Advisor Blog

So, you've decided to work with an advisor that operates under the standard of fiduciary duty and that, consistent with the overwhelming evidence that supports it, chooses to build portfolios based on passive asset class exposure.  So far, so good.

But, even fee-only Registered Investment Advisors offer a bewildering array of services with fee structures that vary widely.  Many appear to offer the same thing for surprisingly low fees that others offer for fees that seem outrageous.

First, decide what type of relationship you want.  Is it bare bones portfolio management - simple asset allocation and rebalancing?  Or, do you want tax management, advanced performance reporting, and complex portfolio design across multiple accounts?  What about wealth management services, like insurance and tax planning, trust administration, or a private banking relationship?  Will the advisor help with your employer's 401(k) and include that in the asset allocation?  Do you need the services of a family office - bill payment, travel arrangement, security services, property management, and/or legal services?

Keep in mind that many small or new advisors may charge fees that are less than the industry average while trying to build their practice.  They may operate out of their home or an executive suite.  They frequently do not have administrative support, in-house compliance programs, sophisticated security systems for the protection of confidential client data, or advanced reporting capabilities.  Are you comfortable with your confidential information residing on someone's home computer or should it be behind a firewall on an encrypted drive in an office that has a monitored security system?  All of these capabilities and safeguards add cost.  But, is it wise to ignore them?

What about the firms that offer a flat retainer fee instead of charging clients based on assets under management?  At first blush, it sounds like a great idea.  But, what is an advisor paid by a flat fee motivated to do?  The only way that that this advisor can increase profitability for his existing account base is to minimize the time spent on each client.  In contrast, the advisor that is paid on assets under management has an incentive to grow each client's portfolio and expand the relationship.  He may be much more willing to spend time with the client in order to do so.

If your primary focus is on portfolio performance, then the yardstick should be the risk adjusted after-fee, after-tax net return of the portfolio.  The advisory fee is actually irrelevant in the comparison of advisors if the risk adjusted net return is higher than that of the competitors.

Many portfolios that provide high expected rates of return are more tilted toward the risk factors that produce return (value and small cap stocks).  But this always comes at the expense of tracking error relative to the common indices (the DJIA, S&P 500, etc) that are talked about on the nightly news or by the CNBC "talking heads" (including clowns like Jim Cramer).  As a result, they require more "hand holding" of clients during the inevitable time periods when the portfolio will underperform the common index that the client uses as a comparison.  These advisors are justified in charging higher fees to compensate them for this activity and for the opportunity cost of lost time developing new clients and growing their practice.

Most prospective clients that engage in "fee shopping" vastly oversimplify the process and tend to choose an advisor for the wrong reason.  Even the fee structures between advisors can be confusing when the services offered are almost identical.  Some advisors that charge based on assets under management use a tiered fee approach and others use breakpoints.  We'll examine the two approaches in the next installment.

Photo by Brian Hillegas

Do you believe in UFOs, astral projections, mental telepathy, ESP, clairvoyance, spirit photography, telekinetic movement, full-trance mediums, the Loch Ness monster, and the theory of Atlantis?

If there's a steady paycheck in it, I'll believe anything you say.

That's a pretty funny line from the movie "Ghostbusters".  What's even funnier, at least to me, is that you can substitute a few key phrases like this:

Do you believe in chart patterns, market timing, stock picking, Elliot Waves, moving averages, stochastics, secular bear markets, Jim Cramer, and the theories of Harry Dent?

Lots of "advisors" do because there's a steady paycheck in it.

In reality, the results are in and active management got crushed - again.  See the article below titled "Keeping Score."  There is an overwhelming amount of evidence that concludes that active management is a losing proposition.  So, why do so many "advisors" believe in it - or, at least, try to convince clients to believe in it?  There are a number of reasons, but perhaps the most obvious is that the majority of prospective clients have been fed a steady diet of active management hype by the talking heads on CNBC and the huge advertising budgets of the big brokerage firms.  It's easier to sell them something that fits their flawed existing belief system than it is to educate them.  Oh, let's not forget that all of this activity supposedly justifies charging higher fees.  Ironically, it's those high fees that help keep active managers from beating their benchmarks.

So, why would you want to bet your future on an active management strategy or align yourself with an advisor that believes in it - or wants you to think that he does?  In reality, a lot of them invest their own money in inexpensive passive portfolios while espousing the virtues of active management.  It's always a good idea to ask if the advisor invests his own money the way he's suggested that you invest yours.

If you choose, based on the evidence, to take the passive route, then you've eliminated the majority of "advisors".  But, you still have a few more decisions to make.

Jim Cramer, the CNBC pundit of "Mad Money" fame, has declared 2010 to be the "year of active investing."  Even if that's the case, and the historical probability indicates that it won't be, active managers have a lot of work to do to catch up. 

Morningstar recently announced the introduction of a new "Box Score" report that analyzes the performance of actively managed US equity fund managers.  The analysis starts with a universe of 22,000 US equity funds and prunes the list by aggregating multiple share classes and eliminating ETFs, sector funds, bear market funds, long/short funds, and lifecycle funds.  They also exclude funds deemed to have a passive investment approach, including the DFA strategies.  All funds available for purchase at the beginning of any particular time period are included, so the results are free of survivorship bias.  Morningstar compares the results to their own stock indices, which seek to capture the returns of the nine distinct Morningstar style boxes and evaluates performance by calculating both Jensen's alpha and a more comprehensive Fama/French alpha.  The report is similar to the SPIVA report published by Standard & Poors that we've discussed before.

Morningstar finds that 41% of actively managed funds outperformed their respective indices for the three-year period ending June 30, 2009 using Jensen's alpha.  But, Morningstar notes that "once the Fama/French factors are taken into account, active managers' outperformance relative to the indices falls materially."  By the latter measure, only 37% of managers outperformed, and average alpha was negative in all nine style categories.

S&P reports that only 31% of large cap core funds for the five-year period ending June 30, 2009 outperformed the S&P 500 index.  Results were even less favorable for non-US markets, where 13% of the international funds and 10% of the emerging markets funds outperformed their respective benchmarks.  We often hear that non-US stock markets exhibit greater pricing errors than the US, supposedly offering opportunities for clever stock pickers.  The numbers suggest that this is fantasy.

Fixed income markets were no less challenging.  For the same five-year time period, S&P found that 22% of intermediate government funds were outperformers, and the number dropped to 11% for high-yield funds and to only 2% for mortgage-backed securities funds.

Many investors think that active managers can somehow avoid losses in bear markets by carefully selecting superior individual stocks or by shifting out of stocks altogether before market declines occur.  The numbers do not support this view.  In fact, the numbers present compelling evidence that supports the idea that a broadly diversified, passively managed portfolio offers the best path for clients seeking to achieve their investment goals.