Advisor Blog

Hindsight is always 20/20.  It is extremely easy to construct a portfolio that will outperform during a particular past time period and, unfortunately, that's what a lot of advisors do.  In many cases, it's deceptive - whether that's intentional or not.

We met with an advisor a few years ago because he was an acquaintance of one of our firm's members and he was the typical insurance salesman turned "investment advisor".  He knew next to nothing about portfolio management and was looking for a turnkey solution for his clients that wanted stock market exposure.  After presenting and discussing our actual results, he showed us the presentation material from the portfolio manager that he was using.  They were very similar to ours.  After I got back to the office, I read the disclosure language on the presentation.  All of the performance information was backtested only - in other words, pure fantasy.  Not one client was actually invested in the hypothetical portfolio.  Even more amazing was the reaction when I pointed this out to the advisor (aka insurance salesman).  He didn't care!  In fact, he cared a lot more about the quality of the marketing materials than whether the claims were real or hypothetical.  Why?  Because he knew that most prospective clients couldn't tell the difference.

It gets worse.  We compete with a well known firm that claims to have a similar investment philosophy.  When they introduced their first portfolio models a few years ago, there was nothing particularly notable about them.  Their asset allocation and performance was similar to many others.  But, after a year or so things changed.  All of a sudden, their performance figures were amazing.  How could that be?  What changed?  It turns out that they decided that commodities were an asset class that should be included in their portfolios.  Never mind the fact that this is extremely controversial and that most of the academic studies don't support it.  Commodities were on a tear (some would say in a bubble) and adding them to the portfolio made the short-term returns look much better.  So, when they made the change and began to report historical performance with the commodity asset class included, how many of their clients had actually experienced that performance?  None.  Of course, they made sure that all of the proper "fine print" was in place.  The hypothetical nature of the portfolio is disclosed in their material and on their website.  But, how many prospective clients actually look at that?  Unfortunately, we know from experience that it is very few.

Here's the point.  Make sure that the model portfolio performance that you are reviewing is realistic.  Ask the advisor how many clients have actually experienced something similar (within the range of variance due to rebalancing schedules, different fee structures for different account sizes, and cash flow amounts/timing) to the model.  Backtesting is a useful tool for portfolio construction, but it is often the case that models perform quite differently out of sample than they do in sample.