Investors aren't the only ones who will have something to worry about if the stock market heads for a major correction. As volatility steadily ticks higher, owners of small financial advisory firms might start to feel as if the walls are closing in on them.
Any business model that links revenues largely to assets under management will suffer the mathematical reality of a market downturn, but for smaller-sized advisory firms, the reality could be downright dire. While some mega firms and consolidators continue to grow and gobble up smaller registered investment advisers, most independent firms still manage less than $100 million and operate on tight margins with little room to make cuts when times get tough.
"The smaller you are, the more vulnerable you are, because if the market goes down 15%, it gets harder and harder to run a business," said David Canter, head of the RIA segment at Fidelity Clearing & Custody Solutions.
"I'm not down on smaller firms, but I want them to take a hard look at what is best for themselves and their clients," he said. "Now that volatility is back, it's time to reexamine the profession, especially with regard to small firms. Less income and less revenue makes smaller firms more vulnerable in a market downturn, and there is also less room for error."
"When the stock market drops, revenues drop, and no expenses immediately come out of the system," said David DeVoe, managing director at the investment bank DeVoe & Co. "Profits can quickly go to zero or even negative."
But the difference between small firms and large firms goes well beyond the blunt measurement of assets under management, Mr. DeVoe said. In a market downturn, he explained, small firms will quickly come to realize where and how scale matters.
"In a strong downturn, there's a big impact on the workload of an advisory firm, because they can literally be working 'round the clock to manage the firm, oversee portfolios and communicate with clients, which will involve lots of hand-holding," he said. "But the other element is with smaller firms, there is less economies of scale, making it harder to right-size the firm."
In other words, sole proprietors with one or two employees can't institute a round of layoffs when times get tough.
One reason small firms might not be paying close attention to the risks that come with a market downturn is that the stock market has enjoyed an historic ride since its March 2009 bottom following the financial crisis.
From that low point of 676.53 on March 9, 2009, the S&P 500 Index has gained 300.8%, enough to make just about any financial adviser look brilliant.
But the devil is in the details.
According to an analysis of advisory firm balance sheets by InvestmentNews Research, firms across the spectrum have benefited from the strength of the stock market. But the impact of market performance is amplified when it comes to small firms, according to Matthew Sirinides, senior research analyst at InvestmentNews Research.
"What you see is that smaller firms are just as good at asset gathering as larger firms, but when you subtract the market, the smaller firms can get hurt badly because margins are thinner, and there's often one adviser managing all the business and responsible for attracting new clients," he said.
According to InvestmentNews, when the S&P gained 9.84% in 2016, firms with less than $100 million in assets saw assets grow by an average of 15.76%.
But a third of that asset growth, or 5.6 percentage points, was from market performance, according to Mr. Sirinides.
Looked at from a different angle, in 2008, when the S&P dropped 37%, the average asset decline at small firms was 4.47%, and market losses drove 20% of that drop.
In the case of a relatively brief market downturn, such as the financial crisis, the full impact on an advisory firm is typically delayed.
In 2009, for example, when the S&P bounced back with a 26.46% gain, the average year-over-year revenue growth at small firms was just 70 basis points, down from 1.45% in 2008.
"It comes down to the balance sheet," Mr. Sirinides said. "As a percentage of the overall book, the smaller firms might appear to be doing slightly better than larger firms because a half-million-dollar client makes a bigger bump on the assets under management. But when the market doesn't contribute, the smaller firms are more vulnerable because they don't have $150,000 technology budgets or $100,000 marketing budgets they can cut from. They suffer more because they just can't cut expenses."
The vulnerabilities of small firms to weather market downturns has been hidden by the steady strength of the stock market, said John Hyland, founder and managing director at Private Advisor Group, which manages $15.2 billion.
"We've seen so many adviser and [breakaway brokerage] teams launch RIAs, and a lot of them look at it on the everything-goes-OK scenario, which is modeled on a perfect world," he said. "The growth of the individual small RIA really popped since 2010, and since then you haven't had a bear market. And bear markets are when customer complaints come out. Even if it's not a real issue, it costs money to deal with complaints."
Impact on acquisitions
At some consolidator firms, such as the $11-billion-asset Carson Group, a down market will put RIAs on the short end of acquisition negotiations.
"A lot of the consolidation comes from the shock and surprise of what the financials look like" after a market downturn, said Aaron Schaben, Carson Group managing partner and executive vice president.
"A bull market hides a lot of sins, especially in an AUM-based model," he said. "We know that 90% of advisers know what their new assets are each year, but only 30% know what their net new number is in terms of assets coming in, assets leaving and the impact of market growth. In a down market, if you don't get new clients, you see a decline from assets leaving, and you'll quickly find yourself 20% or 30% down."
Contributing to that woeful outlook is the way a lot of advisory firms have embraced low-cost market beta, largely through passive exchange-traded funds, to keep clients fully invested while recognizing the increased focus on fees.
"Even in a 70-30 portfolio, a large part of the returns are tied to equity beta, and I would expect portfolios to be hit hard in a downturn," said Phil Shaffer, founder of Halite Partners, which has $110 million in assets under management.
"Even if they don't lose any clients, the fees are tied to a percentage of assets, and that says they are going to have to undo some service and staffing levels," he said. "I think those smaller RIAs will be in deep trouble, and they will be crying for help — screaming 'Buy me' at any price."
That's exactly the scenario Harvey Siegel, senior financial adviser at Apella Capital, wanted to avoid when he sold his $250 million RIA, Arch Investment Planning & Management, in 2016.
"I've been through a number of market declines, and at Arch, I would be the one who had to talk to all the clients. And after you try to calm down your 50th client, it becomes very hollow-sounding to them and to me," Mr. Siegel said. "It hasn't happened yet since I've been part of Apella, but I would think it would be better because I'm not alone. We have research teams, someone to give us support in what we say and how to communicate to clients. I'm certain it will be easier than it was when I was the one who had to talk to clients."
Not everyone in the advice business is sounding the alarm over the possible impact of a bear market on small advisory firms.
Jalina Kerr, senior vice president overseeing small-firm management at Charles Schwab & Co., believes small firms are actually in better shape than they have been during past market corrections because they have a greater reliance on technology and innovation.
Taking advantage of tech
"Three or five years ago, that vulnerability was more acute than it is today," she said. "I think the smaller firms are in better shape now because more of them are taking advantage of tools and technology that enable them to do more with less."
Scot Hanson, an independent contractor with EFS Advisors, has $40 million under management, and he isn't worried about a major market downturn.
"In 2008, our AUM went down, but you've got to live below your means," he said. "I charge 1%, which is $400,000 a year, and I make about $240,000," he said. "I can live off that."
Kristi Sullivan, owner of Sullivan Financial Planning, a state-registered advisory practice that she launched in 2007, believes she'll actually do better in a market downturn. Rather than collecting a percentage of assets, Ms. Sullivan charges clients a flat fee on an hourly or annual basis.
"In a downturn, advisers do have a chance to capture new business, because clients will be unhappy with their performance and might change advisers," she said. "I would imagine for me, the additional appointments and extra work would be miserable, but my revenue would probably be the same or better."