From a risk manager’s perspective, a bank is a derivative on interest rates. Similarly, RIA practices can be viewed as a derivative on stock and bond markets. Here’s a quick way to estimate the sensitivity of your practice to markets.
Start with your firm's AUM. We'll use $200 million for our example.
Segment your book of business into different buckets based on your breakpoints in fees. Here's what we'll use for our example:
Bucket 1 has $25 million generating $250,000 per year (1.00% AUM fee)
Bucket 2 has $55 million generating $495,000 per year (0.90% AUM fee)
Bucket 3 has $75 million generating $555,000 per year (0.74% AUM fee)
Bucket 4 has $45 million generating $270,000 per year (0.60% AUM fee)
Gather the information about your model portfolios. Our example firm uses the following three models:
Aggressive portfolio (80% SPY and 20% SHY)
Moderate portfolio (60% SPY and 40% SHY)
Conservative portfolio (10% SPY and 90% SHY)
For simplicity, let's assume that:
AUM buckets 1 and 2 are comprised of 25% Aggressive, 50% Moderate, and 25% Conservative portfolios
AUM buckets 3 and 4 are comprised 50% Aggressive, 30% Moderate, and 20% Conservative portfolios
Now the big question: what is the market risk to revenues of this firm?
If nothing changes, our example firm is expected to generate $1,570,000 in fees per year. In order to figure out how much is at risk, first, we need to estimate the risk of each portfolio. This is easily done withSmartRisk software. Just input your firm as if it were a client and input the firm's AUM buckets as if they are your "client's" portfolio.
In our example, in a bad quarter, AUM buckets 1 & 2 could drop 13% in value. In a bad year, they eachcould lose 26% of their value.
Our example firm’s revenue after a bad year would look as follows:
Bucket 1 has $18.5 million generating $185,000 per year (1.00% AUM fee)
Bucket 2 has $40.7 million generating $366,000 per year (0.90% AUM fee)
Bucket 3 has $54 million generating $400,000 per year (0.74% AUM fee)
Bucket 4 has $32.4 million generating $194,000 per year (0.60% AUM fee)
This adds up to revenues of $1,145,300 after a bad market year, compared to $1,570,000 if nothing changed:The firm has a risk to revenue of 27.05% due to market exposure.
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