The Business of Investing - Part 6/6: Some Advice

With everything that's wrong in the business of investing, it's absolutely possible to get good quality help, if you need or want it.  The subject of this post - the last in the series - is advice.  It strikes me that the best way to dish out that advice is by putting it within the context of a process - the process someone starting out might go through to find a value-adding investment management arrangement.   You may find that you're already somewhere along the process, not at step one.  So, skip ahead.  This post is intended to be entirely practical, not a narrative. 

Do you need help investing?

Not everybody needs an investment manager, but many people do find value in hiring someone to handle it for them.  Some people can do it on their own, but they don't want to spend the time required to do it well.  Others recognize that they have neither the temperament nor the training to invest.  Still others recognize that because of the offices and roles they hold, managing the money themselves might constitute a conflict of interest.

My friend Steve told me of a urologist known as "the Cowboy."  He earned this moniker because he performed his own vasectomy.

Sorry - I should've warned you to get a bag to breathe into before I shared that one.

I bring the Cowboy up because most people can't do that sort of thing: they don't have the knowledge, nor do they have the practice, nor do they have the stomach to do it.  It's just something beyond their ability.  Investing is a little different.  Many more people can invest well for themselves than can perform their own surgeries, but there are many people who just can't invest well.

For others, hiring an investment manager is more like the decision to hire a lawn care service: they could most likely do the work, but it'll look better if the pros do it and they'll have more free time, too.  Likewise, if you don't need help investing, do you want help investing?  In either case, paying someone else to do it for you is perfectly acceptable, provided the cost is right (more on that later). 

Hire an expert for the work you need.

Later this year, I'm going to enter a contract in what is, for me, a really large deal.  I'm a reasonably well-educated guy, so I'm considering reading the contract carefully and signing it myself.

Oh, sorry, that's what I'm NOT going to do.

I'm no idiot, but I need an attorney to review the contract for me - someone who understands precedent and someone who can say "You know, Steve, I saw this type of structure 5 years ago and it didn't work well."  The unique need I have is to make sure that the big contract doesn't include risks I haven't considered.  Beyond needing help from an attorney, what I really need is a corporate contract specialist.  Even an capable lawyer practicing in torts or family law might not be able to give me the advice I need. 

Medicine works the same way.  I have a friend who has three layers of specialty: 1) he's a surgeon; 2) he's an orthopod; and 3) he deals with traumatic injuries.  His scope of practice is narrow, to be sure, but if you lay your Ducati down on the interstate and crush your femur, this dude is exactly who you want to see.

If you need life insurance, as many of us do, hire an agent whom you respect and who will educate you on your alternatives.  If you need tax return preparation and planning, hire a CPA.  If your financial life is chaotic, consider hiring a financial planner to construct a financial blueprint for you to follow.

But, when these guys go to sell you investment management, remember this: they're not investors.  They may sound like investors.  They may even point to the smart guys at the home office who construct model portfolios for them, saying "But, those guys are investors."  Way too often, insurance guys are really just there to sell high recurring expense annuities.  CPAs can bee myopic with investing - we just had a CPA advise a prospective client against selling her ultra high-cost annuity because it would mean paying a capital gains tax (back when that rate was 15% for her bracket).  And while some financial planners are really good at planning, others do "planning" really as a means of supporting the product sale. 

If you need help investing, hire an actual investor - someone who knows security analysis and portfolio management.  Hire someone who's done the necessary academic work (undergraduate degree in a relevant field from a top university, MBA, MS in Finance, Chartered Financial Analyst, etc.), who has spent years doing the work of an analyst and portfolio manager.   Hire a firm that uses individual securities and does their own fundamental research.  Hire some grey hair, which started getting grey because of dumb mistakes he made 2 or more recessions ago.  Hire a guy who believes that your unique situation demands a unique solution.

But don't ever pay a non-investor to invest for you.  It's just not worth it.

Insist that your needs come first.

A fiduciary is someone who puts others' needs before his own.  Understand that something like 85% of individuals holding themselves out as financial advisors are not actually fiduciaries.  This distinction isn't as important in the institutional space, where knowledgeable investors know the difference between a sales job and analysis.  But when it comes to individual investors, you should always hire someone who puts your interests ahead of their own financial ambitions.  Otherwise, how could you ever tell whether the recommendations given you would be suited primarily to meet your unique needs? 

Fiduciaries are identifiable in a few ways.  One, Registered Investment Advisors (RIAs) are required by the SEC to uphold a fiduciary standard, as laid out in the Investment Advisers Act of 1940.  Generally, you can ask whether a prospective financial advisor (note the strategic similarity of terms) is also an investment advisor, or a registered representative (broker).

Two private designations that force members to adhere to a fiduciary standard are the Chartered Financial Analyst (CFA) and the Certified Financial Planner (CFP).  Even if an advisor is not working for an RIA firm, she could still be held to a fiduciary standard by her membership in the groups sponsoring the CFA and CFP. 

Never, never, never over-pay for professional investment management.

Our fee schedule starts at 1.00% per year on the first $500,000 of assets we manage for clients, and declines from there:

• 0.90% on invested assets between $500,001 and $1,000,000
• 0.75% from $1,000,001 to $2,500,000
• 0.65% from $2,500,001 to $5,000,000
• 0.55% over $5,000,000
• We discount the above fee schedule by 0.15% at each tier for non-profit clients

Three years ago, we participated in a national benchmarking study, which looked at advisory fee structures at scores of firms like ours across the U.S.  The results were illustrative: our pricing was in line with the average for account values over $2.5 million, but below average for the lower tiers.  It's most common for fee schedules to start between 1.25% and 1.50%

Our objective is to keep "all-in" costs below 1% annually for the vast majority of our clients.  However, adding custodian commissions (of which we receive none) to the total cost will generally push clients with account values below $500,000 up to an annual range of 1.03% to 1.07%.

We like this level, because it allows us to appropriately resource our business, without claiming too much of the appreciation due to our clients.  In one recent client review, we discovered that our total fees over the last decade amounted to roughly 10% of the portfolio's total income and capital gains during that period.  That level will vary from client to client, certainly, and in this case it also includes a period of time when they were subject to an even lower fee level.  However the key point is this: you want to pay enough to ensure quality management without losing too much of your capital to management costs.  

This is a good objective for investors: strive to keep "all-in" costs below 1.00% annually.  Because we are slightly under-pricing the business (at least on a peer basis) at the low end and because we believe sticking with the fee schedule for everyone is important, we don't discount our fees.  However, many advisors do discount their fees, and you ought to try to negotiate a fee that favors your situation. 

Keeping all-in costs to less than 1.00% annually is far harder to do with mutual funds, annuities, and third-party money managers than it is with individual securities.  My 1.00% fee on top of shares of a particular company's stock works out to be...drum roll please...1.00%.  However, if I were to layer my 1.00% fee on top of a mutual fund with a 1.00% fee, your all-in cost would double.

I'm humble enough to acknowledge that we are neither the smartest nor the best resourced investment team in the game, and that some managers will out-perform us.  But the level of out-performance (if it occurs at all) will be a small fraction of 1.00% per year.  Thus the all-in costs for our clients are compelling on an after-fee basis, than if we used mutual funds.  To put it another way, if your advisor charges you 1.00% and subcontract the investing work to a mutual fund manager who also charges 1.00%, my "hurdle rate" becomes 1.00%, or the difference between 1.00% (my fee) and 1.00% + 1.00%. 

Folks, I'll happily take that hurdle rate.  All.  Day.  Long. 

What About Mutual Funds?


I don't mean to make it sound as though mutual funds are bad.  They're not.  If you have too little money to diversify adequately in individual securities, you may have trouble attracting the interest of quality investment managers.  That's absolutely not something to be embarrassed about; I'm just being frank.  If you find yourself in this situation, a mutual fund may be a good solution for you.  And here, frankly, you can keep it pretty simple.  I would contact Vanguard and ask them about their LifeStrategy Funds.  These funds  will offer you a great way to accumulate long-term wealth and can be helpful until you have a portfolio of enough size to use individual securities.

Another firm worth noting is Dimensional Fund Advisors.  DFA, like Vanguard, is low cost.  Unlike Vanguard, though, DFA only works through financial advisors - many of whom are independent fiduciaries.  DFA's site will direct you toward an advisor in your area who uses their funds, which is important because DFA is selective in which advisors they allow to use their funds.  You can find a DFA advisor here.   

Keep in mind that if you do go with an advisor using funds before you have much money, it may be difficult to leave them when you accumulate more.  One of the most important long-term considerations is the total or the "all-in" cost, which includes the advisor fee and the mutual fund fee.  If you can keep those two fees to less than 1% of assets annually, then you're probably in a good spot.  If not, you should recognize going in that you should probably switch advisors down the road.

OK, I'm done.

My hope is that this series has positioned you to be a better consumer of financial advice.  Obviously I hope that for you, because you'll be better served if you have some tools to use as you go "shopping."  But I also hope this information gets out because the whole industry will become healthier - consumers and providers alike - when we raise the bar.

For obvious reasons, I cannot give you much specific advice here.  That's one of the reasons why I wanted to take the first 5 posts to describe the current situation in our industry.  If you remember to 1) hire an expert for the need your have, 2) hire someone who's bound to put your interests first, and 3) find a solution with reasonably low on-going costs, you'll do better than most.

And, friends of mine should know, if you have more specific questions, just ask.

The Business of Investing - Part 5/6: Price vs. Value

In the last post, I claimed that in the pursuit of scale, investment management companies have spawned negative consequences.  The majority of those negative consequences can be grouped into two main classes: Price and Value.  Warren Buffett has famously distinguished that "price is what you pay, but value is what you get."  That applies to any service, product, or investment. Unfortunately, in the business of investing, retail investors often pay too high a price for too little quality.  


Value

Let's pick on my internist again, shall we?  Suppose my sleeplessness didn't improve, so I head back to Doc to find out what's next in the plan.  Doc listens - not exactly carefully - but practically before I can stop to breathe, interjects with:

"I've got it!  What you really need is a complete bedroom makeover.  Let's start by toning down the yellow on the walls a bit, then we'll tackle the furniture.  Speaking of furniture, a four-poster bed would just be the bomb in your bedroom!"

"Doc, my bedroom isn't all that bad.  I actually like the color and the furniture works just fine.  Frankly the idea of changing it all around right now makes me tired - is that where you're headed?"

"No, no, no.  You see, while I am also a doctor, what I really am is an interior designer.  Doctoring is just a great way to make money.  Now, how do you feel about modern art?"


Hyperbole again?  Yes.  Out of line?  Hardly.

The vast majority of investment advisors don't know how to use individual securities, and a huge percentage of them actually don't even select mutual funds for you.  Here's how scale works: the home office hires a small number of smart, number-cruncher types to construct model portfolios (read: "mass customization"), which are then distributed through an army of glad-handing, relationship-managing, asset-gathering, socializers.  The socializers are compensated based on production - a variable cost - so, there's relatively little risk in bringing another one, or ten, or two hundred on.  What kind of training do they get?  Ha!  The exams FINRA makes you take (the Series 7, Series 6, etc.) are not only barely worthy of the word "training," they're also not supported by the home office.  No joke: after one of those exams, I came back to the office and told my branch manager that I got a 96% (you needed 70% to pass).  His response?  "You studied too hard."    

Also remember that the glad-handers aren't in it for diversion; they're trying to make a lot of money.  And how do they make money?  Scale, of course!  Their incentives are 1) to plug as many customer assets into model portfolios, and 2) keep them there.  That's it, plain and simple.  Could an advisor manage 100 customer "relationships" this way?  (You must be joking.)  How about 200?  (Seriously: piece of cake.) Is 500 customer relationships too many? (No, I'll just hire a few assistants who know less than I do).  You get the point.

Now, to be fair, not all investment advisors are asset-gathering drones.  Some have other, primary fields of expertise, like accounting, insurance, banking, or financial planning.  But remember the fictitious example of my doctor: what if, because some insurance products are constructed to look like investments, your insurance salesman considers himself a true investment manager?  What if, one day long ago, your CPA thought to herself: "Gee whiz, my clients really get lousy advice from their brokers; I'll bet the competitive bar is set so low that I could get in on some of that action!"

Here's a newsflash people: investing well is hard work.  It's not impossible for you to do on your own.  Nor do you need advanced degrees to succeed as a money manager.  However, if your investment advisor is just some guy who picks mutual funds for you, what is the probability he's adding sufficient value to your life? 

I want to say a few words about financial planning.  This is an area where I'm critical, but it's also distinct from both the glad-handing broker and the mutual fund-selling insurance guy.  Let me start off by saying that financial planners mean well.  Their profession grew part and parcel with the fee-only business, which looked disdainfully at transactionally compensated brokers.  Financial planners - if they hold the Certified Financial Planner designation - are held to a fiduciary standard.  These guys really mean to do the right thing.

And often times, financial planners bring clarity to your finances.  They can help you paint a picture of your financial future - help you understand the future implications of delaying gratifying purchases right now.  They might even introduce you to budgeting for the first time.   

There are a few areas of financial planning that are good to do once (learning how to set up and live with a budget), there are other areas which should be reviewed every several years (the amount of life insurance you need, whether your estate plan - i.e., your will - still fits), but there aren't many that should be done every year.  One that comes to mind is tax planning.  If you happen to own interests in a few small businesses, or if you're contemplating making either a large or illiquid charitable gift, spending good money on a sound tax plan can make a ton of sense.

But here's the thing: tax planning should be done by a CPA, shouldn't it?  Ask any CFP (who's not also a CPA) if they're offering you tax advice, and you'll get a disclaimer a mile long.  Also, if your taxes are complex enough to require help, don't you really want your CPA focused on tax planning and not dabbling in investments because she can make some easy money that way?

As I mentioned in a previous post in this series, I spent two and a half years in financial planning.  I will say that even though we charged a lot for the plans ($5,000 - $15,000 per year), there were enough honest to goodness tax experts in my branch to add some real value to client tax planning.  And yes, for that kind of coin they'd keep a very close eye on all of the other planning areas that actually require less attention.

In many cases, financial planning is a function meant only to help you feel secure about handing over your investment accounts.  Fortunately, that was not at all the case in my experience.  However, my firm did have one giant problem.  While the heartbeat of the organization was planning-focused, 80% of their revenues actually came from investment management, which was - no surprise here - derived from client money, virtually all of which was parked in model portfolios constructed by a small team of "experts" back at the home office.  Unfortunately, the experts weren't that: none of them had ever actually managed securities portfolios before.  Their careers were simply focused on selecting mutual funds, not on understanding value.   

The June issue of National Geographic has a fascinating piece about the climbing conditions on Mt. Everest.  The short version: everything from tattered tents, to human waste, to corpses of dead climbers litters the world's highest peak.  One point the article made was that there exists a wide range of prices and quality of guide services.  Any guide can get you up the mountain; but the experts are the ones that get you back down - alive.  

The same holds for investment management.  If you need a periodic financial plan, hire a planner.  If you need to buy life insurance, hire an insurance broker.  If you need tax return preparation and planning, hire a CPA.  And if what you need is someone to manage investments for you, do yourself a favor by hiring an actual investor. 

Price

You probably get the idea that I'm not wild about commissions.  It just doesn't make sense to hire someone who's actually compensated to place financial products, if what you want is an objective professional service.

But again, recalling the Edward Jones example, it is possible to pay a commission on a fund and amortize that cost over a long holding period.  Furthermore, you can't avoid commissions entirely.  Your no-load mutual fund manager pays some small commissions to trade her portfolio's securities.  And if you had your money managed by an actual money manager, you'd pay a small amount in commissions as well - usually $10 or less per trade these days.

In contrast to commissions, fees better align your interests with those of your advisor.  Regrettably, the practice of investing customer money in mutual fund model portfolios means layer upon layer of fees. The first layer goes to the mutual fund manager, while the second layer goes to the advisor.  Together these fees can add up to 1.75% or more of assets every year.  Let's say that 1.00% of that goes to your advisor, while 0.75% goes to the mutual fund managers.  How much difference does that actually make?

Let's assume you park $100,000 with a manager charging you a total or "all in" fee of 1.75% (1.00% for himself, 0.75% for the mutual fund fees).  We'll also imagine that your investments will earn 7% per year before fees, which makes your after-fee return 5.25%.  After 20 years, your portfolio would've grown to $278,254.43.

Instead, let's say you chose the identical funds yourself, thus avoiding the 1.00% advisor fee, but still paying the 0.75% mutual fund fees.  The actual after-fee return would be 6.25% and the end value 20 years hence would be $336,185.34.

You would've paid an excess of $58,000 in fees and given up 21% of your potential return just by paying the advisor to pick funds for you.  Hey, I'm all for lawn mowing services, but...

What's worse is that often times the mutual fund + advisor arrangement generates an all in cost for investors north of 2.0% annually.  The truly strange phenomenon here is that while lower value mostly means lower cost, in the investing world - because of fees on fees - the opposite holds true.

Folks, if all you need is someone to help you select some mutual funds, you really shouldn't have to pay dearly for that service.  It's really pretty basic.  Mutual funds were designed with you in mind.  That they're viewed as complex is a construct of an industry hell-bent on finding someway to justify its exorbitant fees.

The next post is the last in this series.  In that one, I'm going to try to wrap it all up and offer you several recommendations for getting good investment management at a reasonable cost. 

The Business of Investing - Part 4/6: A Cancer Called "Scale"

I'm a big fan of the industrial revolution, really I am.  The picture many of us have of dirty textile mills and unsanitary, Victorian-era slaughter houses looks apalling when juxtaposed with today's workplace standards.  But if you compare, say, the hardships and health risks of American frontier life, or the life of an 18th century English farm peasant to Chuck Dickens' neighborhood, the latter looks a lot better. 

Certain types of goods and services lend themselves well to mass production.  How many of us could really afford our own cutsom car?  Does it matter to you that your Cherios are identical to mine?  And would it really make sense to pay for your own unique amusement park ride?

In the examples mentioned above, the only way in which certain goods and services could ever be affordable is if essentially the same experience is shared by many people.  Sometimes uniqueness matters, sometimes it doesn't.

Scale Doesn't Always Work 

Let me begin with a rhetorical question: is investment management properly a professional service or a means of product distribution?

In contrast to the Cherios example above, some services require unique solutions because the needs they seek to satisfy are also unique.  Medicine offers a great example.  I went in to see my doctor a few weeks ago because I've been having trouble sleeping for about the last 4 years.  Before the doc prescribed a treatment, he asked me loads of questions about my sleep "hygiene."  "Do you read in bed? (Always.) Then stop; Do you ever have an adult beverage in the evening? (Often times on Friday nights.) Knock that off, too; If you snore, do you stop breathing when doing so? (Um, Doc, how would I know?) Ask your wife and get back to me."

At the end of this interrogation, did I get a prescription to Lunesta or Ambien?  Nope.  I got a four staged solution, geared toward me specifically.  First, I had to control the environment better; I've now quit reading in bed...ouch.  Next, given the impact sleeplessness has on my energy level, Doc recommended I take Melatonin - an over the counter hormone whose natural production in humans begins to decline in middle age.  If that stuff doesn't work, then we might try an anti-depressant: not because I'm depressed but because it has a secondary approved indication for sleeplessness.  Finally, and depending on my wife's snore report, if I do stop breathing when I snore, Doc may put me in a sleep study. 

If my age, weight, medical history, symptoms, or responses to treatment were any different, Doc may have recommended an entirely different treatment plan.

Imagine another scenario where I go to see my Doctor:

"Good afternoon, Steve.  I understand you're having trouble sleeping, is that right?"

"Yes, it started about -"

"Well, I'm going to recommend that we put you on Amoxicillin, Lipitor, and, by the way, you still need to lose 15 pounds.  Your co-pay is $25."

"But, Doc, wait!  What's that stuff have to do with my sleeplessness?!"

"Well, many people get bacterial infections, thus the Amoxicillin.  And lots of guys your age have high colesterol and should lose some weight.  You ask really fantastic questions.  Thanks for coming in, and have a great weekend!"

The Model Portfolio

OK, so that last example was hyperbolic. Any doctor pulling that kind of thing would lose his license.  Yet investors tolerate that same sort of thing from their investment advisors all the time, and the primary vehicle is what's known as "the model portfolio."

Most investment firms - of all sizes - use model portfolios.  A model portfolio just means that the investments within the portfolio are standardized and applied across many investors' accounts.  Let's say you and I each made an appointment with a particular financial advisor, who uses models.  Assuming you and I answer the same few investment questionnaire queries similarly, you and I would be placed into the same model portfolio.  If the model calls for a 10% allocation to XYZ fund, your investment might be $10,000 and mine $5,000, assuming our total account values were $100,000 and $50,000, respectively.

Oh, sure, there could be a little differentiation if our "risk profiles" were different, and the way the advisor would handle that would be by adjusting the primary asset allocation - the mix between stocks and bonds.  If my questionnaire reveals that I'm less risk tolerant than you are, I might be placed in a 75/25 (75% stocks, 25% bonds) model while you might be in an 80/20 model.

Here's the advisor's recipe:

1. Ask a few questions about "risk" tolerance.
2. Select model portfolio indicated by the risk profile.
3. Push the giant green "INVEST" button.
4. Sneak out for the 2:30 tee time.  

And here's what I'm getting at: the model portfolio has become so commonplace that investors don't stop to ask important questions, questions that could well render the model portfolio approach thoroughly inadequate.  Questions like:

• How can I ensure that I have $10,000 available for my daughter's semester in Europe in two years?
• I need $75,000 in income from the portfolio when I retire.  Will the model be able to meet that need with interest rates as low as they are?
• I work for IBM - I don't want any more information technology exposure than I already have.  Can we scale back on tech investments in the model?

Model portfolios aren't designed to meet unique needs - they're designed for scale.  The problem is that the entire purpose of investing is to ensure that unique financial needs are satisfied by financial assets.  Does it make sense that those unique needs could be satisfied with mass-marketed, generalized solutions?

Time to be Painfully Blunt

Investment firms and most of their advisors don't really give a rodent's gluteus about your unique financial needs.

Period.

How do I know this?  Well, for starters, they don't hire investors, they hire "relationship managers" whose sole function is to treat you so well - make you feel so "tucked in" - that you keep your money with their firm through thick and thin.  They hire "asset gatherers" whose function is to distribute model portfolios and financial products to as many people as can be glad-handed, cajoled, or guilted into signing up with their firms.  They hire "financial planners" who run colorful graphs which actually tell you nothing useful, but probably will make you feel as though the advisor really understands your needs.  (By the way, I'm not down on financial planning per se - heck, I spent two and a half years as a planner.  I'm going to address financial planning in a future post.) 

And why do they hire these non-investors to invest your money?  Why wouldn't they hire actual investors to satisfy the needs of their clients?  Why wouldn't they insist that unique investment needs are satisfied with uniquely selected investments?

I'm glad you asked:

1. You don't demand it.  You don't want to deal with the people who know how to invest because, frankly, they're not nearly as fun as the relationship managers.  Investors are geeks.  They tend to drone on about things like cash flow and finding security mispricings.  Relationship managers golf well.  Relationship managers send you birthday cards.  Relationship managers make you feel like you're on their team and that makes you feel successful. 
2. Good investors require years of education and training.  Investors are, in a word, expensive.  Relationship managers, on the other hand, need to pass a barely relevant FINRA exam like the "Series 6" or "Series 7."  All that's really needed to run a successful investment firm are a bunch of ambitious, personable people who want to make a lot of money without having to study too much. So, hire a few investors to construct model portfolios, then send out an army of asset gatherers to jam customers into the sausage maker.  That's a really profitable model because it offers...

Scale.  You're OK with it, and it's way more profitable for the firms that employ it.  So, it remains as the dominant investment management service paradigm.

Puke.


A Bizarre Market Reality


Curiously, some firms do actually employ investors to work with each client to construct unique portfolios geared to satisfy unique financial needs.  And guess what?  95% of the time, it's less expensive than the traditional fee-on-fee approach the non-investors are forced to use.

This discrepancy shouldn't exist in an efficient market.  Investors should recognize the grossness of mass marketed model portfolios and investment products they're sold and should - in theory - fire incompetent glad-handers and hire investors.

But so often, they don't.

This comes back to a point I made in the first post in this series: markets don't function well when participants are either un-willing or uneducated.  That's what I'm on about: education.

Scale-induced incompetency is the cancer that plagues our business.  But, like a deep tumor, it's hard to tell that it's there.  The symptoms of its presence, though, tend to manifest in two distinct ways that are more easily discerned.  The next post will cover the two broad categories of symptoms: price and value.  In the post following that one, I'll conclude the series with my specific recommendations to extract maximum value from an investment management relationship. 

The Business of Investing - Part 3/6: Advisors vs. Investors

Advisors, Not Investors

As I noted in the last post, fee-only advisors have made two major contributions the the business of investing.  One, they introduced the importance of aligning their compensation structures with the goals of their clients, and two, they recognized the importance of the fiduciary standard.

But fee only advisors don't come out smelling all rosy.  Despite their best intentions at arranging compensation to align with customer interests, fee-only advisors - like brokers - have typically never been schooled as investment analysts.  Most fee-only advisors grew out of the brokerage model of the late 1970s and early 1980s, which had simply shifted the broker's product distribution function from newly-issued stocks and bonds to mutual funds.

Now, mutual funds have their place: they're designed to provide diversification when an account value is too low to achieve it with individual securities.  But to their core, mutual funds are designed as means for small investors to band together to hire professional portfolio management.  Mutual funds provide diversification and management for a cost, but layering an advisory fee on top of mutual fund fees and trading costs dramatically diminishes their long-term return potential.

Fees on fees vs. commissions is really a taller midget kind of thing.

But worse than the expense - and also to the point of this series - is the fact that mutual funds allow non-investors the opportunity to earn a living distributing investment advice.

Think about that for a minute.  We'll come back to that one.

Risk and the Academy
  
The idea that mutual fund investing is complicated is preposterous, but it's not without some academic backing.  In the 1950s, a graduate student at the University of Chicago by the name of Harry Markowitz introduced the idea that different types of investments behaved differently in the same economic environment.  Because of this, Markowitz postulated, portfolios of dissimilar assets could be constructed to virtually eliminate long-term risk. Risk, for the purposes of academic models, is mainly construed as mean-variance, or volatility.

It didn't take too many years for advisors to apply this view to their customers investment portfolios.  In order to substantially reduce portfolio-level volatility, mutual funds representing many different "asset classes" were introduced to portfolios.  If the historical model showed that adding a 1.5% position in an emerging market, small-company stock fund would reduce risk while adding return, advisors encouraged customers to buy the new fund.

This risk concept had two critical flaws.  One, investors, in my experience, really don't think of risk as standard deviation, or any other statistical measure.  Yes, they may get nervous when stock prices gyrate, but risk to the average investor is profoundly personal, not statistical.  "What is the likelihood that my financial assets will meet my financial needs?" is a far better way of characterizing the average investor's entirely rational risk measure.

The other problem was that Markowitz's theory ("Modern Portfolio Theory") didn't actually work when it was supposed to.  During the 2008-09 global financial crisis, financial assets across the spectrum declined simultaneously - with the notable exception of U.S. Treasury bonds.  Portfolios of 5, 7, or 9 mutual funds - which were designed to mitigate the volatility of such events - failed miserably, wiping out literally trillions of dollars of wealth.

The Stickiness of Asset Allocation

Despite this obvious failure of theory, advisors continue to stuff portfolios full of mutual funds.  I can only conclude that this practice continues because the pretense of complexity justifies the two layers of fees: one for the mutual fund, the other for the advisor.  If a small investor really only needed one low-cost mutual fund to achieve her goals, how could an advisor justify a high enough fee?

I used to work for a firm which constructed model portfolios of mutual funds for clients.  There were always 7-10 funds in each investor's account and the investment research department would produce detailed PowerPoint slides demonstrating why clients needed to own them.  Field advisors largely relied on the "experts" in the home office to construct the models.  With great predictability, the research department would roll out a few changes to the funds each August, just in time for the Fall meetings with customers.

Of course, managing the money wasn't nearly as difficult as it was held out to be, but that was in the theoretically-heady days before the financial crisis.   However, I understand that essentially the same process continues today, and I have to conclude that the on-going complexity is the result of either a head-in-the sand move or it's used as a means to justify fess on fees.

I'm going to do my best not to pick on specific firms, but I have to use one as an illustration.  Edward Jones isn't what I'd call a top-shelf investment advisory choice.  Seriously, if your strip mall investment store is buttressed by a Subway sandwich shop and The Mattress Firm, you can't possibly be attracting the best and the brightest.

On the other hand, Jones portfolios are very predictably allocated among 3-5 mutual funds managed by the American Funds group.  This is the result of the relatively smart guys in St. Louis keeping their brokers on a short leash.  While these funds charge sales loads, they also tend to carry low annual expense ratios.  If you're going to use mutual funds and you're prepared to keep them for several years, the cost of the load can be amortized across the holding period, making your total annual cost lower than a fee-only alternative. 

Basic asset allocation - among growth assets (stocks), income assets (bonds), and liquidity assets (money market instruments) - is a wise discipline, and obviously sound.  But complex models just add complexity and cost.

Investors

It always puzzles me why more firms don't use individual securities instead of funds.  If you've never learned how to value a company or the principals of diversification, I suppose the process of managing an entire portfolio of individual securities could seem scary and inappropriately "risky."  That might explain the fear I referenced above. 

More likely, it's that advisors aren't expected to be investors.  As middlemen, their firms want them to distribute products, whether that "product" is a loaded mutual fund or a model portfolio of no-load funds.

But there's a far more powerful force at work in the business of investing: scale - and that's the subject of the next post.