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Tuesday October 28, 2014

When Mutual Fund Managers Mimic An Index, Investors Lose.

If investors are going to pay significantly higher fees than an index fund, shouldn’t they expect significantly different holdings than the appropriate benchmark index? If a mutual fund holds similar holdings as its underlying benchmark, after expenses the mutual fund typically underperforms the index.

The Trend

In a 2009 study, Antti Petajisto suggests that mutual funds that hold at least 40% different holdings than their benchmarks are statistically truly active. Taking data from Morningstar, we can see that the 25 largest mutual funds barely constitute “actively” managed. This is measured by a relatively new statistic called Active Share. On a scale of 0 to 100, a score of 0 equals perfect correlation to an index whereas a score 100 equals an entire deviation from the index. Statistically, anything below an Active Share score of 60 means the mutual fund manager is a closet indexer.

Screen Shot 2014-10-28 at 2.39.09 PM

 

 

 

 

 

Many of the biggest and most popular mutual funds exhibit Active Share scores close to the 60% mark. This means that many of these funds mostly hold the same exact stocks that an index fund representing the benchmark would hold.

 

 

 

 

A Closer Look At Closet Benchmarking

I wanted to illustrate closet benchmarking on a graph but when I began looking at the funds above, I couldn’t find one that actually outperformed its benchmark (I gave up after analyzing 14 of them). Instead of visually demonstrating this, let’s explore why a fund manager would choose to do this. Fund managers are under a lot of financial pressure to outperform. Since much of a fund manager’s compensation is tied to assets under management (AUM), they may do whatever it takes to bring in as much AUM as possible. One of the best ways to increase AUM is to advertise outperformance. The only way a fund manager is going to outperform the index is to take a risk and make a bet on a particular stock or sector. If they’re correct on their bet, then their financial incentives dictate they should do anything possible to continue that outperformance. Since this is practically impossible to do in the long term, once they’ve had a success (whether due to luck or skill is highly debatable), they’ll invest very similar to the index to “milk” the outperformance as long as possible. The problem with this is the investors that bought into the outperformance usually do so after the fund manager had their heyday. In effect, all the investor is doing is paying a high price a fund that mimics an index with little incentive to ever outperform again.

The Alternative

Instead of chasing returns where you probably won’t experience the outperformance you thought you were paying for, simply buy the index. You’ll forgo the allure of beating the market, but at least you won’t underperform. An investor can construct a highly diversified portfolio of index funds to achieve their long term financial goals, while adhering to a risk appropriate asset allocation. You can read more how to do this HERE.

Thanks for checking out my blog. If you have questions, please reach out to me!

Wednesday October 22, 2014

Why Your Financial Advisor Should Be A Fiduciary

 

What if you decided to interview a financial advisor for hire and they said this: I want to help you achieve your financial goals, but I don’t want to be legally required to place your interests above mine because that would be too cumbersome for me to implement and my compensation may be diminished. There may be conflicts of interest that arise from time to time, but I will not disclose them to you. In addition, I don’t want to assume the additional liability that comes with a fiduciary standard. But, I will do my best to help you.

Uhhhmmmmm, ok… We don’t always say what we feel, do we? Unfortunately, financial advisors and their employing brokerage firms would have a tough time convincing folks to do business with them if they adopted a proper fiduciary standard. I didn’t come up with the words above, but I had a nice conversation with a new colleague who did. We chatted about his financial advisory practice and how they avoid potential conflicts of interest with their clients. Here are the important takeaways from my conversation:

1. Only a small percentage of financial advisors are true fiduciaries 100% of the time. Even most Certified Financial Planner (CFP) practitioners, who we are lead to believe are held to a higher standard, aren’t necessarily fiduciaries. In our opinion, only investment advisor representatives of Fee-Only Registered Investment Advisors (RIAs) are true fiduciaries.

2. Consumers can’t articulate how their advisors are compensated. Some advisors earn their living 100% on commissions (think Leonardo DiCaprio in The Wolf of Wall Street), others are compensated solely by fees for advice (Fee-Only), while the majority of advisors want the best of both worlds (for them of course). The trend these days is for advisors to have dual registrations; one as a broker and the other as an advisor. This allows them to charge a percentage of investment assets (such as 1.25%) AND sell you products like insurance, annuities, home loans, as well as earn commissions on investment trades. The conflict with earning commissions is an advisor may recommend a product that pays more via a sales charge versus an alternative that costs the client less such as a no-load mutual fund.

3. Even though its a legal obligation for our firms to act as fiduciaries 100% of the time, we wouldn’t need a law forcing us to do so if one didn’t exist. If all advisors behaved this way, the financial services field would resemble something closer to the medical field (Hippocratic Oath to Patients). Until that happens, most financial advisors will continue to operate within the status quo; as salespeople.

Here’s the short list on how you can tell if your financial advisor isn’t a true fiduciary:

If they recommend you invest versus paying down debt without explaining the expected return on the investment and fail to disclose that the recommendation presents a conflict of interest.

If they recommend you execute a rollover without defining the merits of leaving the 401k where it is.

If they recommend cash value life insurance over term insurance without explaining the pros and cons of each.

If they sell you an annuity without any living benefit guarantees in your IRA.

If they recommend you take the lump sum pension option and invest it versus taking monthly guaranteed income.

If they sell you a deferred annuity the moment your existing annuity is free of surrender penalties.

If your annual reviews are structured around switching to shiney new investments instead of discussing progress towards your goals.

If they recommend mutual funds with sales loads.

If they charge you for a financial plan, then sell you insurance products.

 

I have adopted the Fiduciary Oath that The Committee For The Fiduciary Standard has set forth. Here are the tenets I have always abided by since I started my own advisory practice:

 

Screen Shot 2014-10-22 at 9.17.07 AM– I will always put your best interests first.

– I will act with prudence; that is, with the skill, care, diligence, and good judgement of a professional.

– I will not mislead you, and I will provide conspicuous, full and fair disclosure of all important facts.

– I will avoid conflicts of interest.

– I will fully disclose and fairly manage, in your favor, any unavoidable conflicts.

 

Thank you for reading my post. If any of what I mentioned stirred you up, join the club… I’d love to hear your stories and if you have questions or comments, please reach out to me.

 

Monday September 8, 2014

Why I Use Index Funds To Build Better Portfolios

It’s been a while since my last blog post, and yes I’m alive, functioning (sort of), and healthy. It was a busy summer with family and mountain bike racing. If family time is as important to you as it is for me, you’ll understand why I took a break from blogging. If you don’t understand, tough!

Years ago while I was working at my former brokerage firm, it was drilled into us all that mutual funds were the best investments in town. If you recommended anything else, you were an outcast! It also helped that they paid quite a bit, but that was often left out of the training. What always confused me was how I was supposed to select various funds for clients, and more important, how was I supposed to build a proper asset allocation. Although very interested in doing both well, my former employer taught me neither. I was also overwhelmed with keeping up with the service that 276 client households required, I simply didn’t have time. I chose the path of least resistance and invested client’s money into pre-built investment models. I wish I knew knew back then what I know now.

Starting my own company left me with lots of time to research new ideas and prospect for new clients. I’m not sure I’ll ever be great at marketing, but I’m quite confident I’ve spent enough time reading on how to solve the asset allocation puzzle and investment selection dilemma. I’ll focus on specific investment selection for this blog post.

I’ll start with a bold statement; mutual fund managers can’t consistently beat their benchmarks over the long term. There, I even put it in bold to show I mean business!

Here’s some evidence to back this up. The New York Times summarized the results of a study where academics (read: Not Wall Street) wanted to test whether or not fund managers had any skill in stock selection. The study built a database of every actively managed mutual fund that operated with at least a 5-year track record from 1975-2006. Of the nearly 2100 funds analyzed, only 0.6% of fund managers had any genuine stock picking ability. Statistical conclusion: 0.6% is indistinguishable from 0%.

Ok, but maybe some fund managers are good in the short term? S&P Indices just released the mid-year 2014 report, and if you skip ahead to the top of page 3, you’ll see that over the last 1, 3, and 5 years at no time did even 50% of fund managers outperform their benchmarks.

So if mutual fund managers can’t reliably beat their benchmarks, what are the alternatives? The first index fund was created in 1975 by John Bogle (founder of Vanguard) to solve this problem. Index funds on the surface look like mutual funds, but unlike mutual funds that trade in and out of stocks and bonds, index funds are designed to replicate a pre-determined basket of stocks or bonds, without all market timing and trading. Index funds were designed truly as buy and hold investments.

Compared to mutual funds, index funds enjoy extremely low costs, force investors to stick with an investing style (versus the latest investment media fad that’s already lost its luster by the time your broker sells it to you), and generally exhibit more favorable tax consequences. Best of all, we can use a variety of index funds to build a smart asset allocation for a globally diversified portfolio. I’ll touch on all these topics in greater detail in upcoming posts!

 

Wednesday July 9, 2014

How Financial Advisors Sell Mutual Funds

BACKGROUND

Financial advisors are in a unique position of trust. However, that trust is often taken advantage of. One of the most offensive ways advisors do so is by fooling clients into thinking they have some sort of magical process for putting together a portfolio of mutual funds. Advisors convince clients they spend enormous amounts of time analyzing different funds and use language such as “Alpha”, “Risk Adjusted Return”, or my favorite “Upside / Downside Capture Ratio” to demonstrate how smart they are. The end goal is the client should feel like there’s no way they could do it on their own, or God forbid that there might be a better way to build smarter portfolios. It’s a bummer because clients trust, look up to, and sometimes even admire their advisors! 

WHAT ACTUALLY HAPPENS

You sit down with the financial advisor, and they say something like “Fund ABC should be replaced with Fund XYZ because the fund didn’t… blah blah blah ___insert whatever garbage sounds convincing here___”.  You agree with the advisor’s astute assessment, thank them for their exhaustive research, and happily refer your friends and co-workers. What actually happened was prior to your review appointment the advisor had lunch with a sales rep from the mutual fund company (not on the advisor’s dime of course), and the rep convinced the advisor to use his mutual fund. In exchange for using his fund in client accounts, the advisor receives marketing dollars from the mutual fund company. The advisor may have attempted some due diligence on the fund, but when they realized the fund was expensive or didn’t beat its benchmark over the long haul, they cherry-picked a time frame or other metric and used this as the basis of their recommendation. Unfortunately, this is how financial advisors sell mutual funds.

WHY THIS BEHAVIOR IS TOTALLY ABSURD

The reality is that the vast majority of fund managers financial advisors recommend can’t get it right, so how can a financial advisor possibly build a smart portfolio of mutual funds that are in a client’s best interest? It would require an advisor to not only pick a fund manager that in the future is going to perform well, but then that mutual fund manager would have to pick the right stocks and bonds within the mutual fund they run! How can a financial advisor consistently pick the right picker? Newsflash: your financial advisor is not Marty McFly from Back to the Future, nor do they posses some futuristic almanac showing tomorrow’s investment results today! What’s even more insane about this whole issue is the whole basis for the fund recommendation is based on something that already happened. Duh, everyone is brilliant with hindsight’s benefit! You wouldn’t drive around town by looking in the rear view mirror all the time, so why should you believe an advisor is doing you right by touting some arbitrary performance figure to hook you in on outdated information that happened yesterday? 

WHAT TO DO ABOUT IT

Instead of driving your portfolio in the rearview mirror AND trying to beat the market, work with your advisor to build a diversified portfolio with low cost investments like ETFs and index funds. Don’t be surprised if you get some pushback, and don’t let them talk you into sticking to their expensive mutual fund agenda. If you can’t work towards a resolution, it’s time to find a new advisor. Hints: pick one that doesn’t sell products for commissions, doesn’t accept mutual fund 12b-1 fees, and one that integrates a financial plan into your overall situation. You will save truckloads in investment fees, and you’ll end up with a smarter portfolio.

 

Wednesday April 30, 2014

Why You’re Losing Money Buying a Mutual Fund With A Sales Load

You’re feeling good after your last meeting with your financial advisor because they showed you some impressive performance numbers from a mutual fund investment. You think you’re a hero because you’re taking charge of your financial life and being responsible by saving some scratch each month. What if you learned after fees and inflation it was almost impossible to make money purchasing the recommended fund? Not feeling so good anymore, are you?

 You trust your financial advisor and follow their advice. It’s easy! Contributions come right out of your bank account each month. The problem is many mutual funds charge a fee called a sales load and financial advisors LOVE THEM! There are different types of sales loads that can be charged at different times but for the purpose of this post let’s focus on an “A” share mutual fund.

An A share load is charged when you first purchase the fund. Many mutual funds that invest in stocks charge a 5% sales load. What this means is when you invested that $100 last month, only $95 was invested in the fund. Wait, WHAT??? Yup, that extra cost was paid directly to the financial advisor as a commission (with maybe a little bit going to the mutual fund company along the way). Dang, that doesn’t sound good…

So now you know that out of the $1,200 you thought you invested last year, only $1,140 was applied to the mutual fund. Grrrrrr… Then you remembered that the cost of filling up your SUV, buying vegetables because you want to eat healthier, and that Apple gadget you want so bad cost more this year than they did last year. Inflation! The US Consumer Price Index (CPI), which measures the cost of a “basket of goods”, has averaged 2.38% from the beginning of 2004 through the end of 2013 (10 years). Going with the averages, after sales loads and inflation, you’re down -7.38%. Double dang… Really not good.

The icing on this awful tasting cake is when you look at the historical returns of the US stock market. Over the same 10 year period from above, the S&P 500 index rose at an annualized clip of 6.87%. If we assume your mutual fund can’t beat that long term S&P 500 benchmark, and most funds can’t, you lost -0.51% on every dollar you threw into your investment account. That’s some pretty BAD financial advice, and the reasons why you’re losing money buying a mutual fund with a sales load.

There are other ways ways a financial advisor could be compensated for their investment advice, and I touch on this topic in THIS blog post. If you’d like to engage me in further conversation (read: constructive) , feel free to leave a comment by clicking the “Read More” button below or by contacting me HERE.

Thank You!

Greg Lessard, CRPC®

 

Tuesday April 8, 2014

How A Real Financial Advisor Should Be Paid

 

Why is it that financial advisors wonder why our industry isn’t more respected, such as the medical or legal profession (ok, we should be skeptical of some  lawyers)? Maybe it’s because every year thousands of clients are sold financial products that they end up regretting. Too often financial advisors highlight the good attributes of a product, but conveniently leave out the bad parts. For example, an advisor may tout an investment’s great yield, but fail to mention the client is locked into the product or face severe redemption penalties. Even worse, advisors consistently fail to disclose alternatives that may have better returns, lower fees, better liquidity, or lower risk.

There are a number of reasons why this situation plays out. Advisors may be limited by the products their brokerage firms allow them to sell, or they may be tempted to recommend a product that pays a higher commission than a lower cost alternative. Whatever the reason, how can a financial advisor be a fiduciary to clients if they don’t recommend strategies that are always in the client’s best interest?

In my career, I’ve spoken with many people who wished they would’ve known about their advisor’s sales agenda. It really comes down to knowing the right questions to ask. Wall Street does a great job of reminding investors what great financial stewards they can be for clients, but is their message really true when their end goal is to sell a product?

The best solution to mitigate these conflicts of interest is to work with a financial advisor who doesn’t sell products or accept commissions. Many of my colleagues, including myself, are strictly FEE ONLY financial advisors. Some of us charge hourly rates, or others like me charge a percentage of the investment assets we manage. The important theme we share is that our recommendations aren’t influenced by a commission. Personally, I’m a proponent of the asset based percentage fee model because I believe it best aligns my interests with those of my clients. Simply put, my practice makes more money when client assets grow, and I make less when I lose money in client accounts. I believe this compensation model is how a real financial advisor should be paid!

This blog post only scratches the surface of the issue, as well as how I really feel. If you’d like to engage me in further conversation (read: constructive) , feel free to leave a comment by clicking the “Read More” button below or by contacting me HERE.

Thank You!

Greg Lessard, CRPC®