Q3 results from Scotiabank, BMO beat analyst expectations

Canada’s retail securities industry has proven to be surprisingly profitable over the past several years, with larger firms generally outperforming their smaller competitors. As a result, small and mid-sized firms will have to find ways to boost revenue and cut costs, including revising their advisor payouts, if they hope to compete, according to the Investment Industry Association of Canada (IIAC).

The investment industry’s profits were up in the second quarter — both quarter-over-quarter, and year-over-year, according to the latest set of quarterly data from the IIAC, released on Thursday. Moreover, Canada’s wealth-management business has been profitable over the past five years, IIAC president and CEO Ian Russell reports in his latest letter.

Specifically, the investment industry’s revenue rose by about 6% annually over that five-year period while costs rose by just 2% per year, on average. “This performance gives some confidence that future prospects for the wealth-management business are positive,” Russell says, adding that the strong demand for financial advisory services will likely continue as clients age and their need for advice rises in tandem.

However, the performance of the wealth-management business has been uneven, with the large firms (both the integrated firms and the independents) benefiting from their superior scale, cost control and investment in technology whereas, some of the smaller firms have struggled, Russell says.

Indeed, Russell reports that 36 retail firms have left the industry through mergers, acquisitions and closures since 2011 and estimates that at least 30 others “are under considerable earnings stress.”

Nevertheless, many small and mid-sized firms have been profitable over the past few years too, Russell notes: “These firms have made herculean efforts to control cost increases while adapting technology internally or through outsourcing. Tight containment of costs is crucial to sustained performance in the advisory business.”

Some of this cost control has come through the use of technology to improve efficiency, and firms have also altered their payout grids in an effort to boost bottom line performance.

“In the last four years, and even earlier, the advisor payout percentage has been under downward pressure,” Russell notes, with payouts pushed into the 20% range for smaller revenue producers at some of the large firms.

For smaller firms, altering payouts has been more difficult given the need to attract and retain advisors, Russell says, although he suggests this will have to happen at some point.

“Unless this variable compensation moves into better alignment with firm revenue to compensate for rising costs and business risk, small firms will find it difficult to improve net income, attract shareholders and the capital to acquire assets and build scale,” Russell says in his letter.

Increasingly, this pressure may also push firms to adopt principal-agent models for their retail advisory forces, Russell says: “For mid-sized independent firms, with advisors in a principal-agent relationship with the firm, there is good alignment between advisor and the firm in sharing revenue and costs.”

However, payouts under such arrangements are also under pressure, he notes, with the traditional 80% payout being pushed down to 65%-70% at some firms.

From the advisor’s perspective, their service offerings will also have to evolve, Russell suggests: “The key for higher overall advisor performance in a low interest rate environment and trend-less equity markets is to focus on cost-effective discretionary management of market-indexed products, such as ETFs and mutual funds, and value-added financial planning and effective tax advice. The modern advisor, in effect, needs a multi-faceted approach focused on the right products and style of investing, and on building deep client relationships, to succeed in today’s marketplace.”

Ultimately, Russell says he expects that small firms will survive, and thrive: “We are optimistic smaller firms will be successful containing operating costs and boosting revenue through innovative wealth management techniques and productivity enhancements. These measures will improve the bottom line and return on equity, drawing capital to smaller firms.”

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