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Secrets of the Financial Industry from an Insider- Part I

Posted by admin on January 24, 2008 in Misc.

Do you ever want to know what investment advisors think about their own industry? What started out as a Q & A about Preet Banerjee’s new book RRSPs: The Definitive book on Registered Retirement Savings Plan morphed into a wide ranging discussion between Preet and myself on the financial industry, dealing with financial advisors and the excesses of the people who manage our money as follows (I have grouped this into headings for ease of reference since Preet and I go all over the place. My comments are in bold and Preet’s comments are in italics). As per usual, anything that Preet or I may mention in terms of products are informational only and not a solicitation to buy. If you are interested in the products mentioned, please make sure you conduct your own due diligence:

INVESTMENT ADVISORS- GOOD OR BAD?

Investment advisors and planners get a bad rap on the personal finance blogs. I’ll give you an opportunity to refute the argument. Why should someone hire an investment advisor instead of becoming a DIY investor?

In the case of dealing with an investment advisor (who in the truest sense is an advisor who looks mainly at managing your investment portfolio) versus being a DIY investor: If you are a passive investor and have a good understanding of asset allocation models, then there is little (if any) reason to use an investment advisor. Today, it’s very cheap to create and maintain properly diversified portfolios. There is one caveat though – the DIY investor has to commit to proper self-education. You just don’t know what you don’t know. So it’s important to read books (and blogs) on a constant basis. You may not necessarily agree with them, but it’s wise to get all sides of the story.

It can be tough to stick to your guns and you may end up second guessing yourself (especially in times like the present). But many DIY investors who take a predominantly passive approach will probably recognize this…

I mentioned that a good understanding of asset allocation is probably a good pre-requisite if you are trying to build your own diversified portfolio. This goes beyond figuring out what your level of exposure to equities and fixed income should be (i.e. 70 % equities and 30% fixed income.) Perhaps a minimum knowledge requirement would be to be able to understand the difference between systematic and non-systematic risk, correlation, and modern portfolio theory before embarking down the DIY passive investment path…

ACTIVE VS. PASSIVE INVESTING

(for definitional purposes, Preet and I use the term “active” management/investing to refer to trying to outperform the indices/benchmarks by actively buying and selling stocks- whether directly or through the purchase of a mutual fund- whereas “ passive” management/investing means one invests in investment vehicles that mirrors some part of the stock market)

Here’s the issue though- most DIY investors I know (including our fellow bloggers) become DIY investors because they hire an investment advisor, experience below market returns and then learn to do it themselves and fire their advisors. If you have the DIY investor “personality”, isn’t it almost inevitable that there will be a natural progression from being a client of an investment advisor to being a DIY investor?

Agreed: if you have the DIY personality and an interest in personal finance and/or investing this is probably the path that you will take. Some may start as DIY investors from the get go as well.

There are some people who shovel their own driveways, build their own decks, finish their own basements, etc. But in the case of home renovations and investing, the vast majority use professionals. The disconnect is that the guy who built your deck doesn’t charge you a trailer for the rest of your life like many financial advisors do. It’s more acceptable if the advisor is providing ongoing value (perhaps through proper financial planning, good customer service, etc.) – but this is not normally the case.

Portfolios in the beginning are small which means fees tend to be magnified if your advisor puts you into mutual funds.

For the active-management investors with assets under a certain amount (call it six figures for argument’s sake), it’s hard to create a diversified, actively-managed portfolio unless you use some sort of managed product like a mutual fund. Since it has been shown over and over again that mutual funds under-perform and over-charge, a better tool-set to get some semblance of active management might be to actively adjust the asset/sector mix and/or market-time passive products – like index ETF’s or index mutual funds (like the TD e-series).

BUT, trying to time the markets is usually a futile exercise as well. So, for the most part, history and experience have shown me that during the initial accumulation phase, using a passive approach and foregoing any type of timing is generally the best way to go for the average investor. Also consider that as you are starting up, how much you save has a greater effect on your net worth accumulation than how much your investments grow. Of course there will be those who will want to make concentrated bets – that’s fine as long as you understand the risk/return trade-off you are making – it’s your money after all.

What you are suggesting though is almost opposite to what we all do; I started as an active investor and now I am going to passive; my next trade is an ETF. If you start as a passive investor and all you are doing is opening a self-directed account and buying products that track an index why do you need an advisor at all?

You might not need an investment advisor, but you would probably need a financial planner. There is a difference between these two types of advisors. An investment advisor will focus mainly on rate of return and portfolio management. A financial planner will look at so many other things: cashflow management, long term tax planning, estate planning, insurance planning, mortgage planning, retirement planning. This is where a financial planner will make more of a difference.

But here’s the rub. I am going to assuming an investor with the six figures you cited is going to be flooded with calls from every John, Dick and Mary in the financial industry trying to get their business. If I have been smart enough to save or protect that portfolio size why would I hand this over to an investment advisor?

If you built this up on your own, you probably wouldn’t hand it over unless you were out of your comfort zone at higher asset levels, didn’t have the time to manage the portfolio(s) anymore, or found someone you think can outperform you. All three scenarios seem pretty unlikely if you were already a DIY investor though.

There is one example of an advantage of using an investment advisor, even if you are a DIY investor: Assuming you have a collaborative relationship with your advisor (non-discretionary account) and you decide you want to make a purchase of security X – once the transaction sizes get higher, your advisor might call down to a special group of traders (sometimes called large block traders) and they will bypass just throwing up an order on the exchange and call another trader directly to negotiate a better price – and that price savings might be more than what you would pay in commissions with a discount brokerage and a full service brokerage put together. In a case like this, you can see that they have earned their fee. This really only applies to active management.

IS THE FINANCIAL INDUSTRY CORRUPT?

And therein lies the problem… how many advisors would actually advise their clients that they can give a discount in fees instead of selling other products? The entire industry is slanted towards pushing product across their divisional lines and not reducing my costs. I got mail from my mortgage company last week pushing insurance offered by another division of their financial empire.

The last twenty years has been about pushing the “consolidation is good” mantra on the financial industry but this only helps the players and not the customer (it is even arguable that this has helped the shareholders; consolidation seems to help the CEO’s and the board, with share options, first and foremost).

My bank has a new bank manager and the within 3 minutes of meeting him he was trying to get me to move my mortgage to his branch as well as my RSP. I get the sense saving fees is the last thing the industry is taught to do. Instead, my experience is that the industry is taught to push product with trailers and get referrals from other salespeople in the larger financial company.

I echo the negative sentiment directed at financial advisors and the financial advisory services in general. The current (predominant) model of compensation promotes an inherent conflict of interest within the client-advisor relationship and it breeds unscrupulous advisors. It’s archaic and I think a case could be built to argue that it contradicts our fiduciary responsibility to act in the best interest of the client. Unfortunately the profitability of this model will ensure that it continues for some time. We are long overdue for a paradigm shift in the industry. The shift should be to a model that unbundles products, advice and fees in a clear fashion. That’s not even close to being on the horizon though…

The fees specifically attached to the portfolio execution and management should be clearly delineated and the fees specifically attached to the financial planning advice should be kept separate as well.

Yes, but there is no financial impetus to do that. In fact, there would be a disincentive to undertake this model. There are great advisors out there but most retail based brokerages I come across are pumping out glorified sales-people. “Advisors” are there to pump product and not give advice. Why give advice? It creates liability, takes time and there’s no trailer on advice.

You are absolutely correct. And there are some really intelligent, great advisors out there who really make positive contributions to their clients’ finances, but many are bound by the parameters of their firm’s business models or delivery platforms. The system’s compensation structure as it stands right now makes way too much money for way too many people – there is a tonne of inertia to overcome.

With due respect to your industry, it is too easy to get in. I meet too many guys (and, let’s face it, it is still mostly a male profession) that backed into the industry as a 2^nd or 3^rd career because the other ones didn’t pan out (either that or they sell insurance). Compared to other professions where you deal with client money, the barriers to entry are way too low. I had to go to school for 7 years, apprentice for 12 months and then write 3 months of exams to even have the right to call myself a lawyer and I never held in my trust accounts the amount of money an average advisor manages for clients.

You really hit the nail on the head with this one. If I had carte blanche to re-write the rules of the industry, one of the top priorities would be to raise the education requirements for financial advisors BEFORE they get into the industry. They should have some sort of dedicated multiple year educational requirements similar to law school, medical school, etc.

Maybe the delivery system could be a hybrid of the lawyer/doctor professions in which we charged only by the hour or service and then issued a prescription to be filled elsewhere. Take 2 ETF’s and call me in the morning…

Part II tomorrow