We had the honor of being published in Proactive Advisor Magazine. The article was also shared in National Association of Active Investment Managers (NAAIM)s February Newsletter. We are truly blessed to be working with advisors across the United States. Your work is our world.
We’ve all heard the saying “out of left field,” meaning ‘unexpected’ or ‘surprising.’ It’s an idiom from the sport of baseball, where it refers to a play in which the left fielder throws the baseball all the way to first base, or home plate, surprising the runner. In our business, we’re used to things coming out of left field—uncertainty is the underlying reality of all markets, and it’s something we all must manage as market participants. This note will highlight the key difference between the kinds of risk that you manage for clients (market risks), and risks to the advisory business model itself (RIA business risks).
As an advisor, you help your clients manage and navigate uncertainty in the markets. When things come out of left field, as they always do (and will) in markets, it’s you that’s responsible for stepping up to the plate with sage counsel in the face of threatening uncertainty. Market risk takes many forms, and you are expected to have antidotes and answers for all of them as you design client portfolios with painstaking rigor in the face of the unexpected. That task is your responsibility, your passion, and your livelihood.
But business risk—fiduciary risk—is a separate form of risk. Fiduciary risk is that risk transferred from clients to the fiduciary that stewards their capital. Fiduciary risks are threats to the RIA entity itself. The most significant and severe form this can take is a lawsuit from a client claiming that there has been a breach of fiduciary duty.
Many people believe that the greatest drivers of fiduciary risks are mistakes made by advisors themselves, or by defects in process or practice. In fact, fiduciary risk is much more closely correlated with the market environment than errors or negligence. There is a lot of data on this (we know, because we’ve been tracking it for years), and the data is indisputable. What it indelibly illustrates is that there is a clear and direct inverse correlation between equity markets and breach of fiduciary duty lawsuits. These fiduciary breach lawsuits spike when the market becomes corrective, and subside when it is tranquil.
The interesting thing about this relationship from a fiduciary risk perspective is that this is an independent variable from of the quality of the advice you give clients on a day to day basis. In other words, we know and trust that you know how your clients’ portfolios will do in an adverse market environment. The question becomes, how can you make sure your business will thrive in an adverse market environment?
Now, it’s important to say that speaking broadly, we could divide money managers into two camps. The first, and more traditional camp, is positioned opportunistically for an appreciation of the major asset classes (primarily equities) and must thoughtfully “endure” volatility events on the path to these rewards. The second, and more tactical camp, takes some version of the inverse stance—positioned opportunistically for a volatility event, but prepared to underperform the market in the event of a slow, stubborn grind up. If you are one of these managers, volatility is your opportunity to shine, while others are fearful.
The salient question for the first camp is obvious—what is your plan for the kinds of volatility events we can almost certainly expect from a late-stage bull market? If a volatility event will be a setback (and it stands to be a setback if you have participated in the last two years’ gains) then the question is—how will you protect the last two years’ gains? How do you keep them?
The question for the latter camp is more subtle, but just as salient—if you are or have been positioned for a volatility event, and you stand to benefit from it, that’s great—but how did you navigate the last two big up years? What is your plan moving forward?
Here is the most important thing to know about the source of fiduciary risk with your clients: capital is not the only casualty of a drawdown—communication suffers too. This is a reality of behavioral finance that is too frequently overlooked. Client communication is often the first casualty of a pressurized financial reality, like volatility, underperformance, or a drawdown. Communication warps under the pressure and urgency of threats, and assumptions that seemed foundational are questioned. The weakest links of your clients’ understanding of your roles and responsibilities will be tested in these situations, and these communication breakdowns and misunderstandings can take many forms. Interestingly, one of the most frequent forms they take isn’t a client claiming their advisor is guilty of some gross negligence, but something more subtle, such as that they were underprepared for opportunity, or failed to capture gains or avoid turbulence in the market. Perhaps a third party, that doesn’t know the advisor and the advisor can’t communicate with, is whispering in the client’s ear that they received bad advice, or that an opportunity was squandered.
In summary—breach of fiduciary claims are infrequent, but very severe. These claims are tied to the overall market environment (specifically volatility) and not the quality of your advice or stewardship of client assets. You have a plan for market risk, and that risk management drives every portfolio and plan you design for your clients. How do you manage fiduciary business risks?
Written By: Tim Parker
Today’s BPI Advice: Things come out of left field. Your portfolios are built to handle them. Is your business?
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