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.
Friday, June 21, 2013
Friday, June 14, 2013
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:
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:
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.
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:
- Ask a few questions about "risk" tolerance.
- Select model portfolio indicated by the risk profile.
- Push the giant green "INVEST" button.
- Sneak out for the 2:30 tee time.
- 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?
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:
- 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.
- 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...
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.
Friday, June 7, 2013
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.
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.
Friday, May 31, 2013
The Business of Investing - Part 2/6: Brokers, Advisors, and Middlemen
The Middlemen
The practice of paying someone a fee for investment advice is fairly recent. The Investment Advisors Act of of 1940 governs the dispensation of advice, but the practice itself remained a sideshow until roughly the late 1970s. The reason was that the far larger, better established business model wasn't to provide advice but to broker securities transactions.
As the American economy grew and became increasingly industrialized, securities markets developed as a source of capital. Banks continued to lend debt capital, but the need was greater than the availability of loans, so companies issued bonds. If you think about it, a bond is very similar to a bank loan: both are promises to payback the borrowed amount, plus interest. They differ mainly in the source of funding (bank lending portfolios, or investors).
Some companies didn't want - or couldn't afford - the interest payments associated with bonds and bank loans. Their business models might take more time to develop, and cash might not be flowing so soon after starting. However, the entrepreneurs launching those businesses were willing to give up a portion of the ownership of the company in exchange for capital needed to build factories, purchase machines, and pay laborers. The solution was common stock, or equity capital.
With a growing population and the only intact manufacturing capacity among major countries, the US was uniquely positioned for growth following World War II. Capital was needed to fund the expansion, and capital markets matured to meet the need.
Investment banking served a similar function to traditional commercial banking: both provided capital to fund the massive US economic expansion. Commercial banks made - and usually kept - loans. Investment banks, on the other hand, underwrote - and usually sold - new stock and bond issues. Those new issues were sold primarily to wealthy customers of investment banks, many of whom were industrialists themselves and thus qualified to weigh the risks of owning the new securities.
The stockbroker arose as the intermediary between the underwriters at the investment bank and the rich customers who could purchase the new bonds and stocks. A broker's function was never be the objective purveyor of sound advice, but to place securities. Their compensation was structured accordingly: with new issues they would collect part of the spread between the price a security was offered to the public and what was passed on to the issuing company. But brokers also participated in the secondary markets for securities - the exchanges - and would collect a commission for helping customers sell one stock to buy another. The function of the broker and his compensation structure were fairly unobjectionable. Sure, a rogue broker could lie to his customer, but the basic function of placing securities and charging commissions worked well, given the broker's obvious purpose and the his customers' average sophistication.
The Emergence of Advisors
In the mid-late 1970s the business of investing began to change dramatically. On May 1, 1975, the Securities and Exchange Commission abolished the fixed commission schedule. Previously, the only real difference between a broker at Bear Stearns and one at Merrill Lynch had been which one had the best access to new offerings. In mid 1975 though, guys like Charles Schwab and Ernest Olde took advantage of the new de-regulation to begin offering deeply discounted commission rates. This action had two effects. First, the demise of the previously high, uniform commission schedule meant that average savers, or "retail investors," were no longer effectively priced out of owning stocks. The second effect was that traditional investment banks, which had elected to retain high commission rates, were suddenly forced to justify their costs; in part they did this through research. Analysts at "full service" firms issued research reports with the purpose of providing opinions on which stocks investors should buy. Brokers likewise began to assume the role of advisor, offering to help customers choose among different investments. Of course they still retained the function of placing underwritten securities, but they began to see themselves as more than simply brokers for new and secondary issues.
In 1978, Congress amended the Internal Revenue Code and created 401(k) accounts, so named for their section in the Code. Initially, this new arrangement was targeted to high-income employees as a means of deferring tax on a portion of income. But businesses soon found this vehicle to be an attractive offering for employees. Why? 401(k)s allowed employees to bear some of the risk of saving for their own retirement, rather than the company assuming that risk via traditional pension plans. In the highly taxed, economically moribund milieu of the 1970s, shifting risk and cost to employees was very attractive. The mobility of the US workforce would also soon limit the value of the pension.
Pensions, like health insurance, were always a benefit of employment - they were never a right. But as is often the case, a benefit long enjoyed may come to be viewed as a right. However, the key point to understand is that pensions never shielded employees from risks: their employers just absorbed the most obvious risks for them. Pensions worked not as a transfer payment system (a la Social Security), but as common funds. More plainly: corporations could fail and the ultimate successes of the pension plans with them.
Mutual funds - also around since the end of the first half of the 20th century - exploded in popularity as the investment product of choice in 401(k)s. Originally designed as means for retail investors to band together to purchase professional securities management, mutual funds were rightly seen as practical investment vehicles in accounts with relatively small balances. The new 401(k) demand launched myriad mutual fund companies and led other, well-established fund "families" to expand their offerings rapidly.
Not to miss the new trend, brokers got into the 401(k) business too, offering plans to employers of all sizes. The value a broker brought to a firm offering a 401(k) plan was decidedly more advisory in nature: he wasn't placing securities, he was helping employers educate employees on how to save for retirement.
Fee Only
As brokers became - and were sought out as - advisors, some of them started to think critically about whether their compensation structures aligned their interests with those of their customers. Whether compensated via stock commissions or mutual fund "loads", these advisors were sensitive about the awkward relationship between providing objective investment advice and being compensated by fund companies via commissions. The "fee-only" model emerged in the early 1980s as a counter to the commission model. Fees compensated advisors apart from the transaction, and so meant a better alignment between the advisor's goals and those of his customers.
Brokers could sell loaded funds to customers, but these new fee-only advisors eschewed commissions. "No-load" fund companies grew, in part, to satisfy this niche. Of course, fee-only advisors needed to be paid, so they began to charge fees on top of the mutual funds they recommended.
At the same time, an in concert with their convictions about compensation, many fee-only advisors began to embrace the notion of fiduciary responsibility. A fiduciary is a service provider who puts his customers' interests ahead of his own. Brokers, by contrast, retained the "suitability" standard: a broker is obligated to recommend products that are suitable for customers, but he is not required to actually subordinate his own financial interests to those of his customers.
Still Brokers, Still Middlemen
Through this time of intense change, two main aspect of the retail investment business remained constant.
First, brokerage firms never fully bought into the idea that their sales people were actually advisors. Brokers, they continue to think, are there to place securities, not to guide their customers. And so, commissions continue as the predominant compensation method among brokerage firms. Today, though, instead of paying brokers place stocks and bonds - a function that has been in declining demand as our economy has matured - brokerage companies pay brokers to place "financial products" like mutual funds, exchange-traded funds (ETFs), and annuities. For every loaded mutual fund sold to a brokerage customer, the fund company pays a commission (the "load") the brokerage firm, which in turn shares a portion of that commission with the broker. Likewise, a portion of the annual fee - known as a "12b-1" - is also paid to the brokerage (and broker) as a means of ensuring that brokers continue to recommend that their customers keep their mutual funds.
"That's fine," you might say, "but aren't some brokers honest despite their compensation incentives?" Sure, it's possible. But having spent some time near the beginning of my career as a broker, I have to tell you that the basic broker motivation is absolutely to sell a product with a high recurring commission - the 12b-1 - and collect the stream of payments while doing as little work as possible.
Yes, it really is that gross.
Secondly, both brokers and fee-only advisors grew out of - and remain in - the middleman model. Regardless of compensation practices, advisors are, for the most part, not trained as analysts. They don't value securities themselves, they outsource the investing function to managers of financial products. The vast majority of advisors are not only unprepared to utilize individual securities, often times they display a naive fear of them.
Across industries, unless the middleman function is truly an efficiency creator, it will add a layer of cost to the end service. And of course, costs have to be justified at some point. One way costs are justified is through offering ancillary services like tax preparation, insurance sales, or financial planning. Another way costs are justified is through complexity.
If a service is actually complex, it might merit a higher fee. And certainly, there's nothing wrong with offering ancillary services. But is it possible that the practice of investing in mutual funds isn't actually all that complex, and that the apparent complexity has been arranged as a pretense to justify higher fees? Remember: mutual funds were created for small investors to band together to achieve scale and hire professional management. Mutual funds are, in and of themselves, diversified instruments. Furthermore, are ancillary services merely offered alongside primary investment management offering, or are they in effect the means advisors use to attract new business?
Where We Stand Now
I operate in an industry where the vast majority of my competitors either A) are compensated for placing products, not for rendering good investment advice, or B) are not actually investors themselves, but cost-adding middlemen. Is there really any wonder that the average investor is under-served and over-feed?
With this post as background, the next few posts in this series will highlight some of the key ways - methods that are not just commonplace but predominant - in which either compensation or competency dilute the potential effectiveness of investment advice.
The practice of paying someone a fee for investment advice is fairly recent. The Investment Advisors Act of of 1940 governs the dispensation of advice, but the practice itself remained a sideshow until roughly the late 1970s. The reason was that the far larger, better established business model wasn't to provide advice but to broker securities transactions.
As the American economy grew and became increasingly industrialized, securities markets developed as a source of capital. Banks continued to lend debt capital, but the need was greater than the availability of loans, so companies issued bonds. If you think about it, a bond is very similar to a bank loan: both are promises to payback the borrowed amount, plus interest. They differ mainly in the source of funding (bank lending portfolios, or investors).
Some companies didn't want - or couldn't afford - the interest payments associated with bonds and bank loans. Their business models might take more time to develop, and cash might not be flowing so soon after starting. However, the entrepreneurs launching those businesses were willing to give up a portion of the ownership of the company in exchange for capital needed to build factories, purchase machines, and pay laborers. The solution was common stock, or equity capital.
With a growing population and the only intact manufacturing capacity among major countries, the US was uniquely positioned for growth following World War II. Capital was needed to fund the expansion, and capital markets matured to meet the need.
Investment banking served a similar function to traditional commercial banking: both provided capital to fund the massive US economic expansion. Commercial banks made - and usually kept - loans. Investment banks, on the other hand, underwrote - and usually sold - new stock and bond issues. Those new issues were sold primarily to wealthy customers of investment banks, many of whom were industrialists themselves and thus qualified to weigh the risks of owning the new securities.
The stockbroker arose as the intermediary between the underwriters at the investment bank and the rich customers who could purchase the new bonds and stocks. A broker's function was never be the objective purveyor of sound advice, but to place securities. Their compensation was structured accordingly: with new issues they would collect part of the spread between the price a security was offered to the public and what was passed on to the issuing company. But brokers also participated in the secondary markets for securities - the exchanges - and would collect a commission for helping customers sell one stock to buy another. The function of the broker and his compensation structure were fairly unobjectionable. Sure, a rogue broker could lie to his customer, but the basic function of placing securities and charging commissions worked well, given the broker's obvious purpose and the his customers' average sophistication.
The Emergence of Advisors
In the mid-late 1970s the business of investing began to change dramatically. On May 1, 1975, the Securities and Exchange Commission abolished the fixed commission schedule. Previously, the only real difference between a broker at Bear Stearns and one at Merrill Lynch had been which one had the best access to new offerings. In mid 1975 though, guys like Charles Schwab and Ernest Olde took advantage of the new de-regulation to begin offering deeply discounted commission rates. This action had two effects. First, the demise of the previously high, uniform commission schedule meant that average savers, or "retail investors," were no longer effectively priced out of owning stocks. The second effect was that traditional investment banks, which had elected to retain high commission rates, were suddenly forced to justify their costs; in part they did this through research. Analysts at "full service" firms issued research reports with the purpose of providing opinions on which stocks investors should buy. Brokers likewise began to assume the role of advisor, offering to help customers choose among different investments. Of course they still retained the function of placing underwritten securities, but they began to see themselves as more than simply brokers for new and secondary issues.
In 1978, Congress amended the Internal Revenue Code and created 401(k) accounts, so named for their section in the Code. Initially, this new arrangement was targeted to high-income employees as a means of deferring tax on a portion of income. But businesses soon found this vehicle to be an attractive offering for employees. Why? 401(k)s allowed employees to bear some of the risk of saving for their own retirement, rather than the company assuming that risk via traditional pension plans. In the highly taxed, economically moribund milieu of the 1970s, shifting risk and cost to employees was very attractive. The mobility of the US workforce would also soon limit the value of the pension.
Pensions, like health insurance, were always a benefit of employment - they were never a right. But as is often the case, a benefit long enjoyed may come to be viewed as a right. However, the key point to understand is that pensions never shielded employees from risks: their employers just absorbed the most obvious risks for them. Pensions worked not as a transfer payment system (a la Social Security), but as common funds. More plainly: corporations could fail and the ultimate successes of the pension plans with them.
Mutual funds - also around since the end of the first half of the 20th century - exploded in popularity as the investment product of choice in 401(k)s. Originally designed as means for retail investors to band together to purchase professional securities management, mutual funds were rightly seen as practical investment vehicles in accounts with relatively small balances. The new 401(k) demand launched myriad mutual fund companies and led other, well-established fund "families" to expand their offerings rapidly.
Not to miss the new trend, brokers got into the 401(k) business too, offering plans to employers of all sizes. The value a broker brought to a firm offering a 401(k) plan was decidedly more advisory in nature: he wasn't placing securities, he was helping employers educate employees on how to save for retirement.
Fee Only
As brokers became - and were sought out as - advisors, some of them started to think critically about whether their compensation structures aligned their interests with those of their customers. Whether compensated via stock commissions or mutual fund "loads", these advisors were sensitive about the awkward relationship between providing objective investment advice and being compensated by fund companies via commissions. The "fee-only" model emerged in the early 1980s as a counter to the commission model. Fees compensated advisors apart from the transaction, and so meant a better alignment between the advisor's goals and those of his customers.
Brokers could sell loaded funds to customers, but these new fee-only advisors eschewed commissions. "No-load" fund companies grew, in part, to satisfy this niche. Of course, fee-only advisors needed to be paid, so they began to charge fees on top of the mutual funds they recommended.
At the same time, an in concert with their convictions about compensation, many fee-only advisors began to embrace the notion of fiduciary responsibility. A fiduciary is a service provider who puts his customers' interests ahead of his own. Brokers, by contrast, retained the "suitability" standard: a broker is obligated to recommend products that are suitable for customers, but he is not required to actually subordinate his own financial interests to those of his customers.
Still Brokers, Still Middlemen
Through this time of intense change, two main aspect of the retail investment business remained constant.
First, brokerage firms never fully bought into the idea that their sales people were actually advisors. Brokers, they continue to think, are there to place securities, not to guide their customers. And so, commissions continue as the predominant compensation method among brokerage firms. Today, though, instead of paying brokers place stocks and bonds - a function that has been in declining demand as our economy has matured - brokerage companies pay brokers to place "financial products" like mutual funds, exchange-traded funds (ETFs), and annuities. For every loaded mutual fund sold to a brokerage customer, the fund company pays a commission (the "load") the brokerage firm, which in turn shares a portion of that commission with the broker. Likewise, a portion of the annual fee - known as a "12b-1" - is also paid to the brokerage (and broker) as a means of ensuring that brokers continue to recommend that their customers keep their mutual funds.
"That's fine," you might say, "but aren't some brokers honest despite their compensation incentives?" Sure, it's possible. But having spent some time near the beginning of my career as a broker, I have to tell you that the basic broker motivation is absolutely to sell a product with a high recurring commission - the 12b-1 - and collect the stream of payments while doing as little work as possible.
Yes, it really is that gross.
Secondly, both brokers and fee-only advisors grew out of - and remain in - the middleman model. Regardless of compensation practices, advisors are, for the most part, not trained as analysts. They don't value securities themselves, they outsource the investing function to managers of financial products. The vast majority of advisors are not only unprepared to utilize individual securities, often times they display a naive fear of them.
Across industries, unless the middleman function is truly an efficiency creator, it will add a layer of cost to the end service. And of course, costs have to be justified at some point. One way costs are justified is through offering ancillary services like tax preparation, insurance sales, or financial planning. Another way costs are justified is through complexity.
If a service is actually complex, it might merit a higher fee. And certainly, there's nothing wrong with offering ancillary services. But is it possible that the practice of investing in mutual funds isn't actually all that complex, and that the apparent complexity has been arranged as a pretense to justify higher fees? Remember: mutual funds were created for small investors to band together to achieve scale and hire professional management. Mutual funds are, in and of themselves, diversified instruments. Furthermore, are ancillary services merely offered alongside primary investment management offering, or are they in effect the means advisors use to attract new business?
Where We Stand Now
I operate in an industry where the vast majority of my competitors either A) are compensated for placing products, not for rendering good investment advice, or B) are not actually investors themselves, but cost-adding middlemen. Is there really any wonder that the average investor is under-served and over-feed?
With this post as background, the next few posts in this series will highlight some of the key ways - methods that are not just commonplace but predominant - in which either compensation or competency dilute the potential effectiveness of investment advice.
Friday, May 24, 2013
The Business of Investing - Part 1/6: Introduction
For all my griping about blind advocacy, I do advocate from time to time. I believe strongly in minimizing
coercion and will tell you about it if you give me half a chance. I’m passionate about free enterprise and for me, it’s not the “enterprise” part that’s rewarding as much as it is the “free”
part. The individual and societal
benefits of freedom accrue most broadly and rapidly when counter-parties are
informed and agree to an exchange, without threat of force. The consumption of investment advisory
services is one area where there is a basic lack of necessary
information. In other words, one of the parties isn't well informed. So, I am certainly an
investor education advocate.
I continually find that investors don’t know how to evaluate
– i.e. “shop for” – investment management services. The result is that the purveyors of
investment advice tend to be an oddly diverse bunch, occupying spots all along
the competency scale. It’s a peculiar
phenomenon, really. Take the field of
medicine as a comparison: there are certainly differences between
doctors, but if two docs have MDs and are both board certified in the same
field, patients can rest assured that they are buying a basic level of
capability and that each doctor is likely to care reasonably well for them. Law and public accounting are similarly
narrow with respect to competency. And
at the other end of the services spectrum, you also tend to find a relatively
narrow band of competency among, say, lawn mowing service providers, and for
obvious reasons. But with investment
advisors, you’ll find individual investors working with everybody from math & finance PhDs in New York to annuity salesmen in Paducah.
The spectrum itself is a curiosity, but what agitates me is that
such a large percentage of investment advisors cluster in a relatively tight
range we might call "not-really-competent."
Why do investors keep paying – and often times paying way too much – for
this level of non-competency?
Pause. I’m being
careful to speak about competency of practice.
I’m not suggesting a basic lack of intellectual capability. Of currently working advisors, a far larger
percentage of them could be practicing competently than is currently the case. It’s not a lack of smarts; but what is it?
The answer to that has a lot to do with the evolution of the
investment business. Many advisors lack
competence because it’s not demanded of them.
Their employers do not encourage them to be competent because it
doesn’t fit the business model. It’s a matter of institutionalized incompetence, actually. But it doesn’t have to be this way. There are alternatives. One alternative is to give Federal agencies
more power to control financial advice.
You can imagine that in my reluctance to coerce, I’m not wild about
either the hit to freedom or the level of effectiveness that this choice would
yield. But, as a friend recently challenged me: if education - instead of regulation - is the best option, then what exactly am I proposing?
Touché.
Touché.
I'm not sure how much I can do by myself, frankly, but it's worth trying. I believe I can help
investors become better informed, free participants in the selection of
investment advisory services, and if I'm right, I might be able to do some good - at least among
the small number of people within my sphere of influence.
This is the first in a series of posts explaining how we got to this point, a point where far too much money is paid for far too little quality. I also want to propose the "what" and "why" investors can do about it. In the post following this one, I’m going to talk about the history of investment advice – high level – to point out how we’ve come to the place we are. In the posts that follow, I’m going to call out specific practices that are most limiting to the attainment of good investment advice. Then I’ll conclude with some suggestions of what a healthy and ideal investment advisory relationship looks like.
This is the first in a series of posts explaining how we got to this point, a point where far too much money is paid for far too little quality. I also want to propose the "what" and "why" investors can do about it. In the post following this one, I’m going to talk about the history of investment advice – high level – to point out how we’ve come to the place we are. In the posts that follow, I’m going to call out specific practices that are most limiting to the attainment of good investment advice. Then I’ll conclude with some suggestions of what a healthy and ideal investment advisory relationship looks like.
I’d
love to have your feedback on this series. Portions of the material is totally self-congratulatory: the ideal practice I describe looks a lot like my own. I could choose
to be shy about that, but instead I’ll just note that I’ve spent a ridiculous amount of time over my career becoming competent individually and searching
for truly competent partners with whom I can hang out a shingle. I'm comfortable with the awareness that having made many earlier mistakes, I do now 'get it.' Look, I don't think my firm is the perfect investment management solution; I just want to share what I know.
But let’s face it:
I’m a career investment guy. I can no
longer see easily how non-professionals perceive the investment advisory
business, and I'd love to have your feedback on whether my opinions translate into your experience.
Thursday, May 9, 2013
Carr on "The Retirement Gamble" Documentary - Retirement Weekly (MarketWatch)
If you're concerned about investment industry practices and how they impact individuals and their retirement savings, you absolutely should watch Martin Smith's Frontline documentary The Retirement Gamble. Here's a link to the film. It's 52 minutes long and worth your while. I don't agree with everything said or implied, but on the balance it's important and straight.
Bob Powell of the Wall Street Journal's MarketWatch asked me to comment on the film for his Retirement Weekly column. My comments are below.
Bob Powell of the Wall Street Journal's MarketWatch asked me to comment on the film for his Retirement Weekly column. My comments are below.
Stephen Carr, CFA, Director of Research, Peloton Wealth Strategists:
"Martin Smith’s Frontline documentary “The Retirement
Gamble,” had me jumping up and down with enthusiasm. Yes, there were a few points where I cringed,
but for the most part, Smith gets it right: compensation practices in the
investment advisory business are really, really gross. There’s so much that’s wrong; where to begin?
Fee opacity is a good place to start. Think about this: what percentage of annuity
investors would ever buy one if they truly understood that their total annual
expense ratio was north of 2% or 3% and that, if they need to access their
money before the 7, 10, or 20 year surrender period had ended, they’d need to
pay an exorbitant penalty? The same can
be asked of mutual fund 12b-1 fees.
Compensation structure is also a key point raised in the
film and, unfortunately, most financial advisors are compensated for selling
so-called “financial products.” Financial products are co-mingled vehicles
like mutual funds, annuities, and unit trusts.
Virtually the entire advisory business is designed not to tailor
investment solutions to the needs of individuals, but to distribute these
products. Armies of financial advisors
are incentivized as “asset gatherers” or “relationship managers.” They’re not really expected (and certainly
aren’t compensated) to be great investors of their clients’ money. Frankly, if a financial advisor is at all
knowledgeable as an investor, it’s purely coincidental.
Whether, as the film suggests, more regulation is called for
is debatable. The only certain way bad
practices get corrected is by investors demanding improvement. Investors can make three demands that will go
a long way toward righting this ship.
First, investors need to understand that contrary to Peter
Lynch’s claim in the film, investing well is actually difficult. When choosing an advisor, investors should,
when possible, hire a money manager who utilizes individual securities, not
financial products. Individual
securities carry no fees, so the total cost is limited to the management fee
and some commissions (which are frequently very cheap these days). Increasingly 401(k) plans offer employees the
option to “self-direct,” which would allow a third party money manager to
invest on behalf of the individual.
Secondly, investors should limit how much they’re willing to
pay for management. Jack Bogle gets it
right: investors should keep total costs to 1% or less. While Bogle seems to falsely equate indexing
with low-cost investing, the two are not identical. There are numerous reasons why an individual
might not want to assume the risk associated with particular index funds, but
that doesn’t mean that the only other alternative is high-cost, poor
performance.
Finally, the fiduciary standard is critical. Two well-regarded designations that require
advisors to uphold a fiduciary standard are the Chartered Financial Analyst
(CFA) and the Certified Financial Planner (CFP). Professionals holding these designations have
attained a certain level of industry experience and are required to put their
clients’ best interests ahead of their own compensation.
My hope is that one day, investment advisors will be held in
the same high regard as other professional service providers. But while some advisors have earned that
honor, many others continue to pollute the industry with selfish ambition. Until investors begin demanding more
honorable compensation practices from their advisors, there will be very little
incentive for change."
Wednesday, January 2, 2013
George Will on Religion & Government
George Will's December 4, 2012 address to Washington University in St. Louis is a must.
If you like reading, do so here. Otherwise, and if you have the time, the video can be viewed here.
It's difficult to imagine a sounder, or more concise, description of why so many of us (religious and not) fear the current consolidation of political power in our nation's capitol.
If you like reading, do so here. Otherwise, and if you have the time, the video can be viewed here.
It's difficult to imagine a sounder, or more concise, description of why so many of us (religious and not) fear the current consolidation of political power in our nation's capitol.
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