciary rule has put the spotlight on all manner of fees. While the final ruling is still unknown, the fact remains that fees are top-of-mind for investors. With eight years of strong U.S. stock market performance (Russell 3000® Index) and virtually all stocks rising, there is natural skepticism about paying for advice — it doesn’t seem hard to throw together a winning portfolio. While this view completely overlooks the fact that standard investment selection is just one part of an advisor’s value, advisors struggle to clearly articulate that the value their clients derive materially exceeds the 1% fee they typically charge.

Value of an Advisor = A+B+C+P+T

Your fee Annual advisory fee you charge clients

Annual rebalancing of investment portfolios

Behavioral mistakes individual investors typically make

Cost of basic investment-only management

Planning costs or the costs of providing a financial plan, updates and your services

Tax-aware planning/investing T

Coordinating the accumulation, distribution, and transfer of wealth is complex, particularly as we move into a time of potentially lower returns and higher volatility. The fourth annual Value of an Advisor report is designed to quantify the contribution from the technical and emotional guidance a trusted human advisor can offer.

A

B

C

P


EXECUTIVE SUMMARY

As part of Russell Investments’ commitment to powering advisor success, this annual report looks holistically at what advisors do for their clients and the additional value they contribute to an investor’s portfolio.

With growing regulatory attention on advisory fees and natural consumer skepticism about delivered value, given strong U.S. stock performance, today’s advisors may be challenged to articulate the material value they deliver. By looking at the full value equation of an advisor’s services— annual rebalancing, behavior mistakes investors make, the cost of investment-only management, planning and ancillary services, and tax- aware investing— it is clear that the value an advisor delivers to clients materially exceeds the 1% fee they typically charge for their services.

In 2017, the value of an advisor in the U.S. is calculated at 4.08%.

IntroductionIn recent months, the DOL fiduciary rule has put the spotlight on all manner of fees. While the final ruling is still unknown, the fact remains that fees are top-of-mind for investors. With eight years of strong U.S. stock market performance (Russell 3000® Index) and virtually all stocks rising, there is natural skepticism about paying for advice — it doesn’t seem hard to throw together a winning portfolio. While this view completely overlooks the fact that standard investment selection is just one part of an advisor’s value, advisors struggle to clearly articulate that the value their clients derive materially exceeds the 1% fee they typically charge.

Value of an Advisor = A+B+C+P+T

Your fee Annual advisory fee you charge clients

Annual rebalancing of investment portfolios

Behavioral mistakes individual investors typically make



Tax-aware planning/investing T

Coordinating the accumulation, distribution, and transfer of wealth is complex, particularly as we move into a time of potentially lower returns and higher volatility. The fourth annual Value of an Advisor report is designed to quantify the contribution from the technical and emotional guidance a trusted human advisor can offer.

A

B

C

P

127Russell Investments


Annual Rebalancing = 0.2%When markets are rising, it can be easy to underestimate the importance of disciplined rebalancing.

Risk ExposureAs this chart demonstrates, a hypothetical balanced index portfolio that has not been rebalanced would look more like a growth portfolio and expose the investor to risk they didn’t agree to.

MARCH 31, 2009

Fixed Income

Equities

Real Assets

Left alone, a hypothetical ‘balanced’ index portfolio drifted into a ‘growth’ index portfolio, exposing the portfolio to more downside risk.

U.S. Large Cap: Russell 1000® Index; U.S. Small Cap: Russell 2000® Index; Non-U.S. Equity: Russell Developed ex-U.S. Large Cap Index; REITs: FTSE EPRA/NAREIT Developed Index; EM Equity: Russell Emerging Markets Index; Bonds: Bloomberg Barclays U.S. Aggregate Bond Index.

Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Indexes are unmanaged and cannot be invested in directly.

U.S. Large Cap U.S. Small Cap Non-U.S. Equity

EM Equity REITs Bonds

30%

5%

15%5%5%

40%

55%

5%

40%

DECEMBER 31, 2016

Fixed Income Equities

Real Assets

44%

8%13%

4%

7%

24%

69%

7%

24%


Annual Rebalancing = 0.2%When markets are rising, it can be easy to underestimate the importance of disciplined rebalancing.

Risk ExposureAs this chart demonstrates, a hypothetical balanced index portfolio that has not been rebalanced would look more like a growth portfolio and expose the investor to risk they didn’t agree to.

MARCH 31, 2009

Fixed Income

Equities

Real Assets

Left alone, a hypothetical ‘balanced’ index portfolio drifted into a ‘growth’ index portfolio, exposing the portfolio to more downside risk.

U.S. Large Cap: Russell 1000® Index; U.S. Small Cap: Russell 2000® Index; Non-U.S. Equity: Russell Developed ex-U.S. Large Cap Index; REITs: FTSE EPRA/NAREIT Developed Index; EM Equity: Russell Emerging Markets Index; Bonds: Bloomberg Barclays U.S. Aggregate Bond Index.

Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Indexes are unmanaged and cannot be invested in directly.

U.S. Large Cap U.S. Small Cap Non-U.S. Equity

EM Equity REITs Bonds

30%

5%

15%5%5%

40%

55%

5%

40%

DECEMBER 31, 2016

Fixed Income Equities

Real Assets

44%

8%13%

4%

7%

24%

69%

7%

24%

128 Why Advisors Have Never Been So Valuable


Behavioral Mistakes = 2.0%While behavior coach isn’t part of the advisor job description, it is a significant contributor to total value. Left to their own devices, many investors buy high and sell low. From 2009 to 2013, investors withdrew more money from U.S. stock mutual funds than they put in. All the while, the Russell 3000® Index climbed 16.1%. For those that chose to stay in cash since the market bottom on March 9, 2009 to the end of 2016, they missed a cumulative return of 300%, based on the Russell 3000® Index.

Investors chase patterns

Net Flows (Total Equity) Russell 3000® Index Value (with dividends)

Data shown is historical and not an indicator of future results.

Source: Industry flows into equities. www.ici.org/research/stats. Russell 3000® Index: www.ftserussell.com (“value with dividends”). Data as of December 31, 2016.

Index performance is not indicative of the performance of any specific investment. Indexes are not managed and may not be invested in directly.

For illustrative purposes only. Not meant to represent any actual investment Methodology available in footnotes at the end of this report.

Additional ReturnsRegular rebalancing has the potential to add 0.2% in additional return and 1.6% in risk.

Buy and hold Annual

Annualized return 8.6% 8.8%

Annualized standard deviation

10.4% 8.8%

$1,000 investment over 30 years

$1,188,214 $1,255,645

0.0

1000.0

2000.0

3000.0

4000.0

5000.0

6000.0

7000.0

8000.0

-$80.0

-$60.0

-$40.0

-$20.0

$0.0

$20.0

$40.0

$60.0

$80.0

Jan-

87

Jan-

88

Jan-

89

Jan-

90

Jan-

91

Jan-

92

Jan-

93

Jan-

94

Jan-

95

Jan-

96

Jan-

97

Jan-

98

Jan-

99

Jan-

00

Jan-

01

Jan-

02

Jan-

03

Jan-

04

Jan-

05

Jan-

06

Jan-

07

Jan-

08

Jan-

09

Jan-

10

Jan-

11

Jan-

12

Jan-

13

Jan-

14

Jan-

15

Jan-

16

Net

flow

s ($

U.S

. bill

ions

) Russell 3000

® Index V

alue (w

ith dividence)

While 0.2% may not seem like much, compounded over a multi-year period, it can quickly add up. In the hypothetical example above, that’s a $67,431 difference.

Hypothetical rebalancing comparison: Jan. 1988 - Dec. 2016


Behavioral Mistakes = 2.0%While behavior coach isn’t part of the advisor job description, it is a significant contributor to total value. Left to their own devices, many investors buy high and sell low. From 2009 to 2013, investors withdrew more money from U.S. stock mutual funds than they put in. All the while, the Russell 3000® Index climbed 16.1%. For those that chose to stay in cash since the market bottom on March 9, 2009 to the end of 2016, they missed a cumulative return of 300%, based on the Russell 3000® Index.

Investors chase patterns

Net Flows (Total Equity) Russell 3000® Index Value (with dividends)

Data shown is historical and not an indicator of future results.

Source: Industry flows into equities. www.ici.org/research/stats. Russell 3000® Index: www.ftserussell.com (“value with dividends”). Data as of December 31, 2016.

Index performance is not indicative of the performance of any specific investment. Indexes are not managed and may not be invested in directly.

For illustrative purposes only. Not meant to represent any actual investment Methodology available in footnotes at the end of this report.

Additional ReturnsRegular rebalancing has the potential to add 0.2% in additional return and 1.6% in risk.

Buy and hold Annual

Annualized return 8.6% 8.8%

Annualized standard deviation

10.4% 8.8%

$1,000 investment over 30 years

$1,188,214 $1,255,645

0.0

1000.0

2000.0

3000.0

4000.0

5000.0

6000.0

7000.0

8000.0

-$80.0

-$60.0

-$40.0

-$20.0

$0.0

$20.0

$40.0

$60.0

$80.0

Jan-

87

Jan-

88

Jan-

89

Jan-

90

Jan-

91

Jan-

92

Jan-

93

Jan-

94

Jan-

95

Jan-

96

Jan-

97

Jan-

98

Jan-

99

Jan-

00

Jan-

01

Jan-

02

Jan-

03

Jan-

04

Jan-

05

Jan-

06

Jan-

07

Jan-

08

Jan-

09

Jan-

10

Jan-

11

Jan-

12

Jan-

13

Jan-

14

Jan-

15

Jan-

16

Net

flow

s ($

U.S

. bill

ions

) Russell 3000

® Index V

alue (w

ith dividence)

While 0.2% may not seem like much, compounded over a multi-year period, it can quickly add up. In the hypothetical example above, that’s a $67,431 difference.

Hypothetical rebalancing comparison: Jan. 1988 - Dec. 2016



The average stock fund investor’s inclination to chase past performance cost them 2% annually in the 32-year period from 1984-2016. Therefore, an advisor’s ability to help clients stick to their long-term financial plan and skirt irrational, emotional decisions adds this value.

The high cost of investor behavior (1984-2016)

0%

2%

4%

6%

8%

10%

12%

10.7% -2.0%

8.7%

Russell 3000® Index(1) “Average” Investor (2)

Annualized cost to retail “chasers”

(1) BNY Mellon Analytical Services, Russell 3000® Index annualized return from January 1, 1984 to December 31, 2016.

(2) Russell Investment Group & Investment Company Institute (ICI). Return was calculated by deriving the internal rate of return (IRR) based on ICI monthly fund flow data which was compared to the rate of return if invested in the Russell 3000® Index and held without alteration from January 1, 1984 to December 31, 2016. This seeks to illustrate how regularly increasing or decreasing equity exposure based on the current market trends can sacrifice even market like returns.

Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

Cost of Investment-only management = 0.33%Robo-advisors that deliver investment-only management and no financial plan, ongoing service, or guidance have set prices at approximately 0.33%1—for annual statements, online access, and a phone number to call in case of questions.

Planning = 0.75%Advisors add value by building and regularly updating custom financial plans, conducting regular portfolio reviews, and offering ancillary services such as investment education, assistance with annual tax return preparation, Social Security and retirement income planning, and one-off custom requests from clients.

The cost of planningAccording to a recent Financial Planning Association (FPA) study, the cost of developing and building an initial financial plan averages $2,600.2 Planners typically charge approximately $200 per hour for ongoing monitoring and updating.2 Based on this, the value of providing and maintaining a plan is worth 0.50% on a $500,000 account.


The average stock fund investor’s inclination to chase past performance cost them 2% annually in the 32-year period from 1984-2016. Therefore, an advisor’s ability to help clients stick to their long-term financial plan and skirt irrational, emotional decisions adds this value.

The high cost of investor behavior (1984-2016)

0%

2%

4%

6%

8%

10%

12%

10.7% -2.0%

8.7%

Russell 3000® Index(1) “Average” Investor (2)

Annualized cost to retail “chasers”

(1) BNY Mellon Analytical Services, Russell 3000® Index annualized return from January 1, 1984 to December 31, 2016.

(2) Russell Investment Group & Investment Company Institute (ICI). Return was calculated by deriving the internal rate of return (IRR) based on ICI monthly fund flow data which was compared to the rate of return if invested in the Russell 3000® Index and held without alteration from January 1, 1984 to December 31, 2016. This seeks to illustrate how regularly increasing or decreasing equity exposure based on the current market trends can sacrifice even market like returns.

Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

Cost of Investment-only management = 0.33%Robo-advisors that deliver investment-only management and no financial plan, ongoing service, or guidance have set prices at approximately 0.33%1—for annual statements, online access, and a phone number to call in case of questions.

Planning = 0.75%Advisors add value by building and regularly updating custom financial plans, conducting regular portfolio reviews, and offering ancillary services such as investment education, assistance with annual tax return preparation, Social Security and retirement income planning, and one-off custom requests from clients.

The cost of planningAccording to a recent Financial Planning Association (FPA) study, the cost of developing and building an initial financial plan averages $2,600.2 Planners typically charge approximately $200 per hour for ongoing monitoring and updating.2 Based on this, the value of providing and maintaining a plan is worth 0.50% on a $500,000 account.



The cost of ancillary servicesAdvisors consistently underestimate the value of ancillary services. From the time savings and peace of mind offered during tax season to preparation for retirement and custom requests, these services can quickly consume up to 100 hours each year. We estimate this value at 0.25%, assuming they are part of the annual advisory fee.

Tax-aware investing = 0.80%Providing a more tax-aware approach is an area where advisors can distinguish themselves and demonstrate fiduciary standards of expertise.

Dialing down tax dragThe average annual tax drag for the five years ending December 31, 2016 was material. Investors in non-tax managed U.S. equity products (active, passive, ETFs) lost on average 1.53% of their return to taxes. Those in tax-managed U.S. equity funds forfeited only 0.73%. With taxable investors holding $7.2 trillion of the $15.7 trillion invested in open-end mutual funds, this is a widespread concern.3

Average annual tax drag of U.S. equity funds for 5 years ending December 31, 2016

-1.8%

-1.6%

-1.4%

-1.2%

-1.0%

-0.8%

-0.6%

-0.4%

-0.2%

0.0%

Non-tax-managed Tax-managed

-1.53%

-0.73%

Ret

urn

lost

to ta

xes/

year

U.S. equity funds

Tax-aware advisors add value by helping build and implement a personalized, comprehensive, and tax-sensitive investment approach using a variety or products. This can add 0.80% in value.

Tax-managed: Funds identified by Morningstar to be tax-managed. Universe averages*: Created table of all U.S. equity mutual funds identified as tax-managed. Calculated arithmetic average for the Tax Cost Ratio as calculated by Morningstar.


The cost of ancillary servicesAdvisors consistently underestimate the value of ancillary services. From the time savings and peace of mind offered during tax season to preparation for retirement and custom requests, these services can quickly consume up to 100 hours each year. We estimate this value at 0.25%, assuming they are part of the annual advisory fee.

Tax-aware investing = 0.80%Providing a more tax-aware approach is an area where advisors can distinguish themselves and demonstrate fiduciary standards of expertise.

Dialing down tax dragThe average annual tax drag for the five years ending December 31, 2016 was material. Investors in non-tax managed U.S. equity products (active, passive, ETFs) lost on average 1.53% of their return to taxes. Those in tax-managed U.S. equity funds forfeited only 0.73%. With taxable investors holding $7.2 trillion of the $15.7 trillion invested in open-end mutual funds, this is a widespread concern.3

Average annual tax drag of U.S. equity funds for 5 years ending December 31, 2016

-1.8%

-1.6%

-1.4%

-1.2%

-1.0%

-0.8%

-0.6%

-0.4%

-0.2%

0.0%

Non-tax-managed Tax-managed

-1.53%

-0.73%

Ret

urn

lost

to ta

xes/

year

U.S. equity funds

Tax-aware advisors add value by helping build and implement a personalized, comprehensive, and tax-sensitive investment approach using a variety or products. This can add 0.80% in value.

Tax-managed: Funds identified by Morningstar to be tax-managed. Universe averages*: Created table of all U.S. equity mutual funds identified as tax-managed. Calculated arithmetic average for the Tax Cost Ratio as calculated by Morningstar.



Footnotes

1. Based on the average fee charged for investment-only management by 10 robo advice offerings for a client portfolio of $500,000 as accessed on the companies’ websites on 3/7/2017.

2. FPA Research & Practice Institute, “Financial Planning in 2015: Today’s Demands, Tomorrow’s Challenges.” https://www.onefpa.org/business-success/ ResearchandPracticeInstitute/Documents/RPI-2015_Trends-In-Financial-Planning_10-15- 15.pdf

3. 2016 Investment Company Factbook.

Annual rebalancing of investment portfolios 0.20%

0.33%

0.75%

0.80%

4.08%

2.00%Behavioral mistakes individual investors typically make



Tax-aware planning/investing

Total 2017 value of an advisor

A

B

C

P

T

At Russell Investments, we believe in the importance of advisors. We see the advantages you create for your clients. We know the commitment you bring to your relationships. This annual Value of an Advisor study quantifies that dedication and the resulting benefit. It is one small part of our work in powering advisor success.

The Bottom LineAdvisors delivering services and value above and beyond investment-only advice have an estimated contributory value of 4.08%. By demonstrating to clients how this value exceeds the fee charged, advisors can improve client satisfaction at a time of record high U.S. equity markets and likely rising interest rates. Likewise, this value is a meaningful differentiator in a time of margin compression, regulatory scrutiny, and demographic change.

Your clients are your most persuasive advocates. Helping them understand the value you deliver is key.


Footnotes





0.33%

0.75%

0.80%

4.08%






A

B

C

P

T





Footnotes





0.33%

0.75%

0.80%

4.08%






A

B

C

P

T





https://www.onefpa.org/business-success/ResearchandPracticeInstitute/Documents/RPI-2015_Trends-In-Financial-Planning_10-15-15.pdf

https://www.onefpa.org/business-success/ResearchandPracticeInstitute/Documents/RPI-2015_Trends-In-Financial-Planning_10-15-15.pdf


IMPORTANT INFORMATION

*Methodology for Universe Construction: From Morningstar, extract U.S. equity and fixed income mutual fund and ETF’s for reported period. Averages calculated on a given category. For example, average after-tax return for the large cap category reflects a simple arithmetic average of the returns for all funds that were assigned to the large cap category as of the end date run. For funds with multiple share classes, each share class is counted as a separate “fund” for the purpose of creating category averages. Morningstar category averages include every type of share class available in Morningstar’s database. Large Cap/Small Cap determination based upon Morningstar Category. Tax Drag: Morningstar’s Tax Cost Ratio.

The Morningstar categories are as reported by Morningstar and have not been modified.

© 2017 Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is not a guarantee of future results. Indexes are unmanaged and cannot be invested in directly.

Morningstar, Inc., Morningstar, the Morningstar logo and Morningstar.com are registered trademarks of Morningstar, Inc. All other Morningstar products and proprietary tools, including Morningstar Category, Morningstar Rating, Morningstar Risk, Morningstar Return, and Morningstar Style Box are trademarks of Morningstar, Inc. All other brands and names are the property of their respective owners.

Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.

Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.

Russell Investments’ ownership is composed of a majority stake held by funds managed by TA Associates with minority stakes held by funds managed by Reverence Capital Partners and Russell Investments’ management.

Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company.

The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the “FTSE RUSSELL” brand.

Copyright © Russell Investments Group, LLC 2017. All rights reserved.

Russell Investments Financial Services, LLC, member FINRA (www.finra.org), part of Russell Investments.

First used: September 2017. RIFIS: 19182


IMPORTANT INFORMATION

*Methodology for Universe Construction: From Morningstar, extract U.S. equity and fixed income mutual fund and ETF’s for reported period. Averages calculated on a given category. For example, average after-tax return for the large cap category reflects a simple arithmetic average of the returns for all funds that were assigned to the large cap category as of the end date run. For funds with multiple share classes, each share class is counted as a separate “fund” for the purpose of creating category averages. Morningstar category averages include every type of share class available in Morningstar’s database. Large Cap/Small Cap determination based upon Morningstar Category. Tax Drag: Morningstar’s Tax Cost Ratio.

The Morningstar categories are as reported by Morningstar and have not been modified.

© 2017 Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is not a guarantee of future results. Indexes are unmanaged and cannot be invested in directly.

Morningstar, Inc., Morningstar, the Morningstar logo and Morningstar.com are registered trademarks of Morningstar, Inc. All other Morningstar products and proprietary tools, including Morningstar Category, Morningstar Rating, Morningstar Risk, Morningstar Return, and Morningstar Style Box are trademarks of Morningstar, Inc. All other brands and names are the property of their respective owners.

Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.

Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.

Russell Investments’ ownership is composed of a majority stake held by funds managed by TA Associates with minority stakes held by funds managed by Reverence Capital Partners and Russell Investments’ management.

Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company.

The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the “FTSE RUSSELL” brand.

Copyright © Russell Investments Group, LLC 2017. All rights reserved.

Russell Investments Financial Services, LLC, member FINRA (www.finra.org), part of Russell Investments.

First used: September 2017. RIFIS: 19182


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ADVANCING THE FUTURE OF INVESTMENT ADVISORY SOLUTIONS

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