Investment Advisory Solutions

ADVANCING THE FUTURE OF INVESTMENT ADVISORY SOLUTIONS

Journal of INVESTMENT ADVISORY SOLUTIONS

Volume 1 n Number 1 n Fourth Quarter 2017

Inside 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

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

I I M M TH TH

M M 20 20 ANNIVERSARY

WWW.MMINST.ORG Journal of INVESTMENT ADVISORY SOLUTIONS

BOARD OF GOVERNORS Roger Paradiso Marilee Ferone Thomas Malone Ram Subramaniam Chairperson, MMI UBS Financial Services Lord Abbett Fidelity Brokerage Board of Governors, Services Keith Glenfield John Moninger Legg Mason Bank of America Eaton Vance Eric Sutherland Jennifer Abate Merrill Lynch PIMCO Cheryl Nash Lazard Asset Matthew Johnson Fiserv Investment Pete Thatch Management Brandes Investment Services Capital Group David Berkowitz Partners Greg Nordmeyer Troy Thornton Lincoln Financial Carl Katerndahl Ameriprise Financial Goldman Sachs Network Nuveen Investments Services William Turchyn Yanni Bousnakis Scott Kilgallen Daniel O’Lear Mariner Investment Cetera Financial Group Neuberger Berman Franklin Templeton Group John Brett Investments Eric Koestner Jake Tuzza Pershing LLC Edward Jones Kevin Osborn Voya Investment Marc Brookman Envestnet Management Michael Lewers Morgan Stanley BlackRock Stuart Parker Burton White Wealth Management PGIM Investments LPL Financial David Lindenbaum John Coyne Charles Schwab & Co. Craig Pfeiffer Bebe Wilkinson Brinker Capital Money Management MassMutual Andrea Lisher Jeffrey Cusack Institute J.P. Morgan William Golden Nuveen Investments Joseph Schultz MMI Board Advisor Patty Loepker Jeff Dowdle American Century Wells Fargo Advisors John Sweeney Raymond James Investments MMI Board Advisor Financial

MMI JOURNAL OF INVESTMENT ADVISORY SOLUTIONS Volume 1 n Number 1 n Fourth Quarter 2017

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.

CONNECT KNOW GROW Volume 1 n Number 1 n Fourth Quarter 2017

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 6 Ricardo L. Cortez, CIMA, Broadmark Asset Management LLC Discovering Phi: Motivation as the Hidden Variable of Performance 13 The Center for Applied Research (State Street Corporation) | CFA Institute Blockchain Innovation in Wealth and Asset Management: Benefits and Key Challenges to Adopting this Technology 69 EY (Ernst & Young) Sustainable Investing: Investor’s Guide to Corporate Governance 85 Stephen 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 101 Lockwood Advisors | BNY Mellon The Death of Active Management Has Been Greatly Exaggerated: Active investing will never die, but it’s being forced to evolve. 105 Ben 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 109 Artivest Behavioral Alpha: An Advisor’s Greatest Value 113 Dr. Daniel Crosby, The Center for Outcomes | Brinker Capital TAMP Market Overview 120 FUSE Research Network Why Advisors Have Never Been So Valuable: 2017 Value of an Advisor Study 126 Russell Investments

ADVANCING THE FUTURE OF INVESTMENT ADVISORY SOLUTIONS 3 CONNECT KNOW GROW Journal of INVESTMENT ADVISORY SOLUTIONS

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 Paradiso Patty Loepker Craig Pfeiffer MMI Chairman MMI Chair Elect President & CEO Legg Mason Wells Fargo Advisors Money Management Institute

CONNECT KNOW GROW Volume 1 n Number 1 n Fourth Quarter 2017

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

ADVANCING THE FUTURE OF INVESTMENT ADVISORY SOLUTIONS 5 CONNECT KNOW GROW Journal of INVESTMENT ADVISORY SOLUTIONS

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

Summary securities. This approach is used because the goal of these managers is primarily to regulate the exposure The upside/downside capture ratio is an important of the portfolio to the market rather than the selection analytical tool for the investment management of individual long and short securities. Tactical consultant. While they may be calculated for managers strategies are more directional in nature. in all asset classes, in this paper we focus on upside/ downside capture ratio calculations for equity hedge Upside/downside capture ratios for tactical managers and tactical managers. We believe that the time period should provide insight into their ability to manage used with the ratio is significant when evaluating each systemic risk and preserve capital during down market of these types of managers. cycles. We suggest that the best way to achieve this goal is to use a time period that is related to the overall For the purposes of this paper, we define those market environment—e.g., up, down, flat, volatile managers who are generally hedged (usually long cyclical markets—which may be longer than their and short at all times) as “equity hedge.” This monthly variance versus a benchmark. While the designation includes market neutral, relative value investment management consultant is able to use the and long/short managers. We define managers who same mathematical formula for both calculations, we are directional and not necessarily hedged at all believe that the selection of the measurement period is times as “tactical,” including global macro, managed important in evaluating the manager’s particular skill futures and tactical managers. in their area of expertise. The traditional upside/downside capture ratio, which is usually calculated using a monthly time series, is Why Is Upside/Downside Capture best at evaluating an equity hedge manager’s security Analysis Important Now? selection and portfolio construction expertise. As the The rush to passive investing has accelerated in equity hedge portfolio fluctuates versus its benchmark, recent years. In 2016, there was a record net new cash the investment consultant is able to assess an equity inflow in domestic equity index funds (including hedge manager’s performance versus the benchmark ETFs) of over $250 billion. At the same time, there during the up and down periods. was a record net outflow in domestic equity active Tactical strategies, on the other hand, often make funds of over $300 billion. Many market participants extensive use of broad market indexes through ETFs, have asked if this is the new model for investment futures contracts and derivatives rather than individual 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?

6 Calculating Upside/Downside Capture Ratios for Equity Hedge and Tactical Managers Volume 1 n Number 1 n Fourth Quarter 2017

FIGURE 1. RECORD FLOWS INTO PASSIVE FUNDS AND OUT OF ACTIVE FUNDS YEARLY DATA, DECEMBER 31, 1993—DECEMBER 31, 2016

252.79

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

-320.43

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

We believe that a good way to manage risks in a passive portfolio is to allocate a significant portion of “The essence of portfolio management the portfolio to tactical strategies that are designed to manage portfolio risks. We believe this active is the management of risks, not the management allocation is essential to portfolio management, particularly now. management of returns.” —Benjamin Graham 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 at passive versus active investing is that the market 2009, it is prudent to ask at what point the market advance since 2009 has been indiscriminate in will undergo the type of correction to the uptrend driving up stocks; high-quality and low-quality that typically occurs after economic expansions. This securities alike have been buoyed upward by the question is particularly important for those investors rising stock market tide. Active investment managers whose time horizon is less than 10 years. Remember that discern higher quality from lesser quality that if an investment portfolio declines 50%, as it securities have been at a disadvantage because the did during the last recession, it must subsequently stock market has not rewarded this distinction. double in value just to get back even, which begs the question: does the portfolio have sufficient time to recover? Another consideration when looking

Broadmark Asset Management LLC 7 Journal of INVESTMENT ADVISORY SOLUTIONS

Calculation of the Upside/Downside been negative. In the case where a manager registers Capture Ratio positive returns when the benchmark declines, the fund’s downside capture ratio will be negative Upside/downside capture ratios show how much a (meaning it has moved in the opposite direction of the manager has gained or lost compared to a broad benchmark). The selection of a particular benchmark market benchmark over a specified time period. The is important and is usually the stated benchmark for ratios are usually calculated using monthly data, the manager.”1 but any time period can be used. The investment consultant might want use daily or weekly data to Upside/Downside Capture Ratio examine the manager’s sensitivity to very short-term market movements or extend the time period under Measurements for Equity Hedge review to one year or more to measure a manager’s risk Managers capabilities during a large market decline (2008, for Upside/downside capture ratios are commonly instance) and ability to participate in the subsequent calculated using monthly return data. Monthly market advance. calculation is an appropriate measure for those managers who employ security selection as their Monthly upside/downside capture ratios are calculated focus, as this analysis captures how well their positions by taking the manager’s monthly return during contribute to the overall portfolio movement versus the months when the benchmark had a positive return benchmark without regard to the market environment, and dividing it by the benchmark return during that as measured monthly. The goal for an equity hedge same month. Downside capture ratios are calculated portfolio is to select both long and short positions they by taking the manager’s monthly return during the believe will contribute positively to returns. periods of negative benchmark performance and dividing it by the benchmark return. Generally, upside/downside capture ratios are calculated Upside/Downside Capture Ratio over one-, three-, five-, 10- and 15-year periods by Measurements for Tactical Managers calculating the geometric average for both the A tactical manager’s goal is often to capture upward manager’s returns and index returns during the up moves during up market cycles and to avoid losses and down months, respectively, over each time period. during down market cycles. The traditional method of calculating upside/downside capture ratios using According to Morningstar, “An upside capture ratio monthly data does not address the tactical manager’s over 100 indicates that the manager has outperformed use of risk management techniques through portfolio the benchmark during periods of positive returns for exposure in different market environments because the benchmark. A downside capture ratio of less than one month doesn’t capture the full range of a market 100 indicates that the manager has declined less than cycle. By using only monthly data without regard to its benchmark in periods when the benchmark has 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

8 Calculating Upside/Downside Capture Ratios for Equity Hedge and Tactical Managers Volume 1 n Number 1 n Fourth Quarter 2017

Evaluating Equity Hedge and Tactical 2. The securities used reflect the different investment Managers Using the Upside/Downside approaches. Equity hedge managers generally have Capture Ratio long and short individual securities positions in the portfolio. The upside/downside capture ratio as The CFA Institute has stated that “At the manager calculated monthly gives the investment consultant level, we can think of a benchmark as a passive a good idea of how the long and short positions representation of the manager’s investment style, have contributed to the performance of the overall incorporating the salient investment features (such equity hedge portfolio, which in turn offers insight as significant exposures to particular sources of into the manager’s stock selection capabilities. systematic risk) that consistently appear in the manager’s portfolios. A manager’s benchmark However, tactical managers often use broad market encompasses the manager’s ‘area of expertise.’”2 indexes and derivatives rather than individual Investment consultants evaluate a manager’s securities. The evaluation of tactical managers is capability versus a benchmark by identifying the not based upon stock selection, but rather upon relevant features of that manager’s strategy. The the portfolio’s performance during up- and down- appropriate benchmark should encompass the market cycles. By extending the time period to manager’s “area of expertise.” The investment encompass a market cycle or a specific time period consultant should therefore determine how best to within a market cycle, the investment consultant measure this expertise in relation to the benchmark. can better evaluate the correlation of investment returns compared to the benchmark with respect to We suggest that the investment consultant consider systemic risk. four factors when evaluating a manager’s performance versus a benchmark when using the upside/downside 3. The types of risks being measured. Upside/ capture ratio: downside capture ratios using monthly data do a good job of assessing a manager’s ability to 1. The investment time horizon. Tactical managers construct and manage security-specific risks. The often take a top-down macroeconomic or a tactical manager’s primary goal is often to capture quantitative approach to the markets, or use a the larger market upward moves and protect combination of the two. The time horizon targeted the portfolio from systemic, or market, risk. By by these managers might be longer and encompass adjusting the time period used in the calculation, more of an intermediate- or long-term economic and the investment consultant can make sure to stock market cycle—from three months to a year or measure the manager’s skill at managing each type more. The traditional monthly calculations used may of risk—specific risk and systemic risk. be not be helpful in measuring a tactical manager’s success or failure over a longer market cycle.

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

Broadmark Asset Management LLC 9 Journal of INVESTMENT ADVISORY SOLUTIONS

4. The stock market environment. If the stock Conclusion market environment in the next five years is The upside/downside capture ratio can be a powerful similar to the last five years of rising stock prices, tool in evaluating both equity hedge and tactical then the traditional monthly upside/downside managers. However, adjusting the time horizon for capture ratio calculation may be the best way to each of these types of managers can better evaluate assess a manager because it demonstrates the each manager’s area of expertise and management of stock picking and portfolio construction ability specific risk versus systemic risk. of the manager. However, if the approaching stock market environment has more economic The commonly used method of calculating upside/ contractions, declining stock prices or increased downside capture ratios using monthly data is an volatility, then we suggest that a better way to excellent method for assessing an equity hedge assess risk management may be to evaluate how manager’s area of expertise, namely individual a manager performed during longer periods security selection and portfolio construction. of time compared to the benchmark. Adjusting However, when evaluating the area of expertise of the time horizon to reflect the anticipated tactical managers, we suggest broadening the time market environment may enhance an investment period under investigation to include various market consultant’s ability to evaluate each manager’s environments. By expanding the time period used particular area of expertise. 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.

10 Calculating Upside/Downside Capture Ratios for Equity Hedge and Tactical Managers Volume 1 n Number 1 n Fourth Quarter 2017

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 LLC Indexes shown for illustrative purposes only. It is not possible to invest directly Investing involves risk, including a possible loss of in an index. principal. Past performance does not guarantee future results. Portfolio holdings are subject to The specific securities identified and described do change at any time. not represent all of the securities purchased, sold, or recommended for advisory clients, and the reader Broadmark Asset Management (“Broadmark”) is a should not assume that investments in the securities registered investment advisor. The views expressed identified and discussed were or will be profitable. contain certain forward-looking statements Broadmark believes these forward-looking statements Not FDIC Insured | No Bank Guarantee | May Lose Value to be reasonable, although they are forecasts and © actual results may be meaningfully different. This 2017 Broadmark Asset Management LLC. All rights reserved. material represents an assessment of the market at a particular time and is not a guarantee of future All other registered trademarks or copyrights are the property of their respective organizations. 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.

12 Calculating Upside/Downside Capture Ratios for Equity Hedge and Tactical Managers Motivation as Discovering Phi the Hidden Variable of Performance

The Center for Applied Research (State Street Corporation) | CFA Institute 13 After 18 months of research, we’ve made an important discovery...

14 Discovering Phi: Motivation as the Hidden Variable of Performance The Center for Applied Research (State Street Corporation) | CFA Institute 15 16 Discovering Phi: Motivation as the Hidden Variable of Performance ...that has widespread implications for the future of the investment management industry.

The Center for Applied Research (State Street Corporation) | CFA Institute 17 We have discovered a hidden variable of performance –

18 Discovering Phi: Motivation as the Hidden Variable of Performance we have quantifi ed it, and we have named it...

The Center for Applied Research (State Street Corporation) | CFA Institute 19 Phi.

20 Discovering Phi: Motivation as the Hidden Variable of Performance e hidden variable of performance.

The Center for Applied Research (State Street Corporation) | CFA Institute 21 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.

22 Discovering Phi: Motivation as the Hidden Variable of Performance Discovering Phi MOTIVATION AS THE HIDDEN VARIABLE OF PERFORMANCE

Short-term thinking has disconnected us from to long-term organizational performance, client our shared purpose: achieving clients’ long- satisfaction and employee engagement. As in term goals and in turn contributing to economic quantum mechanics, where a “hidden variable” is an growth. Organizations that are able to go back element missing from a model that leaves the system to basics and rediscover their purpose – their incomplete, we nd the same situation in investment raison d’être – should be able to perform better management, i.e., there seems to be an intangible in any return environment. We need to embed factor that has not previously been quantied. in our habits and incentives the connection to purpose. e rst step toward accomplishing We call this variable “phi” — derived from this is to understand what motivates us and how the motivational forces of purpose, habits and our motivations work. Our motivations lead incentives that govern our behaviors and actions. to action and our actions drive outcomes. e phi motivation is distinctly dierent from Based on 18 months of research from May 2015 the short-term outperformance motivation 1 to October 2016, through in-depth interviews or asset-gathering focus of our industry. with more than 200 global industry leaders, the State Street Center for Applied Research and e results of our analysis were exceptional. project partner CFA Institute set out to answer A one point increase in phi is associated with: one fundamental question: How can we leverage motivation to achieve better nancial outcomes? 28% greater odds of excellent organizational performance We combined the qualitative statements from these interviews with the ndings from a survey of nearly 55% greater odds of excellent client satisfaction 7,000 respondents: 3,600 individual investors and more 57% greater odds of excellent employee than 3,300 investment professionals across 20 countries. engagement. (For a detailed explanation

rough this eort, we discovered a previously hidden of phi, please see the appendix.) variable with a statistically signicant relationship

The Center for Applied Research (State Street Corporation) | CFA Institute 23 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 signicantly 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 signicant quantiable 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.

24 Discovering Phi: Motivation as the Hidden Variable of Performance 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.

The Center for Applied Research (State Street Corporation) | CFA Institute 25 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 dierent 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.” 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 diering 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.

26 Discovering Phi: Motivation as the Hidden Variable of Performance Motivation is the engine that drives behavior.

The Center for Applied Research (State Street Corporation) | CFA Institute 27 The Good News: 53% of investment professionals said they pursued a career in investment management because they were passionate about financial markets. 40% of investment professionals report that it is an important reason they remain in the industry.

The Bad News: 28% of our respondents said they remain in the investment management industry for the purpose of helping clients in achieving financial goals. 5% suggest they remain to contribute to economic growth.

28 Discovering Phi: Motivation as the Hidden Variable of Performance The Current State of Motivation PASSION WITHOUT PURPOSE

In order to understand (and ultimately improve) What’s driving this disconnect? Quite simply, the behaviors in our industry, we must rst the environment we’ve created to support our understand the type of motivation behind them. passion limits our connection to purpose.

e good news for our industry is that 53% of the In the workplace, this environment is largely a investment professionals surveyed (asset managers, function of corporate culture and leadership. To asset owners and other intermediaries) said they examine motivation in the context of culture and pursued a career in investment management because leadership, we used Self-Determination eory they were passionate about nancial markets; and (SDT), which identies three innate needs 40% of investment professionals report that it is that, when satised, allow optimal function an important reason they remain in the industry. and growth: competence, relatedness and autonomy. In other words, one must have: e bad news is that despite this passion, the industry appears disconnected from its purpose. 1) e capability and knowledge to work eectively Just 28% of investment professionals said 2) A close-knit environment where people they remain in the investment management understand how their work ts together industry for the purpose of helping clients to benet from collaboration achieve nancial goals, and only 5% suggest they remain to contribute to economic growth. 3) Delegated authority (versus micromanagement). 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.”

The Center for Applied Research (State Street Corporation) | CFA Institute 29 For a better understanding of this, we surveyed To attribute this lack of purpose to shortfalls the following items, asking respondents to in leadership and vision would be a major rate whether their leaders do the following: simplication. As described below, investment professionals face a wide variety of other • Articulate a compelling vision of the future economic and emotional pressures that inuence their motivations and behaviors. • Have a preparedness to challenge assumptions and adapt their vision over time Compensation • Talk to their employees about their most important values and beliefs Conventional wisdom dictates that compensation is an eective tool for motivation. However, • Spend time teaching and coaching employees academic research shows that while Unfortunately, we found that a majority of compensation is indeed a factor that prevents professional investors gave their rm low ratings dissatisfaction, it does not necessarily increase in every one of these categories. e item with the long-term motivation. Indeed, only 20% of lowest scores was about teaching and coaching, our respondents indicated that compensation indicating a lack of commitment to the long- is the reason they remain in the industry. term health of the organization. Furthermore, only 15% of professional investors strongly Studies suggest that monetary incentives may believe their leaders articulate a compelling create an atmosphere in which an individual vision. e most eective leaders make the feels greater external pressures, making it linkage between these external motivators dicult for them to process information and that they drive and the employees’ motivators make decisions. is can be mitigated if the that they are internally wired to use. compensation structure is perceived as fair, controllable and transparent.10 However, only In fact, this lack of articulated and shared 44% of respondents in our study believe their purpose is driving demotivation and stress: compensation structure is fair, 40% believe it is 92% of investment professionals in our survey transparent and 34% believe it is controllable. report being demotivated in some way.

30 Discovering Phi: Motivation as the Hidden Variable of Performance Fear, Stress and Career Risk

Asset owners, asset managers and wealth managers all report various short-term 44% pressures that a ect their decision making. of investment professionals believe their leaders articulate a compelling vision. 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 41% red after 18 months of underperformance. of investment professionals agree that leaders talk to employees about their Among asset managers and wealth managers, most important values and beliefs. 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 33% drive an investor to terminate a relationship with of investment professionals believe that a manager, even if the investor benets from the their leaders are spending time teaching investment in the long run.12 Similarly, 24% feel and coaching employees. 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, 40% comparison and the contingent rewards that result. think their leaders re-examine critical assumptions and beliefs.

The Center for Applied Research (State Street Corporation) | CFA Institute 31 “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.”

32 Discovering Phi: Motivation as the Hidden Variable of Performance The Center for Applied Research (State Street Corporation) | CFA Institute 33 In turn, self-interest tends to prevail — nearly is is the current state of motivation and two-thirds (62%) of investment professionals believe performance in our industry: Our current that their organization is acting in its own best environment “misdirects” our passion for interest rather than the client’s. In the words of beating the market toward behaviors that one asset owner CEO, “It is an industry in which inhibit our performance and undermine the it is OK to behave badly if you are smart enough.” legitimacy and credibility of the industry.

We asked the same question of retail investors, Furthermore, there is a disparity between the and they agreed — more than half (54%) of purpose we say we have on our websites and respondents believe that nancial institutions corporate messaging (helping clients meet their are most likely to oer products and services in goals), and the purpose evident in our actions the rm’s own best interest versus that of the (competition and outperformance for its own sake). client. As a result, less than one third (32%) of retail investors surveyed attribute their long-term We will never be able to compel people to nancial planning success to an advisor or other buy into a particular vision or values, but investment provider. ey were more likely to credit fortunately we do not have to. By implementing themselves (55%) or friends or family (38%).13 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.

34 Discovering Phi: Motivation as the Hidden Variable of Performance 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.

The Center for Applied Research (State Street Corporation) | CFA Institute 35 By implementing changes in our work environment, through the force of culture and leadership,

36 Discovering Phi: Motivation as the Hidden Variable of Performance the passion for beating the market that drives so many industry professionals can be channeled into a more sustainable and valuable motivation.

The Center for Applied Research (State Street Corporation) | CFA Institute 37 38 Discovering Phi: Motivation as the Hidden Variable of Performance The Future State of Motivation THE HIDDEN VARIABLE OF PERFORMANCE

at sustainable motivation is phi: a mindset We calculated phi scores from our survey to deliver performance that’s driven by purpose, respondents using three cornerstone and embedded by habits and incentives. questions based on academic theory:

Individuals with high phi are driven by a belief Purpose. What motivates you to perform? that they are working in the service of something larger than themselves. eir personal goals and Habits. Why do you continue to work in values are aligned with those of their organization the investment management industry? and their end clients. ey are more likely to view their work as a calling rather than just a job. Incentives. Do you think of your work as a job, a career or a calling? 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.

The Center for Applied Research (State Street Corporation) | CFA Institute 39 Phi Distribution Scores for Investment Professionals

N=1,486

40.31% 1 (low phi)

29.88% 2 (moderate phi)

16.62% 3 (high phi)

13.19% 0 (no phi)

40 Discovering Phi: Motivation as the Hidden Variable of Performance In each answer set there were options related How does the investment management industry’s to compensation, status, duty, fun and purpose.14 phi compare to other industries? While we didn’t e maximum score possible was three. measure phi within other industries in this study, e distribution of calculated phi scores is a prior survey by State Street Global Advisors below and additional details can be found asked professionals to what degree their work in the appendix. re ects their values and mission in life. Financial services ranked 12th out of 13 industries, further indicating a signicant opportunity to improve.

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Industrial Production Services Materials

Infrastructure / Technology Construction

Telecom Government / Non-profit

Network Health Care Utilities

Manufacturing Financial Services Consumer Goods Transportation Retail Energy

The Center for Applied Research (State Street Corporation) | CFA Institute 41 Understanding Client Motivations As we consider the nancial system and the important interactions between clients and We are also interested in how individual retail professionals, the level of demotivation in the investors can be motivated to be better investors, industry and the lack of articulated purpose that is, more focused on behaviors that will support from the top also impacts retail investors. their long-term goals. Phi is by no means limited to investment professionals, though a dierent In the most extreme case, the lack of purpose in methodology is appropriate for individual clients investing manifests as individuals avoiding risk and given their dierent role in the system. We therefore return. e average asset allocation to cash among designed our analysis of retail investors using the both our Generation X and Generation Y respondents Biopsychological eory of Personality. is theory is exceptionally high at 36%, which implies that describes two motivational systems that represent younger investors are not taking an appropriate level individual sensitivities to the environment around us. of risk. For high-BIS respondents — who are more motivated by fear of negative consequences than goal- e rst of these systems is the Behavioral Inhibition setting — regression analysis suggests they are more System (BIS), which represents motivation from likely to buy something over saving, more likely to buy fear and negative consequences. e second is the an investment after it has gained signicant value, and Behavioral Activation System (BAS), which represents more likely to sell an investment after a signicant loss. motivation from goal setting and attainment. Research shows that individuals with retirement A one-point increase in BAS sensitivity is associated anxiety are less likely to save and plan for the with: 22% greater odds that an investor believes future, and exhibit a general pattern of avoidance the industry acts in its clients' best interests, 42% toward thinking about and engaging in long-term greater odds an investor knows what they pay investment activities.15 Studies show that anxiety is in fees, 37% greater odds that an investor does created by the feeling of lagging signicantly behind not reject using a nancial advisor, 38% greater your peers and your own goals, promoting a sense odds that an investor considers ESG factors, 79% of defeat and resulting in “throwing in the towel” greater odds that an investor avoids potentially reactions.16 is environment triggers investors’ BIS excessive trading (i.e., more than quarterly). sensitivities, feeding fear, anxiety, and frustration; ultimately leading to sub-optimal outcomes. ese investing habits are clearly driven by purpose and goals, not by fear of loss. is Successful organizations in our industry encourages a sense of commitment and ultimately, should be able to increase the average level a sense of purpose — therefore we have equated of phi among their employees and clients, in BAS sensitivities to phi for retail investors. turn leading to more sustainable results.

42 Discovering Phi: Motivation as the Hidden Variable of Performance The Influence of BAS Sensitivity

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

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

42% greater odds that an investor knows what they pay in fees

38% greater odds that an investor considers ESG factors

37 % greater odds that an investor does not reject using a financial advisor

22% greater odds that an investor believes the industry acts in clients’ best interests

The Center for Applied Research (State Street Corporation) | CFA Institute 43 “The motivational tools we’ve implemented throughout 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

44 Discovering Phi: Motivation as the Hidden Variable of Performance Recommendations PUTTING THE ‘PHI’ IN FINANCE

Both Self-Determination eory and BIS/ values and beliefs, teaching and coaching, and BAS assert that the environment is a critical re-examination of critical assumptions; as well factor in our motivation. Fortunately, it is also as fair, controllable and transparent rewards. the one over which we have the most control. We o er three simple recommendations By creating an environment that supports for investment leaders to create the autonomy and ownership, you create phi. e environment to maximize phi. right environment includes vision, goals,

Leaders Need to Cultivate

Purpose Habits Incentives

The Center for Applied Research (State Street Corporation) | CFA Institute 45 Purpose Our industry has developed two sets of purposes supported 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?

46 Discovering Phi: Motivation as the Hidden Variable of Performance “Culture is key – you need a set of common values.”

Purpose Our industry has developed two sets of purposes supported 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 Purpose works best when it is visible. hard [to internalize] because we’re so many When clients are seen as people rather steps removed from the outcome at the than just an account number, attitudes consumer level.” In other industries, such as begin to change. We suggest that healthcare or construction, professionals are organizations createopportunities for able to see the tangible results of their work.20 investment professionals to understand how their actions impact their clients’ lives.

The Center for Applied Research (State Street Corporation) | CFA Institute 47 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 inuence over behavior.” For example, he found that only 5% of managers he surveyed believe their mission statement has a signicant positive inuence 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.

48 Discovering Phi: Motivation as the Hidden Variable of Performance Five Actions at Will Help Improve Purpose

Vision Create a long-term leadership vision that inspires continual 1 progress towards it. This can also create company citizenship In the 1980s, mission statements became a must-have and an ownership mindset.17 for rms in any industry as corporate “machines” 18 aspired to be humanized. However, in his paper Values and Beliefs “Sex, Lies and Mission Statements,” Christopher Leaders 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 Bart, professor of business policy at McMaster 2 extent a firm wants to change its values, it must change behaviors to University in Ontario, found that mission statements reflect them. Over time, these values will become accepted in the organizational culture. have “no inuence over behavior.” For example, he found that only 5% of managers he surveyed believe Goals their mission statement has a signicant positive Articulate clear goals that tie to your purpose and connect inuence on the day-to-day lives of their employees.19 3 the work individuals do to larger goals that benefit both the client and the organization. Mission statements remain empty unless leaders spend more time talking about their most important values and beliefs, and questioning assumptions in Teaching and Coaching Determine the time your organization can commit to teaching and current practices. is requires an understanding of 4 coaching employees. This was one of the areas that our research how to use values to create new, productive behaviors found is most lacking in organizations today, and it reinforces short- term thinking about the organization’s future. — a challenging but rewarding process.

Re-examine Critical Assumptions Create a culture that regularly re-examines critical assumptions, 5 which conveys that adaptability is more important than tradition — an important quality in a quickly changing profession.

The Center for Applied Research (State Street Corporation) | CFA Institute 49 Habits Developing 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.

50 Discovering Phi: Motivation as the Hidden Variable of Performance Cue

Habit Process

Reward Routine Habits Developing 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 We need to form a new habit of decision making to gains and losses. Investors that have had the environment around us, requiring effective decision such that decisions are being driven by phi, with losses and negative outcomes are more likely making and communication. cognitive and emotional behavioral biases kept to develop especially pessimistic views and in check. Breaking habits and forming new make errors of belief about the investment. We ones is a straightforward process, though for need to replace this habit cycle using phi as the those who have tried to break bad habits, it can driver — rather than losses. From there, the be extremely dicult. Why? Because habits by routine is a process whereby we objectively learn denition are largely within our unconscious. from success or failure, and the reward is an e habit process begins with a cue, then there investment decision based on valid information. is a routine, and nally a reward is received based on this habit. In our industry, we need is also presents a product development to break the habit of having fear trigger action. opportunity. Good habits are only benecial if Camelia Kuhnen of the Kellogg School of they are easy to adopt. Target-date funds were Management found experimental evidence that designed around the idea that a product could we have asymmetric learning when it comes make asset allocation choices for clients who

The Center for Applied Research (State Street Corporation) | CFA Institute 51 were unable or unwilling to do so themselves, propose introducing an assessment of clients’ i.e., no habit is even needed! New products that motivational predispositions using a BIS/ make use of behavioral and event-based data BAS-type questionnaire at the outset of the to oer a personalized advice component could relationship. ese tests are designed to provide help investors with goal setting and attainment, a clearer picture of the psychological forces further stimulating their BAS sensitivity. that drive clients’ nancial decisions, thereby educating clients about their own sensitivities Communication between investment providers and behavioral biases. Both parties can use this and clients can be a signal for misaligned information to build a framework to develop or incentives and poor relationships, and there improve goal-setting habits and communication. is work for the industry to do here. It is worth remembering that communication A similar BIS/BAS assessment for professional includes two parts — a content part and a investors themselves may assist management relationship part. e relationship part can teams in improving their communication become the most important element of the with employees by understanding what drives communication if the relationship itself is them, perhaps even encouraging more eective not well de ned. When there is a lack of feedback among peers. Further, such an understanding with regard to the dierent assessment could help professional investors values of the parties communicating, the recognize their propensity for behavioral content part will invariably be misunderstood. biases that harm investment decisions.22 ese A healthy relationship means that you can learning and communication components communicate openly about goals and sincere can be used to form and improve goal- values to better serve the client’s needs. setting habits for investment professionals in a similar way to retail investors. Eective communication in an organizational setting includes delivering and receiving For retail investors, our research shows that eective feedback. Habit formation is simply having access to a de ned contribution impossible without an understanding of one’s plan and other retirement tools can serve as a own individual tendencies. erefore, we trigger to increase goal-oriented sensitivity.23

52 Discovering Phi: Motivation as the Hidden Variable of Performance were unable or unwilling to do so themselves, propose introducing an assessment of clients’ i.e., no habit is even needed! New products that motivational predispositions using a BIS/ make use of behavioral and event-based data BAS-type questionnaire at the outset of the to oer a personalized advice component could relationship. ese tests are designed to provide help investors with goal setting and attainment, a clearer picture of the psychological forces further stimulating their BAS sensitivity. that drive clients’ nancial decisions, thereby educating clients about their own sensitivities Communication between investment providers and behavioral biases. Both parties can use this and clients can be a signal for misaligned information to build a framework to develop or incentives and poor relationships, and there improve goal-setting habits and communication. “We have to give and take feedback. We should is work for the industry to do here. It is reward and encourage positive behaviors and worth remembering that communication A similar BIS/BAS assessment for professional celebrate success. We must learn and develop. includes two parts — a content part and a investors themselves may assist management relationship part. e relationship part can teams in improving their communication We judge things on a short-term duration and become the most important element of the with employees by understanding what drives we should closely look at our behaviors being communication if the relationship itself is them, perhaps even encouraging more eective developed as a result of short term measurement not well de ned. When there is a lack of feedback among peers. Further, such an understanding with regard to the dierent assessment could help professional investors strategies. We should be brave enough to address values of the parties communicating, the recognize their propensity for behavioral these behaviors.” content part will invariably be misunderstood. biases that harm investment decisions.22 ese A healthy relationship means that you can learning and communication components communicate openly about goals and sincere can be used to form and improve goal- values to better serve the client’s needs. setting habits for investment professionals in a similar way to retail investors. Eective communication in an organizational setting includes delivering and receiving For retail investors, our research shows that eective feedback. Habit formation is simply having access to a de ned contribution impossible without an understanding of one’s plan and other retirement tools can serve as a own individual tendencies. erefore, we trigger to increase goal-oriented sensitivity.23

The Center for Applied Research (State Street Corporation) | CFA Institute 53 Incentives Our 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.

54 Discovering Phi: Motivation as the Hidden Variable of Performance “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.”

e rst step toward developing an incentive We recommend that rms experiment with structure that encourages phi is to assess the new incentive structures that will facilitate fairness, controllability and transparency longer-term thinking. In our research, we of the existing system. Next, eliminate found that 39% of investment professionals short-term contingent rewards wherever would be pleased to have a performance possible (especially those perceived as most bonus on a two-to-ve year cycle versus unfair or least transparent). ese types the typical annual bonus. Some high- of incentives are the most likely to depart functioning teams might wish to adopt this from the alignment of the individual, now, and others can follow based on results. organization and clients' goals and values.24

The Center for Applied Research (State Street Corporation) | CFA Institute 55 “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.”

56 Discovering Phi: Motivation as the Hidden Variable of Performance Conclusion QUANTIFYING THE UNQUANTIFIABLE

We see great potential for phi in the We therefore have been searching for investment community because thus that “secret sauce” or hidden variable far, concepts such as motivation and that sustains firms through difficult purpose have not been measurable. times in the market cycle. With the In our industry we like numbers, and discovery of phi, we have found a way we have little interest in factors that to measure and describe this difference cannot be measured reliably. Still, we — and over time, we may even find it intuitively know there is a cultural has the power to transform our industry difference between firms that are highly into a more respected profession, regarded and those that are not. secure better outcomes for our clients and create greater value for society.

The Center for Applied Research (State Street Corporation) | CFA Institute 57 ABOUT THE TEAM

The Center for Applied Research CFA Institute

e Center for Applied Research (CAR), CFA Institute is the global association of investment an independent think tank residing at professionals that sets the standard for professional State Street’s corporate level, comprises a excellence and credentials. e organization is global team of researchers located across the a champion for ethical behavior in investment Americas, EMEA (Europe/Middle East/ markets and a respected source of knowledge in the Africa) and the Asia-Pacic region. global nancial community. e end goal: to create an environment where investors’ interests come rst, Building on the success of State Street's established markets function at their best, and economies grow. Vision thought leadership program, CAR brings together resources within the industry and CFA Institute has more than 148,000 members across State Street to produce timely research on in 158 countries and territories, including the topics that are most important to investors 141,000 CFA charterholders, and 147 member worldwide. CAR presents at conferences and societies. e CFA Institute Future of Finance provides executive briengs for clients and their initiative is a long-term, global eort to shape boards of directors as a value-add service. a trustworthy, forward-thinking investment profession that better serves society. If you would like more information about the studies or the Center for Applied Research, For more information, visit www.cfainstitute.org. you can contact the authors or send an email to [email protected].

Authors Contributors

Suzanne Duncan Rebecca Fender, CFA Mirtha Kastrapeli Paul Smith, CFA Mimmi Kheddache-Jendeby Roger Urwin, FSIP Phil Palanza

58 Discovering Phi: Motivation as the Hidden Variable of Performance Appendix and Notes

The Center for Applied Research (State Street Corporation) | CFA Institute 59 APPENDIX

Literature Review e theory presents three types of motivation: autonomous motivation, controlled motivation and Motivation is a topic that has been studied extensively amotivation. In contrast to amotivation, autonomous through time and across di erent academic disciplines. and controlled motivations are both intentional, but e application of this wealth of knowledge to the they are very di erent in nature. Only autonomous investment management industry, to gain new insights motivation makes a person perceive that he/she is and perspectives, is however conspicuous by its absence. acting with a sense of own-will, hence experiencing a choice.38 Moreover, the Self-Determination eory Motivation theories try to understand the “why” addresses both the “why” and the direction of behavior. of behavior and throughout time a number of As such, this theory was found well suited to use di erent perspectives on motivation have developed. when answering the problem statement above. Mechanistic theories view the human as passively being forced to act as a result of the interaction Motivation is a ected both by the social environment between psychological drives and environmental and by individual di erences. Within the SDT stimuli.25 Organismic theories on the other hand, framework these individual di erences are captured view humans as active, initiating behaviors by their 39 by measuring an individual’s causality orientation. own free will. Behavioral theories of motivation have is is the degree to which an individual experiences been viewed as mechanistic, focusing on behavior the social context as being controlling or controllable. as a response to stimuli and giving choice and 40 In previous research CAR identied that fear and intention a secondary role as determinants of behavior goals are two very strong drivers of human behavior (e.g. Freud 26).27 However, over time, motivational on an individual investor level. As a result the theories developed which found the explanatory 41 Biopsychological eory of Personality was identied power of behavioral theories unsatisfactory. ese as a more suitable theory to use within the context theories included the concept of self-direction of this paper, to measure individual di erences. e and choice (e.g. Vroom,28 and Bandura29).30 Biopsychological eory of Personality was developed by Gary42 and states that two motivation systems drive Another way to fragment motivational theories is behaviors, the behavioral inhibition system (BIS) to look at content-related motivation theories, that and the behavioral activation system (BAS). e BIS focus on why individuals are motivated (Reiss,31 system is sensitive to signals of punishment and avoids Herzberg32 and Hackman & Oldham33) and behavior that may lead to negative outcomes. As such, process-related motivation theories, that try to the BIS system keeps a person from achieving his/her explain how motivation turns into goal-directed goals. e BAS system, on the other hand, is sensitive behavior (Vroom34 and Locke & Latham35).36 to signals of reward and non-punishment and makes a person engage in goal-directed behavior.43 ese two e Self-Determination eory (SDT) is inuenced motivation systems are aligned with the behavioral by both mechanistic and organismic theories, saying drives identied in CAR’s previous research work. that only some intentional behaviors are truly chosen.37

60 Discovering Phi: Motivation as the Hidden Variable of Performance Survey Methodology managers, retail-oriented asset managers, blend retail/institutional asset managers (more retail- Primary research for this study includes a survey of oriented) and blend retail/institutional asset 6,938 investors, investment providers, and government managers (more institutional-oriented). Participating ocials and regulators across 20 countries. ese intermediaries include bank/broker-aliated countries are: Australia, Brazil, Canada, Chile, advisors, institutional consultants, independent China, France, Germany, Hong Kong, India, nancial advisors and insurance-aliated advisors. Italy, Japan, Mexico, e Netherlands, Singapore, Public entities include regulatory bodies and South Africa, Sweden, Switzerland, e United government ocials, as well as policymakers with a Kingdom, United Arab Emirates, and the United focus on nancial services-related policy matters. States. e retail investor component of the survey includes an equal weighting among these countries, e questions used to calculate phi for while the institutional and regulatory component professionals are listed below, with the reects the size of the relative nancial markets. option indicating higher phi marked in bold and weighted equally in the phi score. Survey data were collected in two rounds. First, CoreData collected information from 3,600 1. (On purpose) What motivates you to perform retail investors and 985 professionals on behalf of generally and in your current role? (Select top CAR through an online survey platform in May three): 2016. Second, CFA Institute conducted a survey to a targeted group of its members in these same a) e hope of receiving a big bonus/salary countries in June 2016, resulting in 2,353 additional increase. professional responses. Quantitative analysis was then conducted through a partnership with the State b) e fact that everyone can see my Street Center for Data Excellence and CoreData. performance and I do not want to look bad. Note that all percentages are rounded. Data were c) I know it is important to ful ll the end supplemented by over 200 in-person interviews client’s goals. with executives and government ocials.44 d) e feeling of doing something in the Participating institutional investors include service of something larger than myself government pension funds, corporate pension funds, (e.g. creating a better life situation for retail pension plans, sovereign wealth funds, central the end client, supporting the values of banks, insurance rms, healthcare institutions, my organization to achieve long-term endowments and foundations. Participating retail organizational growth). investors include mass market, mass auent and e) I just love what I do and would continue high net-worth individuals. Participating asset doing it even if I was not paid. managers include institutional-oriented asset

The Center for Applied Research (State Street Corporation) | CFA Institute 61 2. (On habits) What is the reason that you are 3. (On incentives) Which description most closely still working in the investment management matches the way you think about your work? industry? (Select up to two) a) As a job (I work only for the sake of the a) I am reasonably satised with my job. money. I am really happy when the weekend comes and I satisfy my intellectual curiosity b) It is where the money is, i.e. where I can earn and interests via hobbies and not work.) the most. b) As a career (My work energizes me, and c) I like the status that a job in this industry my aim is to advance and get promoted. I brings. sometimes bring work with me home since I d) I am passionate about the markets. want to deliver excellent results. Sometimes I do however wonder about the meaning and e) I am inspired by a family member/industry importance of what I do.) gure. c) As a calling (I am devoted to my work. f) I can help people and organizations achieve When working I feel that I am part of their nancial goals. something larger than myself. e value my eorts bring is clear to me, and I never g) I like working with very smart people. question the meaning of what I do. I would h) I help facilitate economic growth and continue to work even if I was independently development. wealthy.)

i) It would be too dicult to change jobs and pursue a new career in another industry.

j) I am thinking about quitting.

62 Discovering Phi: Motivation as the Hidden Variable of Performance 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.

The Center for Applied Research (State Street Corporation) | CFA Institute 63 ENDNOTES

1 Phi is the 21st letter in the Greek alphabet 9 Robert Eisenberg and Judy Cameron, and has been used as a variable in many elds. “Detrimental E¥ects of Reward: Reality or One of the most common uses is the Golden Myth?” American Psychologist, 51:1153-1166, Ratio, and the concept of balance conveyed in 1996, and Edward L. Deci, Richard Koestner that is a useful reminder of the balance needed and Richard M. Ryan, “A Meta-Analytic between principals and agents in investing. Review of Experiments Examining the E¥ects of Extrinsic Rewards on Intrinsic Motivation,” 2 David Blanchett and Paul Kaplan, “Alpha, Beta, and Psychological Bulletin, 125, 627-68, 1999. Now…Gamma,” e Journal of Retirement, 2013. 10 Ernst Fehr and Simon Gachter, “Fairness and 3 Chmiel, N. (2008), An Introduction To Retaliation: e Economics of Reciprocity,” Work and Organizational Psychology: A Journal of Economic Perspectives, 14 (3):159- European Perspective. Oxford, UK, and 181, 2000, and Deci, E.L. (1975), Intrinsic Malden, Mass.: Blackwell Publishing. Motivation. New York and London: Plenum Press.

4 N=2417 Respondents were able to select 11 William N. Goetzmann and Sharon Oster, up to two possible responses. “Competition Among University Endowments,” NBER Working Paper No. 18173, June 2012. 5 N=2417 Respondents were able to select up to two possible responses. 12 Another 20% responded “Neutral” to the question, which is nearly as alarming. 6 It is notable that CFA members had signi cantly higher responses to these questions than other 13 Respondents were allowed to choose investment professionals, with 43% of CFA more than one option, which makes the members saying they are passionate about the 32% gure even more disconcerting. markets versus 33% for others, and 30% of CFA members saying their motivation was 14 e questions in full can be found in the appendix. helping clients achieve their goals, versus 24% for other investment professionals. 15 Banerjee, Sudipto, 2014 “Take it or leave it? e Disposition of DC accounts: Who Rolls Over into 7 Deci, E.L. (1975), "Intrinsic Motivation." an IRA? Who Leaves Money in Plan and Who New York and London: Plenum Press. Withdraws Cash?" EBRI Notes May 2014, Vol.35, No. 5; http://www.nber.org/papers/w17345 8 Herzberg, F., Mausner, B. and Snyderman, B.B. (1959), e Motivation to Work. New York: Wiley. 16 Henk ierry, “Payment by Results Systems: A Review of Research 1945-1985,” Applied Psychology, 36: 91-108, 1987.

64 Discovering Phi: Motivation as the Hidden Variable of Performance 17 Doshi, N., and McGregor, L. (2015), 21 Duhigg, C. (2012), e Power of Habit: Primed to Perform – How to Build the Highest Why We Do What We Do and How to Performing Cultures rough the Science of Total Change. Great Britain: Random House. Motivation. New York: HarperCollins. 22 Charles S. Carver and Teri L. White, “Behavioral 18 Christopher K. Bart, “Sex, Lies and Mission Inhibition, Behavioral Activation, and A¯ective Statements,” Business Horizons, 9-18, November- Responses to Impending Reward and Punishment: December 1997. Web. http://papers.ssrn.com/ e BIS/BAS Scales,” Journal of Personality and sol3/papers.cfm?abstract_id=716542 and Jean- Social Psychology, Vol. 67, No. 2. 319-333, 1994. Baptiste Michel*, Yuan Kui Shen, Aviva Presser Aiden, Adrian Veres, Matthew K. Gray, William 23 State Street Center for Applied Research survey Brockman, e Google Books Team, Joseph analysis 2016; Robert Eisenberg and Judy P. Pickett, Dale Hoiberg, Dan Clancy, Peter Cameron, “Detrimental E¯ects of Reward: Norvig, Jon Orwant, Steven Pinker, Martin A. Reality or Myth?” American Psychologist, Nowak, and Erez Lieberman Aiden*. Quantitative 51:1153-1166, 1996; and Ernst Fehr and Analysis of Culture Using Millions of Digitized Simon Gachter, “Fairness and Retaliation: Books. Web. https://books.google.com/ngrams/ e Economics of Reciprocity,” Journal of graph?content=Mission+statement&year_ Economic Perspectives, 14 (3): 159-181, 2000. start=1800&year_corpus=15&smoothing= 3&share=&direct_url=t1%3B%2CMission 24 Atkinson & Hilgard’s (2009), Introduction to +statement%3B%2Cc0 Psychology (15th edition), Cengage Learning.

19 Christopher K. Bart, “Sex, Lies and Mission 25 Fahlke, C. & Johansson, M. P. Statements,” Business Horizons, 9-18, November- (2007), Personlighetspsykologi, December 1997. Web. http://papers.ssrn. Stockholm: Natur och Kultur. com/sol3/papers.cfm?abstract_id=716542 26 Ryan R and Deci E (1985), Intrinsic Motivation 20 State Street Center for Applied Research 2016 and Self-Determination in Human Behavior, Study Interview: R. Rajan calls this an “arms- Springer Science + Business Media: New York length «nancial system.” Rajan notes that this system is particularly problematic for two reasons. 27 Vroom, V. H. (1964) Work and Motivation. First, there is little sense, for the investment San Francisco: Jossey-Bass. professional, of material results of her work (“she is merely a cog in a gigantic machine”). And second, 28 Zimmerman B., Bandura A. and Martinez- the most direct measure of societal contribution Pons M. (1992) "Self-Motivation for Academic is measured by money, “pro«ts and returns.” Attainment: e Role of Self-E´cacy Beliefs and He adds that “arms-length transactions do not Personal Goal Setting", American Educational foster empathy or a long-term focus,” qualities Research Journal, Vol. 29, No.3, 663-676 necessary to achieve sustainable performance.

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

The Center for Applied Research (State Street Corporation) | CFA Institute 65 30 Reiss S (2000) Who am I? – e 16 Basic Desires 40 State Street Center for Applied Research, that Motivate Our Actions and Determine Our "e Folklore of Finance: How Beliefs Personality, New York:Tarcher/Putnam. and Behaviors Sabotage Success in the Investment Management Industry", 2014. 31 Hertzberg F (1966) Work and the Nature of Man, Cleveland: World Publishing. 41 Charles S. Carver and Teri L. White (1994), "Behavioral Inhibition, Behavioral Activation, 32 Hackman, J. R., and Oldham, G. R. (1976) and Aective Responses to Impending "Motivation through the design of work: Reward and Punishment: e BIS/BAS Test of a theory, Organizational Behavior Scales", Journal of Personality and Social and Human Performance", 16, 250-79. Psychology, Vol. 67, No. 2. 319-333

33 Vroom, V. H. (1964) Work and Motivation. 42 Charles S. Carver and Teri L. White (1994), San Francisco: Jossey-Bass. "Behavioral Inhibition, Behavioral Activation, and Aective Responses to Impending 34 Locke, E. A. and Latham, G. P. (1990), Reward and Punishment: e BIS/BAS A eory of Goal Setting and Task Performance, Scales", Journal of Personality and Social Englewood Clis, NJ: Prentice Hall Psychology, Vol. 67, No. 2. 319-333

35 Chmiel Nik, (2008) An Introduction To Work 43 Charles S. Carver and Teri L. White (1994), and Organizational Psychology, A European "Behavioral Inhibition, Behavioral Activation, Perspective, Blackwell Publishing and Aective Responses to Impending Reward and Punishment: e BIS/BAS Scales", Journal of Personality and Social 36 Ryan R and Deci E (1985), Intrinsic Motivation Psychology, Vol. 67, No. 2. 319-333 and Self-Determination in Human Behavior, Springer Science, Business Media: New York 44 Retail Investor survey was conducted by CoreData on behalf of the Center for Applied Research. e 37 Gegne M, and Deci E. (2005), "Self-Determination sample size for this survey is 3600 (of a total of eory and Work Motivation", Journal of 82,597 invited, a 4.4% response rate) with a margin Organizational Behavior, 26: 331-362 of error of 1.6% at 95% con¡dence. One professional investor survey was conducted by CoreData on 38 Autonomy orientation can be measured by behalf of the Center for Applied Research. e using e General Causality Orientation sample size for this survey is 985 (of a total of Scale (GCOS) developed by Deci and 27,391 invited, a 3.6% response rate) with a margin Ryan. Deci E. L., Ryan R. M. (1985) of error of 3.07% at 95% con¡dence. A second professional investor survey was conducted by the 39 "e General Causality Orientation Scale: CFA institute of its members. e sample size for Self-determination in personality", Journal this survey is 2,353 (of a total of 66,159 invited, a of Research in Personality, 19: 119-142. 3.6% response rate) with a margin of error of 1.98%.

66 Discovering Phi: Motivation as the Hidden Variable of Performance Acknowledgments We 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.

The Center for Applied Research (State Street Corporation) | CFA Institute 67 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 State Street Corporation October 2016 and are subject to change based on market and other conditions. This State Street Financial Center 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 One Lincoln Street actual results or developments may differ materially from those projected. Boston, Massachusetts 02111–2900 +1 617 786 3000 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, www.statestreet.com reliability or completeness of, nor liability for, decisions based on such information and it © 2016 State Street Corporation should not be relied on as such. All Rights Reserved The whole or any part of this work may not be reproduced, copied or transmitted, or any 16-27864-1016 CORP-2343 of its content disclosed to third parties without State Street’s express written consent.

68 Discovering Phi: Motivation as the Hidden Variable of Performance Blockchain innovation in wealth and asset management

Benefits and key challenges to adopting this technology

EY (Ernst & Young) 69 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

70 Blockchain Innovation in Wealth and Asset Management Introduction

Overview Evolution of blockchain Blockchain, the underlying technology of bitcoin, is drawing significant focus and investments from technology many financial institutions in the industry. Given Blockchain technology as we know it the technology’s potential to both disrupt and today emerged in January 2009 as enhance processes and systems, many firms have the underlying technology of bitcoin. recently dedicated resources to understand and While bitcoin created initial noise in the integrate blockchain into their businesses. financial world, blockchain technology gained prominence as a hot topic of This article will discuss how wealth and asset discussion by itself. 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 Continued development applications for blockchain and how to approach As funding from venture capital firms blockchain innovation. 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.

EY (Ernst & Young) 71 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 356Block 357 Inception-to-date Inception-to-date Inception-to-date record of record of record of transactions transactions transactions

1 234

New transactions New transactions New transactions

72 Blockchain Innovation in Wealth and Asset Management Applications of blockchain to wealth and asset management

Blockchain 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.

Financial Banking Portfolio Social media and money planning management movement

Client Regulatory portfolio AML reporting

Application of blockchain in wealth management Blockchain 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.

EY (Ernst & Young) 73 74 Blockchain Innovation in Wealth and Asset Management Use case 1: client onboarding and profiling

Key drivers Blockchain 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.

Challenges Approach

• Strict onboarding requirements • Profile stored on a blockchain/distributed ledger • Proof of identification • Trusted parties are granted access to all or part of • Residency the profile based on cryptography • Marital status • New relationships would be initiated by profile owner • Sources of wealth • The system inherently enables an audit trail for tracking • Occupation changes to the chain. As a result, processes • Business interests requiring fact-checking, such as AML, are simplified • Political ties • Integrate blockchain technologies into onboarding and • Complying with numerous reporting requirements ACH and ACAT systems and processes • Information security procedures • Ongoing monitoring of profiles • Automated clearinghouse (ACH) and automated customer account transfer (ACAT) systems take multiple days and involve manual processes using multiple systems and databases

Beneﬁts

• Can facilitate many key functions of onboarding: • Can enhance or possibly replace traditional systems, • Client and risk proﬁling such as ACH and ACAT • Financial planning • Enables near-instantaneous transfers of assets between • Anti-money laundering checks and money movement ﬁnancial institutions with authenticated provenance of tracked changes

EY (Ernst & Young) 75 Use case 2: model management and trade order generation

Key drivers The 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.

Challenges Approach

• A wealth and asset manager using different platforms • Investment managers would create and maintain a and data architectures causes difﬁculties in distributing, model — similar to how they do it today. monitoring and updating third-party models. • Models could be transmitted through a blockchain to • Firms must support redundant model management various subscribed brokers. systems. • Individual accounts can be invested according to the • Managers are often required to email models to model. program sponsors or use proprietary portals. • Customization for restrictions and other account-level constraints can be stored and applied.

Beneﬁts

• Will allow other account transactions and trades to be • Can reduce the amount of reconciliation needed by shared more easily moving from the current segregated master ledger to a • Can provide near-real-time performance, portfolio risk secure, distributed one and drift data, allowing managers to observe more • Reduces the need for some intermediates responsible easily and have greater insights for settling and executing trades

76 Blockchain Innovation in Wealth and Asset Management Distributed Technology allows the distribution of trusted value transfer and execution, infrastructure allowing the disintermediation of intermediaries: the network becomes the intermediary.

Allows the move from master ledgers, e.g., clearinghous es, banks ...

... to distributed ledgers with no intermediaries

EY (Ernst & Young) 77 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 “ Business cases change later on the distributed ledger. should drive 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, technology can only achieve 7 transactions per second compared to Visa’s VisaNet, which currently 1 solutions, not achieves 50,000+ transactions per second. There are also significant unknowns related to the regulatory and legal hurdles that exist in the other way 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 around.” 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.

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

80% 70% 60% 50%

30%30%

Technology Smart contract Interoperability Successful Demonstrated Security standards standards with legacy proof ability to systems of concept handle volume, resiliency, etc. Source: 2016 EY Blockchain Capital Markets Roundtable.

78 Blockchain Innovation in Wealth and Asset Management EY (Ernst & Young) 79 A practical approach to blockchain

Blockchain 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 and threats and defining relevant use cases for analysis • A team structure that includes key stakeholders, as well as select subject-matter experts 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 execution road map

80 Blockchain Innovation in Wealth and Asset Management Sample opportunity framework approach

Process Business expertiseUse case solutioning

es • Establish a framework for use • Define business requirements • Review and validate use case

iv case assessment and document use cases assessment findings with key identified during framework stakeholders Object

• Define use case catalog • Conduct workshops with • Review and agree upon initial use • Identify cross–functional team identified participants based case assessment with key • Perform preliminary review of on use cases identified from stakeholders use case opportunities the preliminary opportunity • Conduct final workshops with

es • Identify in-house and external review identified participants workshop participants • Group and categorize use case • Further define use cases with vi ti

ti • Socialize, review and seek opportunities key participants

ac approval from key stakeholders • Socialize, review and seek • Prioritize use case assessments y approval from key stakeholders and summarize them for Ke • Identify use cases that warrant leadership extended solutioning in the next • Identify and confirm with key phase stakeholders use cases that warrant extended solutioning

• Target requisite workshop • List of key use cases/ • Presentation of key findings participants assumptions for stakeholder to stakeholders ut

tp • List of preliminary use cases/ presentation • Detailed use case assessment

Ou assumptions document

The next logical step is to focus on developing solutions — first working in a vacuum can delay implementation, or possibly on a small scale internally, but gradually ramping up to larger, result in significant rework to integrate new solutions into more impactful internal and client-facing solutions. Several existing systems and business processes. The most successful firms have adopted this approach through an innovation firms define the frameworks for innovation up front and strategy. This strategy is usually defined as the process for then work within the prioritization set earlier to develop the assessing the opportunities previously identified in your solutions. analysis, determining the impacts to current business models It is also possible that the technology solution may not need and strategies, and creating solutions to take advantage of to be developed in-house. There are currently dozens of those opportunities and impacts. blockchain technology providers, and more are launching on In several cases, firms have implemented an innovation a regular basis. Once the concepts have been detailed during strategy through an “innovation lab,” where teams can focus the innovation phase, the next step involves aligning the on evaluating the opportunities and developing proofs of solution to your technology strategy and competencies. Many concept and working prototypes to explore the possibilities firms — even some of the largest players in the wealth and of blockchain. While some of these innovation labs start as asset management space — are collaborating to implement individual, stand-alone groups, many are developed with the blockchain solutions; the largest consortiums in the space today idea that the output will eventually be integrated into the (Hyperledger) include many firms that would normally build organization’s business lines. Most firms now realize that solutions in-house on their own.

EY (Ernst & Young) 81 “ Innovation What to do next? distinguishes With so much confusion regarding FinTech and blockchain, many firms are unsure of where to turn next and how to spend their very limited between a leader strategic dollars. Given that the success of a blockchain solution rests in its distributed nature and the willingness of the participants in the chain and a follower.“ to work together, many firms are shying away from an initial aggressive approach. However, to be successful within an industry such as wealth and – Steve Jobs 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 of concept) by first working to develop and use blockchain internally, and then working to expand the solutions internally until they are incorporated into your business model • Work with a partner to accelerate the process as needed

82 Blockchain Innovation in Wealth and Asset Management Contact us

Nalika Nanayakkara Charles Smith Zackary Nassir Principal Executive Director Senior Manager Financial Services Organization Financial Services Organization Financial Services Organization Ernst & Young LLP Ernst & Young LLP Ernst & Young LLP +1 212 773 1097 +1 212 773 3518 +1 949 437 0313 [email protected] [email protected] [email protected]

Angus Champion de Crespigny Matthew Hatch Ryan Hinkis Financial Services Blockchain Partner Manager and Distributed Infrastructure Ernst & Young LLP Financial Services Organization Strategy Leader +1 415 894 8219 Ernst & Young LLP Ernst & Young LLP [email protected] +1 212 773 1479 +1 212 773 6717 [email protected] [email protected]

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84 Blockchain Innovation in Wealth and Asset Management Sustainable investing SustainableInvestor's guide to corporate governance investing CIO WM Research | 30 March 2017 Investor'sStephen Freedman guide, CFA, Strategist, to corporate stephen.freedman@ubs.com; governance Renato Grandmont, Regional CIO Latin America, [email protected]

CIO WM Research | 30 March 2017 Stephen Freedman, CFA, Strategist, [email protected]; Renato Grandmont, Regional CIO Latin America, [email protected] • Corporate governance considerations have been getting greater attention among investors in recent years. This has • Corporatebeen driven governance by two factors: considerations a) the frustration have withbeen the getting short- greaterterm orientation attention oftenamong prevailing investors in in financial recent years. markets, This with has beencorporate driven governance by two factors: seen a)as the a wayfrustration to extend with investment the short- termtime orientationhorizons; and often b) prevailingthe realization in financial that company markets, valuewith corporateis driven increasingly governance byseen factors as a notway availableto extend in investment traditional timecorporate horizons; financial and b)reporting, the realization with corporate that company governance value isviewed driven as increasingly a tool to gain by afactors fuller picturenot available of the company.in traditional • corporateInvestors focusingfinancial on reporting, corporate with governance corporate should governance seek to viewedunderstand as a toolhow to a gaincompany's a fuller boardpicture of of directors the company. operates, Source: UBS • Investorswhether itsfocusing composition on corporate is adequate governance to face shouldthe company's seek to understandchallenges, howand awhether company's the board board of hasdirectors the necessaryoperates, Source: UBS whetherindependence its composition from management is adequate or controlling to face the shareholders company's challenges,to assume itsand oversight whether responsibilities. the board has An theunderstanding necessary Related Sustainable Investing (SI) research independenceof management from compensation management orand controlling incentives, shareholders possible toconflicts assume of itsinterest, oversight and responsibilities. the degree of Antransparency understanding and • Sustainable value creation in emerging Related Sustainable Investing (SI) research ofdisclosure management is also vital.compensation and incentives, possible markets (update report, January 2017) • conflictsWe look of at interest, academic and evidencethe degree that of transparencyshows corporate and • SustainableDoing well valuewhile creationdoing good:in emerging impact disclosuregovernance is alsoanalysis vital. has provided valuable information to marketsinvesting (update (May 2016) report, January 2017) investors in the past, at times improving performance, and at • We look at academic evidence that shows corporate • Doing well while doing good: impact the very least has been a powerful risk management tool. We governance analysis has provided valuable information to Source:investing UBS (May 2016) investorsalso provide in the four past, case at timesstudies improving of corporate performance, scandals andacross at thethe veryworld, least which has been document a powerful how risk corporatemanagement governance tool. We Source: UBS alsofailures provide contributed four case to thestudies demise of ofcorporate the affected scandals companies. across • theInvestors world, whichcan documentincorporate howcorporate corporate governancegovernance failuresconsiderations contributed into to thetheir demise investment of the affected process, companies. typically • Investorsthrough an caninvestment incorporate manager, corporatein two ways: governance 1) make considerationscorporate governance into theiranalysis investment part of the process, security selectiontypically throughprocess; anand investment 2) influence manager, corporate in twogovernance ways: 1) policies make corporateand behavior governance through analysis active partownership, of the securitysuch as selection actively process;voting proxies and 2)at influenceshareholder corporate meetings, governance engagement policies with andmanagement, behavior throughor filing shareholderactive ownership, proposals such (or asrelying actively on votingan asset proxies manager at shareholderto take these meetings, steps on theirengagement behalf). with management, or filing shareholder proposals (or relying on I. anIntroduction: asset manager to takeWhy these focus steps on theiron behalf).corporate governance? I. Introduction: Why focus on corporate governance?In today’s economic model dominated by shareholder capitalism, the owners of most companies are not the key corporate decision- Inmakers; today’s instead, economic they model have todominated rely on others by shareholder to be the stewards capitalism, of thetheir owners invested of capital.most companies Shareholders are not rely the on keya board corporate of directors decision- to makers;oversee theinstead, company's they have activities to rely and on set others its broad to be strategic the stewards direction. of theirThe board, invested in turn,capital. relies Shareholders on an executive rely on management a board of teamdirectors to run to overseethe business. the company's activities and set its broad strategic direction. The board, in turn, relies on an executive management team to run the business. UBS 85 This report has been prepared by UBS Financial Services Inc. (UBS FS). Please see important disclaimers and disclosures at the end of the document. This report has been prepared by UBS Financial Services Inc. (UBS FS). Please see important disclaimers and disclosures at the end of the document. Given the number of actors involved, investors need to understand Fig. 1: Intangible assets comprise the bulk of what incentives boards and management teams have to act in market value shareholders' interest rather than follow their own agenda. Components of S&P market value in %, 2015

Corporate governance is a central concept in this regard. It repre- 100% 90% sents the set of rules and processes that determine how a company 80% is controlled and operated. Some of these rules are based on legal 70% and regulatory norms in particular jurisdictions, and others may arise 60% 50% Intangible assets from listing requirements or voluntary codes of best practice. 40% Tangible assets 30% Since corporate governance standards vary significantly across 20% 10% firms, there is a solid case for investors to incorporate such factors 0% when selecting companies. They are an important driver of value, 1975 1985 1995 2005 2015 and it is therefore critical for investors to distinguish between com- 1 panies with good and bad governance. Yet, we often still find that Source: Ocean Tomo , UBS 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 disclosure need to be understood by investors to make informed decisions. 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 increasingly 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 incorporated in their portfolios.

86 Sustainable Investing: Investor’s Guide to Corporate Governance 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 performance, 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 companies 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 international work such as the OECD's Principles of Corporate Governance. An example is the German Corporate Governance Code. It contains 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 corporate 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.

UBS 87 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 governance practices at individual companies in light of the relevant regulatory framework and best practices among peers can be challenging. 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 Fig. 2: Board gender diversity tends to expand available skills For analysts and investors, corporate governance can appear to be Percentage of US small-cap boards possessing each a vast and at times intractable topic. Corporate governance cannot expertise be fully appreciated with a standard checklist of issues. A number of

substantive questions must be asked about the company's values, Financial management and corporate structure, policies and the treatment Operations Accounting of shareholders. Combined insights from all these dimensions of International analysis help to gain a fuller picture. Still, it helps to divide the issues M&A Strategy around key topic clusters. Leadership Technology Regulatory 1. Board composition Corporate governance A company's board of directors is the body that is ultimately Marketing Political answerable to shareholders. To assume such responsibility the board Sustainability needs to exhibit the necessary skills, experience and ability to Risk management Human resources operate well as a team. Research & development 0% 20% 40% 60% 80% 100% For investors, it can be useful to consider the skills, experience and other relevant attributes of individual board members but also how Note: Light bars indicate skills the authors founds complementary they are. These are some factors to consider when women board members were more likely to possess. assessing a board: Source: Daehyun and Starks (2016)8.

• 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, but rather to view it in the company's business context. For example, a board composed of seasoned industry veterans with very similar backgrounds may be appropriate in a stable sector, but could signal the risk of strategic errors in a sector facing rapid structural change.

Investors are increasingly focusing on the board's diversity. The benefits of more diverse boards in terms of the quality of decision- making has been well documented by a substantial body of research.6,7 A key insight is that diversity of gender, cultural and ethnic 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 that in the US, more gender diverse boards may exhibit a broader set of functional expertise8 (see Fig. 2).

88 Sustainable Investing: Investor’s Guide to Corporate Governance 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 counterparts, 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.

2. Board independence Fig. 3: Improving US corporate governance The board exists to set strategic direction and to oversee the trends company's management and ensure that it is behaving in the % of S&P 500 companies interest of all shareholders. As such, a critical question is whether % of independent directors the board is independent of executive management, in particular Women as a % of all directors the CEO. Factors to consider include the following: Boards with at least one woman

% of CEOs serving on an outside board • Are the positions of CEO and Chair of the board separate? 2016 Boards where CEO is the An increasingly widespread view is that separation of the roles only non-independent 2011 leads to better oversight and accountability. A number of coun- Independent chairman 2006 tries actively recommend this principle in norms and codes (e.g. CEO is also chairman % of audit committee chairs who are the UK, Australia, Switzerland, Hong Kong). Even in the US, active CEO, chair, president or vice chair where this is not the case, there has been a shift in that direction Boards offering stock option program among companies in recent years. According to Spender Stuart, 0% 20% 40% 60% 80% 100% the fraction of US companies with dual chair/CEO roles fell from 67% in 2006 to 52% in 2016.9 One should note that there are also arguments against separation, particularly concerning the Source: Copyright © 2016 Spencer Stuart9, UBS greater knowledge of the company that a CEO/chair will have. • What is the position of independent directors? In cases where the CEO and the chair are the same person, is there an independent lead director in the board to counterbalance the chair? What proportion of board members is independent compared to mandatory thresholds? Is turnover of board members encouraged, e.g. through term limits or a mandatory retirement age, to help prevent the board from becoming too cozy with management? • What is the committee structure within the board? In particular, is there an audit committee with sufficient independent board members? Are senior executives of the firm allowed to join board committee, in particular the compensation committee? Are the committee chairs independent directors? Is there a governance committee?

3. Compensation and incentives Financial incentives are a very powerful instrument in guiding behavior. Company management is no exception. It is therefore essential for investors to ascertain whether executive compensation provides an appropriate alignment of interest between senior executives 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 they appropriate?

UBS 89 • Does senior management compensation provide incentives to focus on delivering sustainable value over the long run or is it based on relatively short-term results? For instance, how long is the vesting period for incentive compensation and are there claw-back provisions under certain circumstances? • Are severance payments for senior executives within a reasonable range?

4. Conflicts of interest / treatment of shareholders The overall commitment of a company's CEO and board to treating minority shareholders fairly is a key concept of corporate governance. Accordingly, important elements of corporate governance are related to the alignment or misalignment of incentives between the shareholders on one side and the board and executive team on the other. These are some aspects to consider:

• Is the market for corporate control allowed to function and discipline corporate leadership? For instance, are there excessive takeover defenses in place that could perpetuate board and management entrenchment against shareholder interests? • Are there multiple share classes with different voting rights? This can allow company insiders (for example, the founder) to control the company, without the need to provide a majority of the firm's capital. • Do shareholders have enough input on key corporate decisions? For example, are they consulted on compensation packages?

5. Transparency and disclosure A final aspect of corporate governance is the amount and the quality of transparency and disclosure that companies provide to their investors. The quality of financial disclosure is a critical factor here. For instance, analysts spend time and effort evaluating how conservative the assumptions embedded in earnings reports are. This helps them determine whether current results can be repeated in the future. Disclosure of contingent liabilities, expensing of options, related party transactions, executive use of corporate assets and cash, and political donations are additional examples of best practice disclosure. IV. Benefits of focusing on corporate governance for investors

Empirical evidence Over the last several decades, numerous studies have been done on the effects of corporate governance on performance across large sets of companies. The general conclusion is that corporate governance can be valuable as a risk mitigation tool.

Research on the US stock market in the 1990s found that an investment strategy that bought firms with the strongest shareholder rights and sold firms with the weakest rights would have significantly outperformed.

90 Sustainable Investing: Investor’s Guide to Corporate Governance 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

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

Researchers found that US companies whose boards or audit committees had an independent director with financial expertise were less likely to face an accounting scandal in which they had to restate their earnings.12

Another study of the US market found that between mid-2001 and mid-2003, companies with above average corporate governance scores and positive momentum in the score outperformed companies with below average score and negative momentum, with most of the effect arising from the momentum (i.e. corporate governance improvement).13 The same study also found that for UK stocks, market both positive scores and momentum led to outperformance between 2001 and 2003.

The insight that a relatively straightforward measure of corporate governance could be relied on to add value to portfolios seems to have been recognized by analysts and integrated into the investment decision. As a result, more recent evidence (since 2000) reveals that such strategies no longer exhibit a clear pattern of outperformance.14, 15

This doesn't mean that corporate governance information can now be ignored. It just suggests that it requires more thoughtful analysis than simply using a governance score to eliminate companies from portfolios. Evidence still shows that corporate governance information can be very useful for the investment decision, particularly when managing a portfolio's risk. For example, a recent study found that firms ranking higher across a variety of corporate governance indicators had a lower probability of experiencing a stock price crash over the following year.16 There is also evidence that a focus on corporate governance can be a source of value through shareholder engagement (more in Section V).

UBS 91 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 governance 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 Fig. 5: Corporate governance failures illus- from being blindsided by risks and to extend their investment time trated in case studies horizon. Finally, it can serve as a basis for shareholder engagement HIH strategies. Parmalat Satyam Enron Insurance CEO / No Not really Case studies: Insights for corporate governance failures Chair duality While corporate governance matters under business-as-usual cir- Independent No No No cumstances, its implications are perhaps best illustrated by relying board on cases of corporate failures where poor governance was a central Audit Not Not Not factor. committee independent qualified independent Short-term performance Yes In recent decades, many instances of corporate abuse have occurred orientation when the controlling shareholders sought to take advantage of Auditor No No minority shareholders. Entrenched management teams and boards independence have also often played a big role in abusing company assets and Sound shareholder trust. In most cases, even those where financial fraud management No incentives was at work, a closer look reveals that poor corporate governance principles and practices such a perverse incentives, weak Source: Endnotes 20-23, UBS 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 governance 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 consider corporate governance at the level of security selection and of shareholder engagement.

92 Sustainable Investing: Investor’s Guide to Corporate Governance ESG integration: Make corporate governance analysis a part of your security selection If, as documented above, corporate governance influences a company's risk and valuation, analysts would be expected to incorporate 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 relevant, factors into investment decisions. ESG factors become relevant over a time horizon that is somewhat longer than those of Fig. 6: Percentage of US shareholder proposals most analysts. A sound understanding of these factors requires By type, 2006-15 and 2016 an appreciation of how corporate activities affect a broad range of stakeholders and how these interactions ultimately determine 2016* value creation for shareholders in the longer term. As a result of these commonalities, investment managers who emphasize corporate governance often also incorporate relevant environmental Corporate Governance 2006-15 and social factors into their investment process. Executive Compensation Social Policy Shareholder engagement: Influence through active ownership Incorporating 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 Source: ProxyMonitor.org.18 250 largest publicly traded investors can take to be more active owners of the underlying American companies, by revenues, as determined by companies in their portfolios. The purpose is to promote better Fortune. magazine.(*) In 2016, based on 231 com- corporate governance practices, including greater disclosure, more panies holding annual meetings by August 31. diverse board composition and other aspects discussed in Section III. Such efforts are typically undertaken at the investment manager Fig. 7: Deeper look at US shareholder proposals level. Shareholder proposals per 100 companies Shareholder engagement includes: Environmental Concerns • Actively and independently voting through proxy at share- Political Spending or Lobbying holder meeting: ESG topics are increasingly making they way Separate Chairman / CEO onto the ballot at annual meetings. The easiest way for an Voting Rules 2015 Proxy Access investment manager to try to induce change at a company is by 2016* independently assessing what preferable outcomes are rather Special Meetings / Written than automatically following management recommendations. Human Rights • Conducting informal discussions with companies: asset man- Employment Rights agers often have access to company boards or management 0 5 10 15 20 25 30 teams. They can use these interactions to raise concerns about 18 ESG topics. This is often a first step in addressing issues. Such Source: ProxyMonitor.org. 250 largest publicly traded American companies, by revenues, as determined by interactions can often help change company behavior, espe- Fortune. magazine.(*) In 2016, based on 231 com- cially when the investment manager is large, persistent or the panies holding annual meetings by August 31. concerns are shared by other investors. • Filing shareholder resolutions: this is the most active approach and involves submitting a proposal for a vote at the annual shareholders' meeting. This is often viewed as a last resort after attempts to sway company management fail.

Florida's State Board of Administration (SBA), the agency responsible for investing the assets of Florida's retirement system, conducted a study in 2015 to evaluate the value of its proxy voting practices.19 UBS 93 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 supported 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 dissident was elected.

VI. Appendix: Case studies

Enron: A corporate scandal Enron'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 followed 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 positions 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

• The board did not fulfill its fiduciary duty, failing to critically and independently supervise the company's activities. Many board members had a long tenure – more than 20 years in several instances. • Financial incentives further reduced their independence as board members were receiving stock compensation as well as fees for consultancy. There is little evidence that Enron's problems were concealed from the board, and much indicating that it failed to act. • There were significant problems with management compensation. First, the board approved excessive amounts of compensation for company executives, while failing to monitor the cash drain caused by these compensation plans. Second, there was a heavy reliance on stock options as an instrument of senior management compensation, which may have provided incentives that exacerbated short-term profit seeking. • Enron’s auditor Arthur Andersen lacked independence as it was receiving considerable fees for consultancy services.

Parmalat: Italian dairy and food producer The Italian multinational company Parmalat was a world leader in the food and dairy industry, which went into bankruptcy in late 2003 following revelations of accounting fraud.

94 Sustainable Investing: Investor’s Guide to Corporate Governance 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 shareholders. 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 chair and the CEO were the same person, which was not common in Italy at that time. • The board of directors included a minority of non-executive directors, and among them few could be considered independent. • The internal control committee (audit committee) had no independent members in violation of the Italian corporate governance code. Two members were on the executive committee and the third member was the Tanzi family's accountant, and therefore hardly independent.

These corporate governance features at Parmalat made control functions highly ineffective and helped perpetuate the financial abuse by the controlling shareholder.

Satyam: Indian IT company By 2008, Satyam had been grown by its chairman and founder Ramalinga Raju into a global IT services provider with over 50,000 employees globally across sixty seven countries. It had received numerous accolades and had been listed on the New York Stock Exchange since 2001. Yet, it was about to give rise to the biggest corporate scandal in India at the time. In early 2009, after a loss of investor confidence, a plunge in the share price and allegations of bribery, Raju admitted to fraudulent financial reporting, resigned and 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 been visible. In addition, significant corporate governance deficiencies have been identified that contributed to enabling fraud on such a large scale.

• While the chairman and the CEO positions were nominally separate, the CEO was Raju's brother, with a clear lack of independence between the two. This was a case of an all-powerful chairman. • On the surface, the board of directors did not appear to lack non-executive members and included audit, compensation, and investor grievance committees. However, a closer look actually revealed a lack of independence as most board members came from overlapping social circles with strong ties to Harvard University (from which Raju had graduated) and the Indian government. • Internal controls were weak. Audit committee members lacked the necessary education and experience as none of them was a financial expert. UBS 95 • The business strategy favored a short-term performance orientation with constant double-digit revenue growth targets. • Conflicts of interest were prevalent. The Raju brothers had a history of investing cash reserves in other family businesses to the detriment of other shareholders.

Once the dust settled, the Satyam scandal spurred significant corporate governance reforms in India.

HIH Insurance: Financial troubles down under Health International Holdings (HIH) Insurance was Australia's second largest insurance company when it collapsed in 2001. It had been on an aggressive expansion course to increase its market share for several years. In 1998-1999, HIH purchased FAI Insurances Limited without proper due diligence or consulting the board and ended up overpaying. In the process, it accumulated more debt than it could handle.23 With its financial position deteriorating, HIH was eventually placed in provisional liquidation in 2001. The HIH Royal Commission, in its 2003 report, identified key corporate governance failures that contributed to the collapse:

• The audit committee was deemed ineffective. This is not surprising as the chairman of HIH, Geoffrey Cohen, was also the chairman of the audit committee. Moreover, he regularly attended audit committee meetings accompanied by members of the senior management. • The auditor, Arthur Andersen, was found to be not independent enough, particularly concerning non-audit-related business with HIH.

96 Sustainable Investing: Investor’s Guide to Corporate Governance VII. Endnotes / Bibliography 1 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.

UBS 97 17 CalPERS, www.calpers.ca.gov/page/investments/governance/corporate-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 governance: 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.

98 Sustainable Investing: Investor’s Guide to Corporate Governance Appendix

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UBS 99 Journal of INVESTMENT ADVISORY SOLUTIONS

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

100

CONNECT KNOW GROW 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

Lockwood Advisors | BNY Mellon 101 The key features and differences of passive and active sub-set of the broader universe of securities included in management are highlighted in Table 1. Passive traditional indexes. The context of this paper, however, is management, more commonly called indexing, seeks focused on passive strategies designed to track traditional to match performance of an index (before fees). The indexes represented by widely accepted benchmarks. Themanagement key features style and is considereddifferences passiveof passive because and active sub-set of the broader universe of securities included in In contrast to passive management, active management managementportfolio managers are highlighted do not make in Table decisions 1. Passive on which traditional indexes. The context of this paper, however, is seeks to outperform the market (as measured by a management,investments to more buy orcommonly sell; they called simply indexing, seek to mirrorseeks focused on passive strategies designed to track traditional benchmark index) on a risk-adjusted basis. Portfolio tothe match index. performance Because passive of an management index (before seeks fees). toThe track indexes represented by widely accepted benchmarks. managers make decisions on which securities to buy or managementperformance ofstyle an index,is considered investors passive must bebecause satisfied with sell as well as the underlying market exposures (industry, portfoliomarket performance—including managers do not make decisionsmarket-like on performance which In contrast to passive management, active management sector, style, size, country, region, etc.) to establish within investmentsduring market to declines—and buy or sell; they the simply corresponding seek to mirror volatility. seeks to outperform the market (as measured by a the portfolios. Active managers typically have flexibility theIt is index.important Because to note passive that, overmanagement the past severalseeks to years, track benchmark index) on a risk-adjusted basis. Portfolio to manage/mitigate risk within the portfolios as well as performanceadditional types of an of index,passive investors investment must strategies be satisfied seeking with managers make decisions on which securities to buy or implement more defensive measures and positioning marketto track performance—including “non-traditional” rules-based market-like indexes performance have sell as well as the underlying market exposures (industry, during market declines. As a result of this decision- duringbecome market available declines—and within the marketplace. the corresponding In contrast volatility. to sector, style, size, country, region, etc.) to establish within making, active managers have the potential to maximize Itthe is traditionalimportant tomarket-capitalization note that, over the past weighted several indexes, years, the portfolios. Active managers typically have flexibility gains and minimize losses—including the potential to additionalthe “non-traditional” types of passive rules-based investment indexes strategies are designed seeking to to manage/mitigate risk within the portfolios as well as minimize losses during market declines. tocapture track “non-traditional”specific market factors rules-based or sources indexes of return—a have implement more defensive measures and positioning become available within the marketplace. In contrast to during market declines. As a result of this decision- Tablethe traditional 1 market-capitalization weighted indexes, making, active managers have the potential to maximize the “non-traditional” rules-based indexes are designed to gains and minimize losses—including the potential to capture specific market factors or sources of return—a minimize losses during market declines. Passive Management/Indexing Features Active Management

TableMarket-driven 1 Investing Style Manager-driven

Flexible. Seeks to capitalize on Inflexible.Passive Management/Indexing Seeks to match perfor- Features Active Management perceived opportunities and mitigate mance of the benchmark; no flexibil- Decision Making Flexibility risk; flexibility to vary holdings and ityMarket-driven to vary holdings or exposures Investing Style Manager-driven exposures Flexible. Seeks to capitalize on Inflexible. Seeks to match perfor- Fees tend to be lower than active perceivedFees tend opportunitiesto be higher than and passive mitigate mance of the benchmark; no flexibil- InvestmentDecision Making Management Flexibility Fees management risk;management flexibility to vary holdings and ity to vary holdings or exposures exposures No; seeks market-like performance Potential for Risk Management Yes Feesof its tendunderlying to be lower index than active Fees tend to be higher than passive Investment Management Fees management management No; seeks market-like performance Potential for Yes No;of its seeks underlying market-like index performance Down Market Protection Potential for Risk Management Yes of its underlying index Seeks to match performance of an Potential for Above-/ Potential for above- and/or below- No;index, seeks before market-like fees performance Below-MarketPotential forReturns index returns, before fees Yes of its underlying index Down Market Protection Source: Lockwood Advisors, Inc. Seeks to match performance of an Potential for Above-/ Potential for above- and/or below- index, before fees Below-Market Returns index returns, before fees

Source: Lockwood Advisors, Inc.

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102 Active Versus Passive Investing: Our Perspective 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 While the theoretical and empirical evidence behind both example). The lighter research coverage of these markets approaches is useful and make for a lively debate, the tends to create less efficiency and, therefore, offers an relevant issue for most investors is not whether one strategy empirical opportunity of outperformance. This level of is better than the other in theory, but rather, how to design inefficiency is grounded in the availability of information, and Whilethe most the beneficialtheoretical approach and empirical to managing evidence their behind particular both example).not in the emotionalThe lighter reaction research of coverage investors. of In these addition, markets active approachesportfolio. The is intelligent useful and management make for a lively of diversifying debate, the assets tendsmanagement to create may less also efficiency provide and, additional therefore, ability offers to customize an relevantis a complex issue process, for most and investors a one-word is not answer whether to onean either-or strategy empiricalan investor’s opportunity portfolio ofregardless outperformance. of the market This level environment. of isquestion better than(“Active the orother Passive?”) in theory, is probably but rather, too how simplistic to design for inefficiencyTo the extent is that grounded active inmanagement the availability is used, of information, professional and theoptimal most results. beneficial approach to managing their particular notmanager in the selection emotional is reaction a key aspect of investors. to success. In addition, active portfolio. The intelligent management of diversifying assets management may also provide additional ability to customize Lockwood Advisors, Inc. (Lockwood) believes there is merit For the informed investor, knowing where the “best” is a complex process, and a one-word answer to an either-or an investor’s portfolio regardless of the market environment. in both positions of this debate, and that the consultative opportunities for active management may be for assuming question (“Active or Passive?”) is probably too simplistic for To the extent that active management is used, professional process for each client should include comparing the active management risk within each asset class and optimal results. manager selection is a key aspect to success. characteristics of active and passive management against investment style is crucial for determining the proper mix Lockwoodthe client’s Advisors, investor profile.Inc. (Lockwood) Indeed, more believes often there than is merit Forof active the informed versus passive investor, management knowing where styles the in “best” a diversified innot, both we positionsfind that aof managed this debate, blend and of that active the and consultative passive opportunitiesinvestment portfolio. for active Constructing management portfolios may be thatfor assuming seek to processstyles of for management each client hasshould tended include to produce comparing the highestthe activerecognize management the strengths risk andwithin weaknesses each asset of class the two and styles, characteristicsprobability of achieving of active a and long-term passive investment management goal against while investmentas well as combining style is crucial them forin an determining effort to balance the proper their mix theaccommodating client’s investor the profile.client’s Indeed,tolerance more for oftenrisk. than ofeffects active and versus diversify passive the managementrisks, reconciles styles the in ongoing a diversified debate not, we find that a managed blend of active and passive investmentbetween the portfolio. benefits Constructingof index and activeportfolios management. that seek toIt However, as mentioned earlier, several studies indicate that styles of management has tended to produce the highest recognizealso provides the astrengths more holistic and weaknesses framework that of the is designedtwo styles, to long-term performance in passively managed portfolios probability of achieving a long-term investment goal while asenable well assetas combining allocation them decisions in an effort to have to balancea higher their probability tends to be better, on average, than performance in actively accommodating the client’s tolerance for risk. effectsof success, and adiversify better potential the risks, to reconciles mitigate downsidethe ongoing risk debate and a managed approaches. The key to portfolio outperformance, betweenlower cost the than benefits a 100% of activelyindex and managed active management. portfolio. It then, lies in looking for the active management approaches However, as mentioned earlier, several studies indicate that also provides a more holistic framework that is designed to that have a reasonable expectation of delivering strong risk- And finally, Lockwood incorporates a blend of index and long-term performance in passively managed portfolios enable asset allocation decisions to have a higher probability adjusted performance, and incorporating them into a blended active approaches within our discretionary multi-style tends to be better, on average, than performance in actively of success, a better potential to mitigate downside risk and a active-passive portfolio strategy. investment solutions. In addition, Lockwood’s investment managed approaches. The key to portfolio outperformance, lower cost than a 100% actively managed portfolio. then, lies in looking for the active management approaches approach is designed to emphasize a long-term investment As we examine the range of management styles, we can that have a reasonable expectation of delivering strong risk- Andhorizon, finally, focus Lockwood on downside incorporates risk management a blend of andindex access and the see that, historically, outperformance tends to occur in adjusted performance, and incorporating them into a blended activeexpertise approaches and worldwide within resources our discretionary within BNY multi-style Mellon—a trio management styles that function in the less analyzed capital active-passive portfolio strategy. investmentof key differentiators, solutions. inIn ouraddition, view. Lockwood’s investment markets (small-cap and international equity styles, for approach is designed to emphasize a long-term investment As we examine the range of management styles, we can horizon, focus on downside risk management and access the see that, historically, outperformance tends to occur in expertise and worldwide resources within BNY Mellon—a trio management styles that function in the less analyzed capital of key differentiators, in our view. markets (small-cap and international equity styles, for

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Lockwood Advisors | BNY Mellon 103 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 Important Disclosures The 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, Importantasset class, style, Disclosures 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. The statements contained herein are based upon the opinions of Lockwood Advisors, Inc. (Lockwood) and the data available at the time of publicationDiversification and areand subjectstrategic to asset change allocation at any time do notwithout guarantee notice. 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. This communication does not constitute investment advice, is for informational purposes only and is not intended to meet the objectives or suitabilityInvestors should requirements carefully of consider any specific the investment individual objectives,or account. risks,An investor charges, should fees andassess expenses his or her of anyown portfolioinvestment before needs investing based on his or her Statementsown financial of futurecircumstances expectations, and investment estimates andobjectives. other forward-looking statements are based on available information and Lockwood’s Theview statistical as of the time data of contained these statements. herein has Accordingly, been obtained such from statements third party are sources inherently (see speculative, below) believed as they to beare reliable; based on however, assumptions Lockwood that has may notinvolve verified, known and and cannot unknown guarantee, risks and the uncertainties. accuracy of the Actual information results, performanceprovided. or events may differ materially from those expressed or implied in such statements. Neither the information nor any opinions expressed herein should be construed as a solicitation or a recommendation by Lockwood or its affiliatesPast performance to buy or issell not any a guaranteesecurities ofor futureinvestments. 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 thanIt is important their original to remember cost. 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,For more information so that an investor’s about Lockwood, assets, aswhen well sold, as its may products, be worth fees more and or services, less than please their originalrefer to Lockwood’scost. 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,Diversification Wrap Feeand Brochurestrategic forasset Co-Sponsored allocation do Programs, not guarantee Wrap Feea profit Brochure or protect for the against Managed360 a loss in® Programdeclining or markets. the Firm Past Brochure, performance as is not a applicable,guarantee of which future may results. be obtained All investments through yourare subject financial to risk,advisor including or by writingthe loss to: of Lockwood, principal. Attn: Legal Department (AIM #19K-0203), 760Investors Moore should Road, carefullyKing of Prussia, consider PA the 19406, investment or by calling objectives, (800) 200-3033,risks, charges, option fees 3. and expenses of any portfolio before investing LockwoodStatements Advisors, of future Inc. expectations, (Lockwood) estimates is an investment and other adviser forward-looking registered in statements the United areStates based under on availablethe Investment information Advisers and Act Lockwood’s of 1940, anview affiliate as of the of timePershing of these LLC statements.and a wholly Accordingly, owned subsidiary such statements of The Bank are of inherentlyNew York speculative,Mellon Corporation as they (BNY are basedMellon). on Pershingassumptions LLC, thatmember may FINRA,involve NYSE,known SIPC. and unknown Trademark(s) risks belong and uncertainties. to their respective Actual owners.results, performance or events may differ materially from those expressed or ©2017implied Lockwood in such statements. Advisors, Inc. PastFS-LKA-CMI-5-17 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

104 Active Versus Passive Investing: Our Perspective Spotlight: The Future of Investing

allocation decisions are increasingly implemented The Death of Active Management using ETFs and index mutual funds. The managers making these decisions are doing so in a number Has Been Greatly Exaggerated of different settings and with varying degrees of activity. These range from broadly diversified Active investing will never die, but it’s strategic asset-allocation models that are managed at intermediary platforms’ home offices to being forced to evolve. so-called robo-advisors and ETFs of ETFs. Among these actors, the preference for passive is JUNE/JULY 2017 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.

PASSIVE Both phenomena demonstrate that active Ben Johnson management is alive and well and that The growth of these model-builders is most readily the distinction between active and passive is measured by the increase in assets under as blurry as ever. management of target-date funds, the assets It is no secret that actively managed funds under management or advisement in ETF managed are struggling (EXHIBIT 1 ). Over the three-year Investors Are Getting Active With Passive portfolios, and the amount of money managed on period ending April 30, U.S.-domiciled The objects of many active managers’ digital advice platforms (aka robo-advisors). actively managed mutual funds and exchange- decision-making process are changing. Instead of traded funds witnessed collective outflows choosing between Coca-Cola KO and Apple Assets in U.S.-domiciled target-date funds stood at of nearly $514 billion. Passively managed mutual AAPL, many active managers are deciding between $880 billion as of the end of 2016.² Of that sum, funds and ETFs collected nearly $1.57 trillion U.S. large caps and U.S.-dollar-denominated 39%, or $343 billion, was invested in target-date in net new money during that same span. What emerging-markets debt. These active asset- series that use passive funds exclusively. These began as more discerning culling of positions in underperforming U.S. stock funds has become more widespread. For example, during the 12 EXHIBIT 1 months ending Jan. 31, investors pulled $99 billion Active Is on the Ropes Assets in active strategies are plummeting, while from funds that beat their Morningstar Category indexes over that same period.1 passive thrives. Trailing 12-Month 01/1994–03/2017 Passive Active Estimated Net Flows Are we approaching the End of Days for active +800 management? I don’t believe so. In my opinion, USD Bil active management will never die. There will +643.7 always be investors who hope for something better than getting the market’s return net of a small +400 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 0 changed in recent years as evidenced by: –267.9 1 The growth in the active use of passive funds. –400 2 The expansion of a class of nominally passive 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 funds that make active bets. Source: Morningstar.

Assets Under Management Estimated Net Flows 1 Ptak, J. 2017. “Loveless: Even Winning Funds Are Bleeding Assets” Morningstar. March 28, 2017. http://news.morningstar.com/articlenet/article.aspx?id=798866 600.0 70.0 2 Holt, J. 2017. Morningstar Target-Date Fund Landscape 2017. https://corporate1.morningstar.com/ResearchLibrary/article/803362/2017-target-date-fund-landscape/ USD Bil USD Bil

450.0 52.5 Morningstar 105

300.0 35.0

150.0 17.5

0.0 0.0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 20102011 2012 2013 2014 2015 2016 EXHIBIT 2 EXHIBIT 3 Active Use of Passive More mutual Clues ETFs such as SPY have high turnover rates, an indication that they are being funds are using ETFs, and their ETF used in an active fashion. positions are growing.

# of Mutual Funds Median Size of ETF Average AUM Average Holding Period Holding ETFs Holdings (% of AUM) Average Holding Periods of the 10 Largest ETFs ($Bil) (Days) 2006 595 1.2 SPDR S&P 500 ETF SPY 204.40 15.4 2007 711 1.3 iShares Core S&P 500 IVV 82.58 149.6 2008 964 1.5 Vanguard Total Stock Market ETF VTI 65.94 354.2 2009 785 1.3 iShares MSCI EAFE EFA 59.80 70.3 2010 850 1.7 Vanguard S&P 500 ETF VOO 52.44 172.9 2011 862 2.3 Vanguard FTSE Emerging Markets ETF VWO 42.26 111.7 2012 1,045 2.0 iShares Core US Aggregate Bond AGG 40.19 187.4 2013 1,110 3.0 PowerShares QQQ ETF QQQ 39.86 22.3 2014 1,216 3.2 Vanguard FTSE Developed Markets ETF VEA 37.31 185.7 2015 1,234 4.3 SPDR Gold Shares GLD 35.98 43.7 2016 1,222 4.5 Source: Morningstar. Data as of 04/30/2017.

Source: Morningstar.

series’ share of the target-date market increased As individuals and advisors show a growing The starkest data demonstrating the active use from 17% as of 10 years ago. ETF managed preference for solutions over products and grow of passive building blocks is the rate of turnover in portfolios are investment strategies that typically more comfortable with technology, it is likely that many ETFs’ shares. SPDR S&P 500 ETF SPY is the have more than 50% of portfolio assets invested in these active asset allocators will continue to most actively traded security on the planet. ETFs. Primarily available as separate accounts attract new money from investors. According to NYSE, SPY’s average daily turnover in in the United States, these portfolios represent March was $21.4 billion. Over the year ending April one of the fastest-growing segments of the Actively managed mutual funds are also making 30, the average holding period for SPY was managed-accounts universe. As of Dec. 31, greater use of passive funds, and ETFs in particular 15.4 days.3 That hardly seems passive. ETFs are Morningstar was tracking 881 strategies from 162 ( EXHIBIT 2 ). Since 2006, the number of actively being used in countless ways by countless firms with total assets of$84.8 billion in this managed U.S.-domiciled mutual funds that different market participants. For some, they are space. This is just the tip of the iceberg, as there hold at least one ETF has more than doubled. low-cost, tax-efficient, buy, hold, and rebalance are tens of billions of dollars invested in similar Meanwhile, the size of the median ETF positions building blocks. For others, they are a substitute strategies that are managed by teams at a number held by these funds has nearly quadrupled. for a derivative, a trading tool, or a hedge. of different intermediary platforms, which are Security selectors are using ETFs to fill gaps in their Unlike mutual funds, there is no way to trace ETF not captured in our database. Lastly, there are the portfolios. Some have substituted them for users or to discern how they are being used. Trying robo-advisors. Firms like Vanguard and Charles futures contracts to equitize cash. Others invest in to do so is like a playing a frustrating game of Clue. Schwab SCHW have seen rapid growth in the them to take sector bets when they don’t have All we know for certain is that the candlestick adoption of their digital-advice platforms. Schwab expertise to select the most attractively priced was the murder weapon (SPY, in our case). We Intelligent Portfolios were home to $16 billion in stocks in a corner of the market. The growing use have no idea who committed the crime, why they investors’ assets as of the end of March. of ETFs by active fund managers is a clear did it, nor in what dark corner of the mansion Vanguard’s Personal Advisor Services segment example of the increasingly fuzzy distinction the deed was done. What we can say for certain is now oversees more than $50 billion. between active and passive. that ETFs are being used actively (EXHIBIT 3).

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).

106 The Death of Active Management Has Been Greatly Exaggerated Spotlight: The Future of Investing

Passive Itself Is Getting More Active compounded at an annualized rate in excess of market-cap-weighted index fund. It also takes an Not only are investors making active use of passive 40% during that period ( EXHIBIT 5 ). important risk off the table—manager risk. funds, but the complexion of passive funds is also Omitting the uncertainty associated with the changing. Asset managers are looking to marry the These funds make rules-based active bets against human element of active security selection is an best traits of active and passive, pairing active the market in a nominally passive manner. important differentiating feature. Furthermore, bets with the strict discipline and lower costs of an Unlike traditional actively managed funds, there is because these strategies are delivered via an ETF, index approach (EXHIBIT 4). This has given rise no ongoing research or day-to-day buy, sell, or hold they can be more tax efficient than traditional to a swelling number of strategic-beta (aka “smart” decisions made in response to developments in active funds. Most important, however, is the fact beta) ETFs and substantial growth in these funds’ the markets. As these are active bets, these funds that these funds tend to charge lower fees than assets. From the launch of the first generation of give investors the opportunity for outperformance, most of their active peers. these ETFs in 2000, their collective AUM had grown less risk, or some combination of the two relative to $556 billion as of the end of 2016, having to owning the market at large via a broad-based 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 EXHIBIT 4 succeed in generating better risk-adjusted returns Best of Both Worlds Strategic beta attempts to marry the best traits of active relative to plain-vanilla market-cap-weighted index and passive. funds over the long haul. And like the best active managers, these funds will experience cycles of performance marked by droughts and market- Market Capitalization Passive Implementation Passive beating returns. As such, investors’ patience will Weighting Trailing 12-Month 01/1994–03/2017 Passive Active Estimated Net Flows be tested, and their behavior may be suboptimal. +800 We have already seen examples of all-too-familiar USD Bil performance-chasing behavior among investors in Rules-Based Active +643.7 Passive Implementation Strategic Beta these funds. The active decisions that matter most Screening/Weighting are still those made by the end investor. +400

Rules-Based and/or I’m Not Dead Discretionary Active Active Implementation Active Active management will never die. It will continue Screening/Weighting 0 to evolve—we hope for the better. Fees will face pressure, and fee arrangements themselves may Source: Morningstar. –267.9 also evolve. Performance fees and loyalty programs –400 are among the ideas being mulled by fund 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 sponsors. New share-class and product types are EXHIBIT 5 also coming to the market. Smart Growth Strategic-beta ETFs have grown substantially since the first generation was launched in 2000. Active managers may also get more active. The Assets Under Management Estimated Net Flows exodus from actively managed funds has 600.0 70.0 disproportionately affected funds that are high- USD Bil USD Bil priced benchmark huggers. Taking on more active risk is the only way that many managers 450.0 52.5 can possibly justify their current fee levels. The movement to passive and the growth of strategic-beta and other factor-oriented funds will 300.0 35.0 drive the evolution of active managers and further reinforce the fact that active and passive are 150.0 17.5 becoming more indistinguishable by the day. K

0.0 0.0 Ben Johnson, CFA, is director of global ETF research with 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 20102011 2012 2013 2014 2015 2016 Morningstar Research Services and is editor of Morningstar ETFInvestor. He is a member of the editorial board of Source: Morningstar. Morningstar magazine.

Morningstar 107 Journal of INVESTMENT ADVISORY SOLUTIONS

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

108

CONNECT KNOW GROW Volume 1 n Number 1 n Fourth Quarter 2017

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

The technological innovations of the Digital This investor may be a follower of the herd. She Revolution have engendered new expectations from may believe that passive strategies will outperform individual investors, changing the way advisors, active ones in perpetuity. Or she may be one of the distributors and asset managers demonstrate savvy variety. She may understand that bull markets their value. Digital technologies have transformed never last forever and that uncorrelated returns “shopping” for everything from groceries to one’s life come at a premium. But whereas before the crisis partner. With consumer-facing technology assuming she was interested in the advisors and managers asset allocation functionality, many financial advisors with the highest returns, she is now acutely aware (FAs) have redefined their value proposition. These of the importance of investment process and risk changes for advisors have had knock-on effects for management protocol as drivers of sustainable returns. distributors and asset managers. In this feature, we will Also, although she is bombarded with data from the look at the evolving preferences of individual investors, 24-hour news cycle, she is eager for someone to parse assess the wealth and asset management industry’s the information and make it relevant to her situation. response and explore the digital practices that are gaining the most traction. Our investor may give an automated portfolio manager (a.k.a. “robo-advisor”) a try for part of her investable Meet Today’s Client assets. But she may also (or instead) value hands-on advice and choose to cultivate a relationship with a She sizes up her local brick-and-mortar establishments financial professional. Either way, however, her online against Amazon for every household purchase, consumer experiences have colored her expectations comparing costs and weighing convenience against for the delivery of goods and services. As EY observes immediacy and hands-on experience. She tries to be a in its 2015 publication on money management in the smart consumer of all products and services, including digital age, “Wealth and asset management clients will financial advice. increasingly demand seamless, coordinated, visually stunning, rich, easy digital access to their providers.” The financial crisis, though nearly a decade in the rearview mirror, has left her with an enduring sense To satisfy our consumer, traditional money managers of cost-consciousness, a heightened aversion to risk, must not only go beyond their online counterparts, then, and a skepticism as to the integrity and efficacy of the to understand individual situations and make studied, entire money management industry. After the crisis, thoughtful recommendations. They must also emulate she watched a protracted, liquidity-driven bull market the “anywhere, anytime” convenience and visual appeal favor passive investments in inexpensive ETFs and of the best e-commerce sites. Taken together, this is a tall index funds over the majority of active mutual funds— order, especially in light of the pressures that the money even before fees. She witnessed hedge funds closing management industry has faced. 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.

Artivest 109 Journal of INVESTMENT ADVISORY SOLUTIONS

Today’s Wealth and Asset Managers Myths: HNWIs and Millennials The two main currents permeating our investor’s The inertia is also given cover by the persistence of mindspace—fee consciousness and online two widely-believed myths about tech adoption in the orientation—impact wealth and asset managers just wealth space: that it is relegated to the “mass affluent” as profoundly. The rise of passive investing and the market and to Millennials. Indeed, the mass affluent growth of fintechs have put pressure on fees. But this market—that of investors with less than $1 million only accounts for the squeeze on the revenue side of investable assets—has gravitated more quickly to of managers’ income statements. On the cost side, online financial advice than have wealthier segments. peculiarities of the liquidity-driven post-crisis bull However, the consumer we described above does not market, including a historic lack of market breadth, live within a specific wealth stratum. She has been have made it increasingly difficult to deliver alpha, caught up in a cultural shift that is means-agnostic. raising the price of superior investment talent. The cost of sales talent, meanwhile, has also grown Age has also been tied to digital practice. Much has unabated, particularly for managers focused on the been written about the coming dominance of the more labor-intensive individual investor channel. Millennial generation, which stands to inherit $15 Last but not least, regulatory costs have risen, from trillion dollars and dominate the workforce in the compliance with the Volcker Rule to preparation for coming decades. Although 78% of younger high- the eventual enforcement of the DOL Fiduciary Rule. net-worth investors (HNWIs) indicate that they will leave a financial advisor over “lack of channel All of these factors go a long way in explaining why integration” (i.e. a non-seamless user experience), managers have been slow in adapting their technology advisors often discount these data as a weaker indicator to the needs of today’s investor. In his write-up of a than the reality of their practice, which may have a worldwide survey of 458 money managers sponsored higher average client age or which may feature strong by Dassault Systemes, Amin Rajan, CEO of CREATE- relationships with the Millennial offspring of their Research observes two phenomena at work: first, longtime clients. However, regardless of whether an there is the “innovator’s dilemma,” in which thinning FA has rationalized away the Millennial phenomenon, margins promote a survivalist rather than forward- all of her clients—young and otherwise—are living thinking orientation with regard to spending and transacting in an increasingly digital world. In on innovation. Second, managers face a “legacy fact, nearly half (48%) of over-40 HNWIs expect all or technology problem,” in which IT has been developed most of their wealth management relationship(s) to be in piecemeal fashion, making it hard to integrate with conducted digitally in next 5 years. new systems. 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.

110 Links in the Chain: Why Asset Managers Must Embrace the Digital Revolution Volume 1 n Number 1 n Fourth Quarter 2017

Wealth Management on the Front Lines As we recall from our profile of today’s investor, the crisis and the ensuing bull market shifted investor On the whole, wealth managers are significantly priorities significantly. Specifically, they highlighted further along in their adoption of digital technology the need for alternative return streams, which are than asset managers. This is not surprising: the digital complex, alpha-driven and characterized by significant revolution is consumer-led, and wealth management differences in the returns of the best- and worst- is the first point of contact for individual investors. performing managers. As alternatives surged in Indeed, wealth managers - via both home offices popularity among individual investors, asset managers and financial advisors—often provide the wholesale were pressed to take a hard look at their sales practices. channel through which asset managers access The increasingly important wealth channel demanded individual investors. not just more resources, but different resources, most Another major dynamic within the field of financial notably educational tools to bring advisors quickly advice has also increased the urgency for wealth up to speed on an entirely new vocabulary and new managers to develop market-leading technology. paradigms for measuring success. Wirehouses and private banks have lost significant market share to independent firms including Reaching Through the Value Chain registered investment advisors (RIAs) and independent The most successful asset managers have long broker-dealers (IBDs). RIAs and IBDs, in turn, prioritized education for FAs, including resources have been avid and nimble consumers of a host of they can use at the point of sale. With clients technologies, many provided by enterprising fintechs demanding insight and context around their FA’ that opened their doors specifically to serve this recommendations, advisors face a much more pressing rapidly-growing market. To retain their top producers, ongoing need for relevant, value-added content. therefore, traditional wealth managers have surveyed Asset managers who want to gain share in the wealth the same field of fintechs and/or developed digital market would be well-served to develop that content, capabilities internally. particularly around alternative investments, and to deliver it in an intuitive and appealing digital format. Asset Managers, Know Thy Customer While wealth managers as a population have felt Until roughly the past decade, asset managers have more urgency to evolve their digital practice for their focused mainly on serving institutional clients, increasingly online-oriented clients, asset managers generally including only the wealthiest individual increasingly perceive how closely they are linked to investors and their family offices among that cohort. advisors in the value chain. 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.

Artivest 111 Journal of INVESTMENT ADVISORY SOLUTIONS

Finally, education is by no means the sole axis along Conclusion which there is the imperative to digitize. If asset The wealth industry’s (albeit slow) embrace of digital managers are to take their cue from wealth manager best practices and the attendant removal of costs and behavior, it is important for them to note that of 8 complexity from the system are a boon for all parties— technology categories surveyed by CREATE, the investors, advisors, distributors, and asset managers. one with the highest implementation rate (56%) Digitization, moreover, introduces the aggregation of among wealth managers is the use of client-facing data, facilitating more targeted product development digital platforms. Asset managers offering online and opportunities for all providers to better educate workflows that communicate seamlessly with these and inform their clients. The good news for those systems, therefore, stand to capture the lion’s share asset managers who have contemplated or begun of advisor allocations, all else equal. Those asset leaping the “digital divide” is that they are still in the managers offering private alternative funds have vanguard. First-mover advantage is theirs to capture. 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.

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112 Links in the Chain: Why Asset Managers Must Embrace the Digital Revolution Advisor education that changes the conversation

Advisor education that changes the conversation

behavioral alpha: anbehavioral advisor's greatest alpha value : an advisor's greatest value

A discussion of the value financialA discussion advisors of the bring value to the wealthfinancial management advisors bring process to the wealth management process In this paper, you will learn:

In Howthis paper,advisors you can will enhance learn: an investor's life by helping improve their decision-making process How advisors can enhance an investor's life by Howhelping working improve with their an advisordecision-making may increase process an investor’s sense of confidence and security How working with an advisor may increase an investor’s sense of confidence and security

Authored by: Dr. Daniel Crosby, Executive Director The Center for Outcomes Authored by: Dr. Daniel Crosby, Executive Director The Center for Outcomes The Center for Outcomes | Brinker Capital 113 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.

Because of this commitment to a game 2.73x multiple. Good financial advice pays plan, the wealth discrepancies between in the short run, but the multiplication of families who receive advice and those who those gains over an investing lifetime is do not grows over time. truly staggering.

The chart below shows how those who This paper will examine the ways in which receive four to six years of advice, the working with a financial advisor makes multiple attributable to advice is 1.58. sense. It will also explore the finan- Those receiving seven to 14 years of advice cial advisory activities that add the most nearly double (1.99x) their no-advice peers, value. Finally, it will discuss areas in which and those receiving 15 or more years of the advisor-investor relationship can be advice clocked in at an overwhelming enhanced.

3.00x 2.75x The value of advice 2.50x multiplies over time 2.73x 2.25x

2.00x 1.75x 1.99x 1.50x

1.25x 1.58x

1.00x 4-6 Years 7-14 Years 15+ Years

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

114 Behavioral Alpha: An Advisor’s Greatest Value Financial advice pays

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.

Years ago, brokers and advisors were the guard- was conducted from 2006 to 2008 and compared those ians of financial data, the keeper of the stock quote. receiving “help” in the form of online advice, guidance Today, investors need only an iPhone and a free through target date funds or managed accounts to online brokerage account to do what just 30 years those who “did it themselves.” Their finding during this ago was the exclusive purview of Wall Street. It is time was that those who received help outperformed worth asking in such an age, “Is my advisor really those who did not by 1.86% per annum, net of fees. earning their fee?” An appeal to the research shows that the answer is a resounding “yes”, albeit not for Seeking to examine the impact of help during times the reasons you might have supposed. of volatility, they subsequently performed a similar analysis of “help vs. no-help” groups that included In a seminal paper titled “Advisor’s Alpha,” the famously the uncertain days of 2009 and 2010. They found that fee-sensitive folks at Vanguard estimate that the value the impact of decision-making assistance was height- added by working with a competent financial advisor ened during times of volatility and that the outper- is roughly 3% per year. The paper is quick to point out formance of the group receiving assistance grew to that the 3% delta will not be achieved in a smooth, 2.92% annually, net of fees. The research suggest that linear fashion. Rather, the benefits of working with an the benefits of advice are disproportionately experi- advisor will be “lumpy” and most concentrated during enced during times when rational decision-making times of profound fear and greed. This uneven distri- becomes most difficult. bution of advisor value presages a second truth that we will discuss more fully in the next section; that Behavioral alpha can add up to 3% of value each year the highest and best use of a financial advisor is as a 3.5 behavioral coach rather than an asset manager. 3.0 Further evidence of advisor efficacy is added by 2.5 2.92% 3.00% Morningstar in their whitepaper, “Alpha, Beta, and 2.0 to value Now…Gamma.” “Gamma” is Morningstar’s shorthand 1.5 1.86% for “the extra income an investor can earn by making 1.0 1.82% value better financial decisions" and they cast improving value% 0.5 1.82 decision-making as the primary benefit of working 0.0 with a financial advisor. In their attempt at - quanti Morningstar Aon Hewitt Vanguard fying Gamma, Morningstar arrived at a figure of 1.82% per year outperformance for those receiving advice aimed at improving their financial choices. Again, We have now established that financial guidance tends it would seem that advisors are more than earning to pay off somewhere in the ballpark of 2% to 3% a their fee and that improving decision-making is the year. Although those numbers may seem small at first primary means by which they improve clients’ lives. blush, anyone familiar with the marvel of compounding understands the enormous power of such outperfor- Research conducted by Aon Hewitt and managed mance. If financial advice really does work, the effect accounts provider Financial Engines, also supports the of following good advice over time should be substan- idea that help pays big dividends. Their initial research tial and indeed, research suggests that very thing.

The Center for Outcomes | Brinker Capital 115 Financial advice improves quality of life

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.

After all, many people perfectly capable of mowing emergency versus only 22% of those without a plan. a lawn, cleaning a home or painting a room will Finally, 51% of respondents with a plan felt prepared outsource those jobs. While you may have lawn for retirement against a frightening 18% of those not mowing skill equal to that of the person you hire, receiving advice. 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 Receiving good advice advisor, it also provides increases in confidence and pays a dividend that security that are no less valuable. builds both wealth The Canadian “Value of Advice Report” found that those paying for financial advice reported a greater and confidence. 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 Receiving good financial advice pays a dividend that the Financial Planning Standards Council found that builds both wealth and confidence. The research is 61% of those paying for financial advice answered unequivocal that a competent financial guide can affirmatively to “I have peace of mind” compared to both help you achieve the returns necessary to arrive only 36% of their “no plan” peers. The majority (54%) at your financial destination while simultaneously of those with a plan felt prepared in the event of an improving the quality of your journey.

"Do you have peace of mind?" "Are you prepared for retirement?"

those with those with 61% an advisor 51% an advisor those those 36% without 18 % without

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

Source: Investment Funds Institute of Canada, "Value of Advice Report" (2012). Financial Planning Standards. 116 Behavioral Alpha: An Advisor’s Greatest Value Where do financial advisors add value?

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.

The tendency to seek complexity and ignore simplicity has been alive and well for years in invest- An advisor is adding more ment circles. For far too long, financial advisors have led with proprietary product pitches or the value when they manage assertion that they can outperform the market through superior investment acumen. This appeal emotions than when they to complexity has rung true to an investing public manage your money. overwhelmed by the vagaries of financial markets, but is beginning to crumble in the face of popular research that highlights the difficulties in generating Morningstar’s “Gamma” study is also illustrative of the investment “alpha.” true value added by an advisor and the things inves- Once again, we will appeal to the research to try and tors should seek out when choosing a professional. determine the sources of outperformance for those The study lists the sources of added values as follows: receiving professional financial advice. Vanguard’s Asset allocation “Advisor’s Alpha” study quantifies the value added (in basis points, or bps) by many of the common activ- Withdrawal strategy ities performed by an advisor, and the results may surprise you. They include: Tax efficiency

Rebalancing: 35 bps Product allocation

Asset allocation: 0 to 75 bps Goals-based advice

Behavioral coaching: 150 bps While some sources of gamma can easily be self-taught (e.g., asset allocation) others remain uniquely powerful What will surprise most investors seeking an in the hands of an outside advisor. Just as anyone can appropriate financial guide is that hand-holding look up a sensible workout regimen, it is not difficult provides more added value than any of the activ- to find instructions on investing in a broadly diversified ities more directly associated with the manage- mix of asset classes. But if knowledge were sufficient ment of money. Based on the above assumption of to induce appropriate behavior, America would not be 3% per year average added value, fully half of that the most obese developed country in the world and be owes to behavioral coaching, or preventing clients staring down the barrel of a looming retirement crisis. from making foolish decisions during times of fear While appropriate knowledge is an important starting or greed! point, a personal coach that ensures adherence to a plan is demonstrably even more important.

The Center for Outcomes | Brinker Capital 117 The bottom line

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

C. Daniel Crosby, Ph.D., investment experience that is both more enjoy- Educated at Brigham Young able and more rational. and Emory Universities, Dr. Daniel Crosby is a psychol- Dr. Crosby is at the forefront of behavioralizing ogist, behavioral finance finance. He constructed the “Irrationality Index,” expert and asset manager a sentiment measure that gauges greed and who applies his study of fear in the marketplace from month to month. market psychology to every- His ideas have appeared in the Huffington Post, thing from financial product Think Advisor, and Risk Management, as well as design to security selec- his monthly columns for WealthManagement. tion. In the summer of 2016, Dr. Crosby released com and Investment News. Daniel was named one his latest book, The Laws of Wealth. In this book of the “12 Thinkers to Watch” by Monster.com, a readers are treated to real, actionable guidance as “Financial Blogger You Should be Reading” by AARP the promise of behavioral finance is realized and and in the “Top 40 Under 40” by Investment News. practical applications for everyday investors are Crosby’s well-reviewed first book, You’re Not That delivered. Great (2012) applies elements of behavioral finance such as loss aversion and the availability heuristic In 2014, Dr. Crosby co-authored his second to the pursuit of a meaningful life. book with Chuck Widger, Founder and Executive Chairman of Brinker Capital. The New York Times When he is not consulting around market bestseller, Personal Benchmark: Integrating Behavioral psychology, Daniel enjoys living near Atlanta, Finance and Investment Management, outlines a watching independent films, fanatically following highly personalized approach to investing that St. Louis Cardinals baseball, and spending time aligns intention with action while fostering an with his wife and three children.

118 Behavioral Alpha: An Advisor’s Greatest Value Who we are Who we are

The Brinker Capital Center for Outcomes brings Since 1987, Brinker Capital has provided together experts in education, behavioral finance, innovative investment solutions based business, investments, sales, and communica- on creative ideas generated from actively tions to provide education that strengthens the listening to the needs of financial advisors and advisor-client relationship through conversa- investors. From being a pioneer of the multi- tions that center around outcomes. The Center asset class investment philosophy to using for Outcomes Model is a repeatable communi- behavioral finance to help investors manage cation model that enables advisors to save time, the emotions of investing, our highly strategic, improve productivity, increase client retention, disciplined investment approach is the key to and enhance their reputation in the investor helping advisors and their clients achieve better marketplace. outcomes.

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

Important Information Views expressed are those of Dr. Daniel Crosby, a consultant BrinkerCapital.com of The Center for Outcomes offered through Brinker Capital Holdings. Content is for informational/educational purposes. 1055 Westlakes Drive, Suite 250 Please consult your advisor before investing in any product. Berwyn, PA 19312 Investment decisions should be made based on the investor’s 800.333.4573 specific financial needs and objectives, goals, time horizon, tax liability, and risk tolerance. When investing in managed accounts Connect With Us and wrap accounts, there may be additional fees and expenses added onto the fees of the underlying investment products.

Brinker Capital Inc., a Registered Investment Advisor. WP_CFO_BEHAVE_ALPHA

The Center for Outcomes | Brinker Capital 119 September 9, 2017 Issue Brief TAMP Market Overview

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.

120 TAMP Market Overview Platform Types: AUA vs. AUM September 9, 2017 Issue TheBrief 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 TAMP Market Overview 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)

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 Sources: Money Management Institute, Dover Financial Research financial planning and client-facing responsibilities. However, recently launched Model Marketplaces like TD Ameritrade’s iRebal Model Portfolio Marketplace may unbundleProgram the Types: MF Advisory and UMA Display Strong Growth investment and back-office services TAMPs provide. Generally, the following are the account type varieties offered by TAMPs, including high-level definitions. According to Tiburon Strategic Advisors, TAMPs have grown from $147 billion in 2011 to nearly $1.8With each account type, the type of investment, associated fees, and the role of the TAMP changes trillion at the end of 2015. They also assert that one-quarter of advisors work with a TAMP. Others,significantly. like Northern Trust, have reported this number to be higher, upwards of 50% of advisors and close to 35 •firmsM utual Fund Wrap Accounts—Also referred to as Mutual Fund Advisory Programs, they are control the vast majority of TAMP business. Wealth Advisor’s 2017 America’s Best TAMPs reports that essentially baskets of mutual funds selected from the prescreened professional managers on the Envestnet is the largest competitor, followed by SEI and AssetMark. These three providers control a majorTAMP platform. share of the TAMP market. • Exchange-Traded Funds (ETF) Wrap Accounts—Same as above using ETFs. • Separately Managed Accounts (SMAs)—Professionally managed portfolios comprised of This FUSE Issue Brief examines the largest TAMPs in the marketplace, assets under advisement vs. assetsindividual securities. A fee-based SMA program utilizes multiple SMAs. A single SMA can also form under management, programs driving asset growth, and corresponding fees. Advisor benefits, the rise ofa single sleeve within a UMA structure. Model Marketplaces, and the future outlook for TAMPs are also included. • 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.

FUSE Research Network 121 • Other—Includes Rep as Portfolio Manager (fee-based, managed program that allows the advisor to act as the portfolio manager) and Rep as Advisor (non-discretionary, fee-based, advisory program 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 managed portfolio. In the case of the UMA, it should be just the managers’ models without the associated trading 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 firm and the advisor’s compensation tied to the account.

122 TAMP Market Overview 3. Other services—These services, such as financial planning, should be billed separately. ETF wrap fee maximums should be less than 150bp for smaller accounts. UMAs that serve larger accounts September 9, 2017 Issue Brief with more complex portfolios should fee between 100bp and 175bp, dependent on use of models and type of overlay services provided.

TAMP Market Overview 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 Investment Management Total Type Fees Fees 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 the minimums noted above. Source: Wealth Advisor, 2017 America’s Best TAMPs 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,The fees paid by the client—which may range from 85bp to 280bp dependent on the type of program advanced technology, and third-party asset management, where the investment managerand as set classes included as noted in the table above—have to be appropriately divided among the determines the investment models and implements the trades. The popularity of theseasset manager, the advisor, the sponsor, the platform provider, and the overlay manager (if utilized), platforms is directly related to the positive impact on a financial advisor’s business generally on a monthly basis. The fee sharing ranges are illustrated in the exhibit below. 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 Fee Sharing Among Managed Account Participants Marketplaces like TD Ameritrade’s iRebal Model Portfolio Marketplace may unbundle the investment and back-office services TAMPs provide.

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

FUSE Research Network 123 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

Channel Practice Type

Sources: FUSE Research and WealthManagement.com

124 TAMP Market Overview Will the Model Marketplace Disrupt TAMPs?

TWillhree thedifferent Model platforms Marketplace announced theDisrupt rollout TAMPs?of a “Model Marketplace” where advisors can use robo September 9, 2017 Issue Brieftrading 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 beenThree reported different that platforms “Model announced Marketplaces the rolloutwill threaten of a “Model both existing Marketplace” ‘marketplace where’ advisincumbents…,ors can use and robo the currenttrading andparadigm rebalancing of third automation-party TAMPs tools,1” FUSEto implement does not third view- partythis as-managed a substantial models threat, and buttrades rather using as thea TAMP Market Overview potentialadvisor’s existingdevelopment platform for theand two ultimately to coexist no longerwith unbundling needing to options fully delegate as well toas acost TAMP savings.. Although it’s been reported that “Model Marketplaces will threaten both existing ‘marketplace’ incumbents…, and the Tcurrenthe first paradigm platform, ofiRebal third Model-party TAMPsPortfolio,1” Marketplace FUSE does not was view announced this as a substantialby TD Ameritrade threat, i nbut early rather 2017 as. a Apotentialdvisors will development be able to directlyfor the two access to coexistthird-party with investment unbundling management options as well strategies as cost savings. by having their models uploaded directly into the iRebal trading software for the advisor to implement themselves. The first platform, iRebal Model Portfolio Marketplace was announced by TD Ameritrade in early 2017. AlsAdvisorso, Riskalyze will be announced able to directly that itsaccess robo third-advisor-party-for investment-advisors AutoPilot management platform strategies was launching by having a “Partnertheir Store”models that uploaded would directlyallow advisors into the to iRebal use its trading new trading software and for rebalancing the advisor tools to implemen to directlyt themselves.implement the models from a series of third-party investment managers. As of February 2017, it was reported that the AutoPilotAlso, Riskalyze Partner announced Store already that itshad robo at least-advisor a dozen-for-a thdvisorsird-party AutoPilot managers platform available. was launching a “Partner Store” that would allow advisors to use its new trading and rebalancing tools to directly implement the Finmodelsally, Orionfrom aAdvisor series ofServices third-party announced investment the launch managers. of Eclipse, As of Februarywhich is embedded 2017, it was in reportedits own version that the of a newlyAutoPilot launched Partner trading Store andalready rebalancing had at least software a dozen platform third-party. Another managers initiative available. is “Orion Communities,” where advisors can share their investment models for implementation with other advisors and may eventuallyFinally, Orion be Advisorused to distributeServices announced third-party the manager launch models.of Eclipse, which is embedded in its own version of a Turnkey asset management platforms (TAMPs) are being used by more than 25% of newly launched trading and rebalancing software platform. Another initiative is “Orion Communities,” financial advisors and assets have grown tenfold. TAMPs provide back-office support,Futurewhere advisors of TAMPs can share their investment models for implementation with other advisors and may eventually be used to distribute third-party manager models. advanced technology, and third-party asset management, where the investment managerAs noted above, the emergence of the Model Marketplace will not be a TAMP replacement but may determines the investment models and implements the trades. The popularity of theseultimFuture ately of lead TAMPs to the unbundling of TAMP offerings, resulting in lower fees attached to these platforms. platforms is directly related to the positive impact on a financial advisor’s business Total TAMP fees range from a low of 85 basis points to a high of 280 basis points—and we expect these practice—they allow advisors to spend less time on back office activities and more timerangesAs noted on will above, likely tdecline.he emergence Financial of advisorsthe Model will Marketplace have the choice will notto fully be a outsource TAMP replacement to a TAMP, but delegating may theirultim investmentately lead to process, the unbundling its implementation, of TAMP offerings and back, resulting office responsibilities in lower fees attached; they may to choosethese platforms. to financial planning and client-facing responsibilities. However, recently launched ModelleverageTotal TAMP a Model fees range Marketplace, from a low utilizing of 85 thebasis trading points and to a rebalancing high of 280 software; basis points or —theyand may we expectelect a these Marketplaces like TD Ameritrade’s iRebal Model Portfolio Marketplace may unbundlecombinationranges the will likely of the decline. two by Financial selecting advisors certain willofferings have thefrom choice a TAMP to fullyand outsourceothers from to a a Model TAMP, Marketplace. delegating investment and back-office services TAMPs provide. their investment process, its implementation, and back office responsibilities; they may choose to Wleveragee expect a Modela portion Marketplace, of advisors utilizingwill elect the to tradinguse the and software rebalancing, but a considerablesoftware; or theynumber may of elect financial a According to Tiburon Strategic Advisors, TAMPs have grown from $147 billion in 2011 to nearly $1.8advisorscombination —particularly of the two smaller by selecting independent certain advisors offerings with from limited a TAMP resources and others—will from stay a committedModel Marketplace. to trillion at the end of 2015. They also assert that one-quarter of advisors work with a TAMP. Others,TAMPs like like Envestnet or AssetMark for management of the investment process and back office Northern Trust, have reported this number to be higher, upwards of 50% of advisors and close to 35capabilities.W firmse expect a portion of advisors will elect to use the software, but a considerable number of financial control the vast majority of TAMP business. Wealth Advisor’s 2017 America’s Best TAMPs reports thatadvisors —particularly smaller independent advisors with limited resources—will stay committed to Envestnet is the largest competitor, followed by SEI and AssetMark. These three providers control aTAMPs major like Envestnet or AssetMark for management of the investment process and back office share of the TAMP market. capabilities.

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

FUSE Research Network 125 WHY ADVISORS HAVE NEVER BEEN SO VALUABLE 2017 VALUE OF AN ADVISOR STUDY

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

126 Why Advisors Have Never Been So Valuable NOT FDIC INSUREDTHIS • MAY MATERIAL LOSE IS VALUEFOR FINANCIAL • NO PROFESSIONAL BANK GUARANTEE USE ONLY AND NOT FOR DISTRIBUTION TO CURRENT OR POTENTIAL INVESTORS. EXECUTIVE SUMMARY EXECUTIVE SUMMARY

As part of Russell Investments’ commitment to powering advisor success, this annual report looks holistically at what advisors do for their clientsAs part of Russell Investments’ commitment to powering advisor success, and the additional value they contribute to an investor’s portfolio.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,With growing regulatory attention on advisory fees and natural consumer today’s advisors may be challenged to articulate the material valueskepticism they about delivered value, given strong U.S. stock performance, deliver. By looking at the full value equation of an advisor’s services—today’s advisors may be challenged to articulate the material value they annual rebalancing, behavior mistakes investors make, the cost ofdeliver. By looking at the full value equation of an advisor’s services— investment-only management, planning and ancillary services, andannual tax- rebalancing, behavior mistakes investors make, the cost of aware investing— it is clear that the value an advisor delivers to clientsinvestment-only management, planning and ancillary services, and tax- materially exceeds the 1% fee they typically charge for their services.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%. In 2017, the value of an advisor in the U.S. is calculated at 4.08%. Introduction In recent months, the DOL fiduciary rule has put the spotlight on all mannerIntroduction of fees. While the final ruling is still unknown, the fact remains that fees are top-of-mindIn recent for months, the DOL fiduciary rule has put the spotlight on all manner of fees. investors. With eight years of strong U.S. stock market performance (Russell While3000® the final ruling is still unknown, the fact remains that fees are top-of-mind for Index) and virtually all stocks rising, there is natural skepticism about paying investors.for advice With eight years of strong U.S. stock market performance (Russell 3000® — it doesn’t seem hard to throw together a winning portfolio. While this viewIndex) completely and virtually all stocks rising, there is natural skepticism about paying for advice overlooks the fact that standard investment selection is just one part of an advisor’s— it doesn’t seem hard to throw together a winning portfolio. While this view completely value, advisors struggle to clearly articulate that the value their clients derive overlooksmaterially the fact that standard investment selection is just one part of an advisor’s exceeds the 1% fee they typically charge. 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 Value of an Advisor = A+B+C+P+T A Annual rebalancing of investment portfolios A Annual rebalancing of investment portfolios B Behavioral mistakes individual investors typically make YourB feeBehavioral mistakes individual investors Annual typicallyadvisory makefee Your fee C Cost of basic investment-only management you charge clients Annual advisory fee C Cost of basic investment-only management you charge clients P Planning costs or the costs of providing a financial plan, updates and your services P Planning costs or the costs of providing a financial plan, updates and your services T Tax-aware planning/investing T Tax-aware planning/investing

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

2 // RUSSELL INVESTMENTS // WHY ADVISORS HAVE NEVER BEEN SO VALUABLE THIS MATERIAL IS FOR FINANCIAL PROFESSIONAL USE ONLY AND Russell Investments 127 2 NOT// RUSSELL FOR DISTRIBUTION INVESTMENTS TO CURRENT // ORWHY POTENTIAL ADVISORS INVESTORS. HAVE NEVER BEEN SO VALUABLE THIS MATERIAL IS FOR FINANCIAL PROFESSIONAL USE ONLY AND NOT FOR DISTRIBUTION TO CURRENT OR POTENTIAL INVESTORS. Annual Rebalancing = 0.2% WhenAnnual markets Rebalancing are rising, = it 0.2% can be easy to underestimate the importance ofWhen disciplined markets rebalancing. are rising, it can be easy to underestimate the importance Riskof disciplined Exposure rebalancing. AsRisk this Exposure chart demonstrates, a hypothetical balanced index portfolio that hasAs notthis been chart rebalanced demonstrates, would a hypothetical look more like balanced a growth index portfolio portfolio and that expose thehas investor not been to rebalancedrisk they didn’t would agree look to. more like a growth portfolio and expose the investor to risk they didn’t agree to. Left alone, a hypothetical MARCH 31, 2009 ‘balanced’Left alone, index a hypothetical portfolio MARCH 31, 2009 drifted‘balanced’ into aindex ‘growth’ portfolio index portfolio, exposing Equities drifted into a ‘growth’ theindex portfolio portfolio, to more exposing Equities Fixed downside risk. Income the portfolio to more Fixed 30% 40% downside risk. Income 30% 40% 40% 55% 40% 5% 55% 15% 5% 5% 5% 15% 5% 5% 5%

Real 5% Assets Real Assets

DECEMBER 31, 2016 DECEMBER 31, 2016 Fixed Income 24% Fixed Equities Income 24% 24% Equities 24% 44%

7% 7% 44% 4% Real 7% 7% Assets 69% Real 4% 13% 8% Assets 69% 13% 8%

U.S. Large Cap U.S. Small Cap Non-U.S. Equity EMU.S. Equity Large Cap REITsU.S. Small Cap BondsNon-U.S. Equity EM Equity REITs Bonds 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;U.S. LargeBonds: Cap: Bloomberg Russell 1000Barclays Index; U.S. U.S. Aggregate Small Cap: Bond Russell Index. 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 IndexIndex; returns Bonds: represent Bloomberg past Barclays performance, U.S. Aggregate are not a guaranteeBond Index. of future performance, and are not indicative of any specific investment. Indexes are unmanaged and cannot be invested in directly. 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.

3 // RUSSELL INVESTMENTS // WHY ADVISORS HAVE NEVER BEEN SO VALUABLE THIS MATERIAL IS FOR FINANCIAL PROFESSIONAL USE ONLY AND 128 Why Advisors Have Never Been So Valuable NOT FOR DISTRIBUTION TO CURRENT OR POTENTIAL INVESTORS. 3 // RUSSELL INVESTMENTS // WHY ADVISORS HAVE NEVER BEEN SO VALUABLE THIS MATERIAL IS FOR FINANCIAL PROFESSIONAL USE ONLY AND NOT FOR DISTRIBUTION TO CURRENT OR POTENTIAL INVESTORS. Additional Returns Regular rebalancing has the potential to add 0.2% in additional return and 1.6%Additional in risk. Returns Regular rebalancing has the potential to add 0.2% in additional return and 1.6% in risk.

Hypothetical rebalancing comparison: Jan. 1988 - Dec. 2016 Hypothetical rebalancing comparison: Jan. 1988 - Dec. 2016 Buy and hold Annual Buy and hold Annual Annualized return 8.6% 8.8% Annualized return 8.6% 8.8% Annualized 10.4% 8.8% standard deviation Annualized 10.4% 8.8% $1,000 investment standard deviation $1,188,214 $1,255,645 over 30 years $1,000 investment $1,188,214 $1,255,645 over 30 years For illustrative purposes only. Not meant to represent any actual investment Methodology available in footnotes at the end of this report. For illustrative purposes only. Not meant to represent any actual investment Methodology available in footnotes at the end of this report.

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.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. Behavioral Mistakes = 2.0% While behavior coach isn’t part of the advisor job description, it is a significantBehavioral contributor Mistakes = 2.0% to total value. Left to their own devices, many investors buy high and sell low.While From behavior 2009 coach isn’t part of the advisor job description, it is a significant contributor to 2013, investors withdrew more money from U.S. stock mutual funds than theyto total put value. Left to their own devices, many investors buy high and sell low. From 2009 in. All the while, the Russell 3000® Index climbed 16.1%. For those that choseto to 2013, stay investors withdrew more money from U.S. stock mutual funds than they put in cash since the market bottom on March 9, 2009 to the end of 2016, they missedin. All thea while, the Russell 3000® Index climbed 16.1%. For those that chose to stay cumulative return of 300%, based on the Russell 3000® Index. 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 Investors chase patterns $80.0 8000.0

$80.0 8000.0 $60.0 7000.0 3000 Russell

$60.0 7000.0 3000 Russell

$40.0 6000.0 dividence) (with

$20.0 5000.0 $40.0 6000.0 dividence) (with

$0.0 4000.0 ® $20.0 5000.0 Index Value Index

$0.0 4000.0 ®

-$20.0 3000.0 Value Index

-$40.0 2000.0 -$20.0 3000.0 Net flows ($U.S. billions) -$60.0 1000.0 -$40.0 2000.0 Net flows ($U.S. billions)

-$80.0 0.0 -$60.0 1000.0

-$80.0 0.0 Jan-11 J an-87 J an-88 J an-89 J an-90 J an-91 J an-92 J an-93 J an-95 J an-96 J an-97 J an-98 J an-99 J an-00 J an-01 J an-02 J an-03 J an-05 J an-06 J an-07 J an-08 J an-09 J an-10 J an-12 J an-13 J an-15 J an-16 J an-94 J an-04 J an-14 Jan-11 J an-87 J an-88 J an-89 J an-90 J an-91 J an-92 J an-93 J an-95 J an-96 J an-97 J an-98 J an-99 J an-00 J an-01 J an-02 J an-03 J an-05 J an-06 J an-07 J an-08 J an-09 J an-10 J an-12 J an-13 J an-15 J an-16 J an-94 J an-04 J an-14 Net Flows (Total Equity) Russell 3000® Index Value (with dividends) Data shown is historical and not an indicator of future results. Net Flows (Total Equity) Russell 3000® Index Value (with dividends) ® Source: Industry flows into equities. www.ici.org/research/stats. Russell 3000 Index: www.ftserussell.com Data shown is historical and not an indicator of future results. (“value with dividends”). Data as of December 31, 2016. Source: Industry flows into equities. www.ici.org/research/stats. Russell 3000® Index: www.ftserussell.com Index performance is not indicative of the performance of any specific investment. (“value with dividends”). Data as of December 31, 2016. Indexes are not managed and may not be invested in directly. Index performance is not indicative of the performance of any specific investment. Indexes are not managed and may not be invested in directly.

4 // RUSSELL INVESTMENTS // WHY ADVISORS HAVE NEVER BEEN SO VALUABLE THIS MATERIAL IS FOR FINANCIAL PROFESSIONAL USE ONLY AND NOT FOR DISTRIBUTION TO CURRENT OR POTENTIAL INVESTORS. Russell Investments 129 4 // RUSSELL INVESTMENTS // WHY ADVISORS HAVE NEVER BEEN SO VALUABLE THIS MATERIAL IS FOR FINANCIAL PROFESSIONAL USE ONLY AND NOT FOR DISTRIBUTION TO CURRENT OR POTENTIAL INVESTORS. The average stock fund investor’s inclination to chase past performance cost them 2%The annually average instock the fund32-year investor’s period frominclination 1984-2016. to chase Therefore, past performance an advisor’s cost ability them to2% help annually clients instick the to 32-year their long-term period from financial 1984-2016. plan Therefore,and skirt irrational, an advisor’s emotional ability decisionsto help clients adds thisstick value. to their long-term financial plan and skirt irrational, emotional decisions adds this value.

The high cost of investor behavior (1984-2016) The high cost of investor behavior (1984-2016) 12% 12% Annualized cost to 10% -2.0% 10.7% retailAnnualized “chasers” cost to 10% -2.0% 8% 10.7% retail “chasers” 8.7% 8% 8.7% 6% 6% 4% 4% 2% 2% 0% ® (1) (2) 0% Russell 3000 Index “Average” Investor Russell 3000® Index(1) “Average” Investor (2) (1) BNY Mellon Analytical Services, Russell 3000® Index annualized return from January 1, 1984 to December 31, 2016. (1) BNY Mellon Analytical Services, Russell 3000® Index annualized return from January 1, 1984 (2) Russellto December Investment 31, 2016. 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 (2) Russell Investment Group & Investment Company Institute (ICI). Return was calculated by deriving of return if invested in the Russell 3000® Index and held without alteration from January 1, 1984 to the internal rate of return (IRR) based on ICI monthly fund flow data which was compared to the rate December 31, 2016. This seeks to illustrate how regularly increasing or decreasing equity exposure of return if invested in the Russell 3000® Index and held without alteration from January 1, 1984 to based on the current market trends can sacrifice even market like returns. December 31, 2016. This seeks to illustrate how regularly increasing or decreasing equity exposure Indexesbased onand/or the current benchmarks market are trends unmanaged can sacrifice and cannot even bemarket invested like returns.in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Returns represent specific investment. 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-advisorsCost of Investment-only that deliver investment-only management management = 0.33% and no financial plan, ongoing service,Robo-advisors or guidance that deliverhave set investment-only prices at approximately management 0.33% and1—for no financial annual statements, plan, ongoing onlineservice, access, or guidance and a phone have set number prices to at call approximately in case of questions. 0.33%1—for annual statements, online access, and a phone number to call in case of questions. Planning = 0.75% AdvisorsPlanning add = value0.75% by building and regularly updating custom financial plans, conductingAdvisors add regular value portfolioby building reviews, and regularly and offering updating ancillary custom services financial such asplans, investment education,conducting assistance regular portfolio with annual reviews, tax returnand offering preparation, ancillary Social services Security such and as investmentretirement incomeeducation, planning, assistance and one-offwith annual custom tax requests return preparation, from clients. Social Security and retirement income planning, and one-off custom requests from clients. The cost of planning AccordingThe cost of to planning a recent Financial Planning Association (FPA) study, the cost of developing andAccording building to an a recentinitial financial Financial planPlanning averages Association $2,600.2 Planners(FPA) study, typically the cost charge of developing approximatelyand building an $200 initial per financial hour for planongoing averages monitoring $2,600. 2and Planners updating. typically2 Based charge on this, theapproximately value of providing $200 per and hour maintaining for ongoing a plan monitoring is worth and0.50% updating. on a $500,0002 Based on account. this, the value of providing and maintaining a plan is worth 0.50% on a $500,000 account.

5 // RUSSELL INVESTMENTS // WHY ADVISORS HAVE NEVER BEEN SO VALUABLE 130 Why Advisors Have Never Been So Valuable THIS MATERIAL IS FOR FINANCIAL PROFESSIONAL USE ONLY AND 5 // RUSSELL INVESTMENTS // WHY ADVISORS HAVE NEVER BEEN SO VALUABLE NOT FOR DISTRIBUTION TO CURRENT OR POTENTIAL INVESTORS. THIS MATERIAL IS FOR FINANCIAL PROFESSIONAL USE ONLY AND NOT FOR DISTRIBUTION TO CURRENT OR POTENTIAL INVESTORS. The cost of ancillary services Advisors consistently underestimate the value of ancillary services. From the The cost of ancillary services time savings and peace of mind offered during tax season to preparation for Advisors consistently underestimate the value of ancillary services. From the retirement and custom requests, these services can quickly consume up to time savings and peace of mind offered during tax season to preparation for 100 hours each year. We estimate this value at 0.25%, assuming they are retirement and custom requests, these services can quickly consume up to part of the annual advisory fee. 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 distinguishTax-aware investing = 0.80% themselves and demonstrate fiduciary standards of expertise. Providing a more tax-aware approach is an area where advisors can distinguish themselves and demonstrate fiduciary standards of expertise. Dialing down tax drag The average annual tax drag for the five years ending December 31, 2016 wasDialing down tax drag material. Investors in non-tax managed U.S. equity products (active, passive, TheETFs) average annual tax drag for the five years ending December 31, 2016 was lost on average 1.53% of their return to taxes. Those in tax-managed U.S. equitymaterial. Investors in non-tax managed U.S. equity products (active, passive, ETFs) funds forfeited only 0.73%. With taxable investors holding $7.2 trillion of the lost$15.7 on average 1.53% of their return to taxes. Those in tax-managed U.S. equity trillion invested in open-end mutual funds, this is a widespread concern.3 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 Average annual tax drag of U.S. equity funds for 5 years ending December 31, 2016 Non-tax-managed Tax-managed 0.0% Non-tax-managed Tax-managed 0.0% -0.2% -0.2% -0.4% -0.4% -0.6% -0.73% -0.6% -0.73% -0.8% -0.8% -1.0% -1.0%

Return lost to taxes/year -1.2%

Return lost to taxes/year -1.2% -1.4% -1.53% -1.4% -1.53% -1.6%

-1.6% -1.8%

U.S. equity funds -1.8% U.S. equity funds 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. Tax-managed: Funds identified by Morningstar to be tax-managed. Universe Calculated arithmetic average for the Tax Cost Ratio as calculated by Morningstar. 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.

Tax-aware advisors add value by helping build and implement a personalized, comprehensive, and tax-sensitive investment approach using a variety or products.Tax-aware advisors add value by helping build and implement a personalized, This can add 0.80% in value. comprehensive, and tax-sensitive investment approach using a variety or products. This can add 0.80% in value.

6 // RUSSELL INVESTMENTS // WHY ADVISORS HAVE NEVER BEEN SO VALUABLE THIS MATERIAL IS FOR FINANCIAL PROFESSIONAL USE ONLY AND Russell Investments 131 6 NOT// RUSSELL FOR DISTRIBUTION INVESTMENTS TO CURRENT // OR WHY POTENTIAL ADVISORS INVESTORS. HAVE NEVER BEEN SO VALUABLE THIS MATERIAL IS FOR FINANCIAL PROFESSIONAL USE ONLY AND NOT FOR DISTRIBUTION TO CURRENT OR POTENTIAL INVESTORS. The Bottom Line Advisors 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 Theof record Bottom high U.S. Line equity markets and likely rising interest rates. Likewise, this value AdvisorsisThe a meaningful Bottom delivering differentiator servicesLine and in valuea time above of margin and beyond compression, investment-only regulatory advice scrutiny, haveAdvisorsand andemographic estimated delivering contributorychange. services and value value of above4.08%. and By beyond demonstrating investment-only to clients advice how this value exceeds the fee charged, advisors can improve client satisfaction at a time Yourhave clientsan estimated are your contributory most persuasive value ofadvocates. 4.08%. By Helping demonstrating them understand to clients the how of record high U.S. equity markets and likely rising interest rates. Likewise, this value valuethis value you exceedsdeliver is the key. fee charged, advisors can improve client satisfaction at a time isof a recordmeaningful high differentiatorU.S. equity markets in a time and of likelymargin rising compression, interest rates. regulatory Likewise, scrutiny, this value andis a demographic meaningful differentiator change. in a time of margin compression, regulatory scrutiny, and demographic change. YourA clients Annualare your rebalancing most persuasive of investment advocates. portfolios Helping them understand0.20% the valueYour youclients deliver are youris key. most persuasive advocates. Helping them understand the value you deliverBehavioral is key. mistakes individual investors 2.00% B typically make A Annual rebalancing of investment portfolios 0.20% CA CostAnnual of basicrebalancing investment-only of investment management portfolios 0.33%0.20% Behavioral mistakes individual investors 2.00% B typically make PlanningBehavioral costs mistakes or the individual costs of providinginvestors a PB 0.75%2.00% typicallyfinancial make plan, updates and your services C Cost of basic investment-only management 0.33% TC CostTax-aware of basic planning/investing investment-only management 0.33%0.80% Planning costs or the costs of providing a P 0.75% financialPlanning plan,costs updates or the costsand yourof providing services a TotalP 2017 value of an advisor 0.75% financial plan, updates and your services 4.08% T Tax-aware planning/investing 0.80% T Tax-aware planning/investing 0.80% At Russell Investments, we believe in the importance of advisors. We see the advantagesTotal 2017 you value create of for an your advisor clients. We know the commitment4.08% you bring to your relationships.Total 2017 This value annual of Valuean advisor of an Advisor study quantifies that4.08% dedication and the resulting benefit. It is one small part of our work in powering advisor success. At Russell Investments, we believe in the importance of advisors. We see the advantagesAt Russell Investments,you create for we your believe clients. in theWe importanceknow the commitment of advisors. youWe bringsee the to your relationships.advantages you This create annual for Value your ofclients. an Advisor We know study the quantifies commitment that youdedication bring to and your therelationships. resulting benefit. This annual It is oneValue small of anpart Advisor of our studywork inquantifies powering that advisor dedication success. and the resulting benefit. It is one small part of our work in powering advisor success.

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/ Footnotes ResearchandPracticeInstitute/Documents/RPI-2015_Trends-In-Financial-Planning_10-15- 15.pdf

1.Footnotes Based on the average fee charged for investment-only management by 10 robo advice offerings 3.for 2016 a client Investment portfolio Company of $500,000 Factbook. as accessed on the companies’ websites on 3/7/2017. 1. Based on the average fee charged for investment-only management by 10 robo advice offerings 2. FPAfor Researcha client portfolio & Practice of $500,000 Institute, as“Financial accessed Planning on the companies’ in 2015: Today’s websites Demands, on 3/7/2017. Tomorrow’s Challenges.” https://www.onefpa.org/business-success/ 2.ResearchandPracticeInstitute/Documents/RPI-2015_Trends-In-Financial-Planning_10-15- FPA Research & Practice Institute, “Financial Planning in 2015: Today’s Demands, 15.pdf 7 // RUSSELL INVESTMENTS // WHY ADVISORS HAVE NEVER BEEN SO VALUABLE Tomorrow’s Challenges.” https://www.onefpa.org/business-success/ THIS MATERIAL IS FOR FINANCIAL PROFESSIONAL USE ONLY AND 3. 2016ResearchandPracticeInstitute/Documents/RPI-2015_Trends-In-Financial-Planning_10-15- Investment Company Factbook. 15.pdf NOT FOR DISTRIBUTION TO CURRENT OR POTENTIAL INVESTORS.

3. 2016 Investment Company Factbook.

7 // RUSSELL INVESTMENTS // WHY ADVISORS HAVE NEVER BEEN SO VALUABLE 132 Why Advisors Have Never Been So Valuable THIS MATERIAL IS FOR FINANCIAL PROFESSIONAL USE ONLY AND NOT FOR DISTRIBUTION TO CURRENT OR POTENTIAL INVESTORS. 7 // RUSSELL INVESTMENTS // WHY ADVISORS HAVE NEVER BEEN SO VALUABLE THIS MATERIAL IS FOR FINANCIAL PROFESSIONAL USE ONLY AND NOT FOR DISTRIBUTION TO CURRENT OR POTENTIAL INVESTORS. IMPORTANT INFORMATION *Methodology for Universe Construction: From Morningstar, extract U.S. equity and fixed incomeIMPORTANT mutual fund INFORMATION and ETF’s for reported period. Averages calculated on a given category. For example, average after-tax return*Methodology for the large forcap Universe category Construction: reflects From Morningstar, extract U.S. equity and fixed income mutual fund and ETF’s for a simple arithmetic average of the returns for all funds that were assigned to the large cap categoryreported as of period. the end Averages date run. calculated For on a given category. For example, average after-tax return for the large cap category reflects funds with multiple share classes, each share class is counted as a separate “fund” for the purposea simple of creating arithmetic category average averages. of the returns for all funds that were assigned to the large cap category as of the end date run. For Morningstar category averages include every type of share class available in Morningstar’s database.funds with Large multiple Cap/Small share Cap classes, each share class is counted as a separate “fund” for the purpose of creating category averages. determination based upon Morningstar Category. Tax Drag: Morningstar’s Tax Cost Ratio. 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. 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© 2017 Morningstar Morningstar, nor its Inc. content All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar; (2) may providers are responsible for any damages or losses arising from any use of this information. Pastnot performancebe copied or distributed;is not a and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content guarantee of future results. Indexes are unmanaged and cannot be invested in directly. 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, MorningstarMorningstar, Rating, Inc.,Morningstar Morningstar, Risk, the Morningstar logo and Morningstar.com are registered trademarks of Morningstar, Inc. Morningstar Return, and Morningstar Style Box are trademarks of Morningstar, Inc. All other brandsAll other and Morningstar names are productsthe and proprietary tools, including Morningstar Category, Morningstar Rating, Morningstar Risk, property of their respective owners. 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. 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. 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 typePlease of rememberportfolio structuring, that all investments carry some level of risk, including the potential loss of principal invested. They do attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.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.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 Frankare permitted Russell Companyto use under is the owner of the Russell trademarks contained in this material and all trademark rights related license from Frank Russell Company. 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. 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. Copyright © Russell Investments Group, LLC 2017. All rights reserved. Russell Investments Financial Services, LLC, member FINRA (www.finra.org), part of Russell Investments. Russell Investments Financial Services, LLC, member FINRA (www.finra.org), part of Russell Investments. First used: September 2017. RIFIS: 19182 First used: September 2017. RIFIS: 19182

8 // RUSSELL INVESTMENTS // WHY ADVISORS HAVE NEVER BEEN SO VALUABLE THIS MATERIAL IS FOR FINANCIAL PROFESSIONAL USE ONLY AND Russell Investments 133 8 NOT// RUSSELL FOR DISTRIBUTION INVESTMENTS TO CURRENT // ORWHY POTENTIAL ADVISORS INVESTORS. HAVE NEVER BEEN SO VALUABLE THIS MATERIAL IS FOR FINANCIAL PROFESSIONAL USE ONLY AND NOT FOR DISTRIBUTION TO CURRENT OR POTENTIAL INVESTORS. 1177 Avenue of the Americas, 7th Floor New York, NY 10036

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ADVANCING THE FUTURE OF INVESTMENT ADVISORY SOLUTIONS