The financial industry has attracted a lot of negative attention lately. And understandably so. Several scandals in recent years—from old-fashioned Ponzi schemes and insider trading scandals to the more sophisticated techniques of coordinating interest and exchange rates through secret networks—have caused a wave of global mistrust. The private wealth management industry has not gone unscathed. Scandals such as these have not just challenged investors emotionally but have also wiped out years of savings for many. The role of advisors as fiduciaries has come into question, with regulators scrutinizing their practices more than ever.

There is a silver lining beneath these troubles, however. Investable assets of the world’s high net worth individuals (HNWIs) continue their ascent to record highs and are projected to reach US$55.8 trillion by 2015.1 The number of HNWIs around the world is also following the same trajectory.¹ Private wealth management remains an attractive business that offers new avenues of growth for many firms around the world. In Canada, for instance, the wealth management business continues to be a key driver of profitability for the financial industry.

But the reputational damage has not been fully undone. Rebuilding clients’ trust stands out as the key challenge for wealth management firms.² That is the essence of CFA Institute’s Future of Finance initiative, a global effort to advance ethical conduct in the financial industry by emphasizing the utmost importance of clients’ interests. This spirit was illuminated at CFA Society Toronto’s 2014 Wealth Management Conference, which featured leading industry thinkers and experts who shared their insights on the future of private wealth management.

The first presenter, Roger Urwin, FIA, from London, U.K., is the Global Head of Investment Content at Towers Watson, an Advisory Director to MSCI Inc., and a member of the board of CFA Institute. A champion of transformational change in wealth management, Urwin explained the prerequisites for creating a sustainable business in what he called “the professionally focused firm.” Urwin defined the professionally focused firm as one that is “highly empathic to client context and passionately focused on client outcomes.” He argued that “the short-sightedness of many investment firms has created a great opportunity for the professionally focused firm that has the staying power to make some short-term investment in their clients as a route to long-term business and client success.”

Urwin emphasized that once clients’ interests were positioned at the core of a firm’s strategic values, culture and leadership were the key enablers of a firm’s strategy. He stressed that culture is harder to change than strategy. However, it is the firm’s culture that establishes expectations and trust, develops the communications and engagement activities, and ultimately reduces uncertainty and anxiety for the clients. Moving to a client-centric culture throughout the firm requires exceptional leadership, which is key in setting vision and creating the “organizational muscle.” Leaders, therefore, are “carriers and developers of culture,” Urwin explained. He concluded his presentation with the insight that “our real problem, then, is not our strength today; it is rather the vital necessity of taking action today to ensure our strength tomorrow.”

NET, NET RETURNS

Ensuring the strength of clients’ retirement portfolios was the focus of the presentation by Harold Evensky that followed. Evensky is President of Evensky & Katz Wealth Management, Professor of Practice at Texas Tech University, and a leading expert on personal finance. He shared his views on meeting clients’ expectations in today’s investment environment. Evensky explained that the dynamics of longevity, higher-risk premiums, and the drag of lower-risk premiums have all colluded together to create an era in which traditional asset allocation fails to satisfy clients’ investment objectives. He therefore argues that managers must not only consider forward-looking estimates of risk and return but must also incorporate expenses and taxes in order to deliver what he calls the “net, net return.”

“Culture is harder to change than strategy.”

To get there, Evensky claims that “the key to a successful investment model will be one focused on an optimal strategy instead of an optimal portfolio.” He is a big proponent of the core-satellite investing approach, in which the core allocation captures the market return, and the satellite provides the alpha. Tracking risk is reduced by a significant allocation to the core, whereas the satellite provides flexibility to act on tactical opportunities. Surprisingly, allocating 100 percent of the risk budget to the satellite could generate an expected of two percent net of expenses and taxes. This compares much more favourably to the empirical evidence he presented that demonstrated there was a less-than-15-percent probability of generating an alpha of greater than one percent for more traditional asset allocations.

Furthermore, he highlighted some lessons from behavioural finance, based on his years of experience in managing clients’ expectations. The importance of keeping a cash-flow reserve to manage unexpected events, whether in the market environment or in a client’s situation, is critical to avoiding unconstructive actions.

With regard to the importance of framing, Evensky suggested positioning the cash-flow reserve as a critical component of the total portfolio, but one that is distinct from the investment portfolio. When rebalanced, income generated from the investment portfolio would complement the cash reserve, which in turn will disburse regular payments to the investor to maintain a constant amount. This “two bucket” approach, Evensky suggested, would shelter the investment portfolio from investors’ behavioural biases caused by volatility and provide financial flexibility by reducing withdrawal risk.

Creating a win-win relationship is not that difficult after all. The interests of both the client and advisor can flourish by focusing on the longer term rather than on near-term gains or market movements. Despite the ups and downs, the scandals and innovations, there is a winning business model where trust, honesty, and ethical conduct form the foundation. Those who do not put clients’ interests first will eventually be driven out of business by natural selection. And those who do uphold these principles will not only survive and attract more clients but also exemplify the future of finance.

¹ http://www.worldwealthreport.com/
² http://www.pwc.com/gx/en/banking-capital-markets/private-bankingwealth-management-survey/industry-forecast-trends.jhtml