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.