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.
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