EnCana is one of the largest oil and gas companies in the world which, at oil and gas prices being what they are, also makes it one of the largest companies in the world (Forbes Magazine ranks it as one of the 200 best companies in the world). On Sunday, EnCana announced it would split itself into two different companies. For lack of a better term, EnCana Gasco (which will hold all its natural gas properties and assets) and EnCana IntegratedOilco (which will hold all of its oil properties and assets including those in the Alberta oilsands). The market reacted favorably to the move, sending EnCana stock up more than 8% in a day (this is not a recommendation to buy). EnCana is not the first company to split itself up into parts: Altria spun out Philip Morris recently and Canadian Pacific Limited spun itself out into 5 subsidiaries in 2001. Why do companies do this and is this good for the investor?

1. Wall Street is much stupider than you think.  The financial industry loves simplicity. Most analysts have never run a business before. Many take their newly minted MBA to a big investment bank so they don’t understand the day to day of running a business. They only look at numbers and businesses with lots of different operations confuse them. EnCana confused analysts because they had natural gas production and oil production and, despite the fact they are both energy plays, it left the street confused (insert your own observations here). Thus, EnCana splitting itself into two companies that concentrate on one thing only feeds the street’s need for simplicity.  For the investor, this is good too because you invest in businesses which is easy to comprehend and simple to understand businesses send stock prices soaring. On the other hand, complicated businesses suffer from the dreaded “conglomerate discount” where the analysts get confused and throw their hands up in the air and punish the stock (see General Electric as a prime example or even Citibank pre-subprime where critics complained that it had become too unwieldy of a financial services empire and difficult to understand- well, they solved that problem didn’t they?).
2. The upside of the company just doubled. Every shareholder of EnCana currently will receive one share each in each company and the current dividend will be split such that the shareholder is going to receive the same amount of dividend but now paid by two entities. Thus, the investor has twice the opportunity for the stock price to go up. For the companies and investment community, any company that gets split up into smaller parts makes it easier for it to be taken over (think of a cake; it is easier to eat two medium sized slices than one big one. Same logic applies to a company a competitor wants to buy) which equals $$$ for advisors in a take-over situation and a greater return for the investor of the company being acquired.
3. You can always make a quick buck. Companies that split themselves up only do so after lobbying from the investment industry (see above for the reasons why). When they do listen to the investment industry, the stock typically shoots up quite quickly (although not always the case) so it presents an opportunity for a shareholder to cash out quickly once the company announces it is splitting up.

Companies that split themselves up do not always present a winning situation for investors but, because of magnitude of the move, most companies only undertake this if they know the outcome will be generally positive for all. However, there are always exceptions to the rules: some companies split up after a disastrous merger (for years, shareholders have demanded that AOL Time Warner break itself up after one of the worse corporate mergers in history). But, even in these circumstances, the stock tends to head up after the announcement (although the gain is relative considering the stock price probably crashed).

As an observation about the cyclical nature of business (or the fickleness of the business community), EnCana is actually the product of a merger as recent as 2002. One of the primary reasons for the merger was to satisfy the investment communities’ desire to create an energy company sufficiently big to be competitive globally- and now its too big for the same community to comprehend. Go figure. Same thing happened to AT & T: it is almost back together from its Ma Bell days (although they were forced to break themselves up).  Having a lot of degrees does not guarantee you’ll be just as indecisive as the rest of us.

Nancy aka the money coach is a regular contribution on this blog. As a newly minted insider to the credit union world, I am more than happy for her to discuss what exactly a credit union is, how a credit union is regulated, the social responsibility of credit unions and what the difference is between a credit union and a bank and provide some information we don’t know about credit unions. Thanks for the post Nancy!

Thanks, Thicken My Wallet, for the opportunity to guest post! Some readers may recognize me as “nancy, aka money coach”. Citizens Bank of Canada recently created a position for me (yahooo!) as their bank evangelist. Citizens Bank is one of Canada’s best-kept-secrets, and I’m very passionate about it (hence the nerve to pitch myself to the CEO). Here’s why.

Citizens Bank is a federally chartered bank, but owned by a credit union. We’re also a virtual bank, high interest, low/no fees (a home grown alternative to … errr… you know who). This combination makes the bank very unique. To understand why, we first need to understand the difference between a credit union and banks.

Fundamentally…

Banks, of course, are ultimately accountable to their shareholders and have as a chief mandate generating profit for their shareholders. Shareholders vote for the board of directors who then set the direction of the bank.

Credit Unions are cooperatives, and accountable to the members of the cooperative. Members vote for the board of directors, who then set the direction for the credit union, within the principles of the cooperative movement.

What does that mean for Citizens Bank? It means that we’ve been freed up to operate for the triple bottom line: People.Planet.Profits. It’s a little deeper even than behaving like a good corporate citizen. Around here, we say “csr is in our dna”.

Here are some specific examples.

• RRSPs: for every $1000 a member contributed in Jan/Feb this year, we donated $10 to Habitat for Humanity.

• Visas: cardholders can pick from an Amnesty, Oxfam or Shared Interest Visa. In addition to the usual points, we donate 10 cents to the chosen beneficiary, every single swipe.

• Shared Interest: a portion of our profits get pooled. Members nominate non-profits and charities as recipients. We choose 12 of these nominations, and then members vote on them. The profit pool is divided in direct proportion to the votes. (sneek peak of 2007 recipients available next week!)

• Shared World Term: you’ve likely heard the breathtaking story of economics professor and nobel peace prize laureate Muhammad Yunus, who founded the Grameen Bank. The bank provides micro-credit loans (et alia) allowing thousands of people to move out of poverty. We have a term deposit that does the same - every dime is lent out as very favourable rates to individuals in impoverished conditions around the world.

We have a clearly articulated ethical policy.

And oh yeah… we’re carbon neutral as of Dec 2007, 2 years ahead of plan. (deets on how we did it, here.)

If you haven’t guessed, we’re a bank with ideals. We’re full of staff with imagination, some of whom are blueblood bankers, some of us (*cough* that would be me *cough*) quirky, and all of us committed to doing banking differently in a way that contributes to a better world.

Welcome to the latest edition of my insider’s conversation series. The goal of this series is to speak to insider in a particular industry and get their viewpoints from within the industry. Our last insider took us inside the world of hedge funds. Today, we are joined by Melanie McLister from Mortgage Architects who has kindly agreed to take us inside the world of mortgages whether obtaining a mortgage, renewing a mortgage and what happens if you are in default of a mortgage. Melanie and her partner run a great blog on mortgage trends.

…of course, the disclaimers! Melanie is not giving any advice or recommendations and the information she is providing on mortgages may not apply to every jurisdiction. Please contact her directly about your particular situation.

My questions in bold; Melanie’s answers in italics…

Melanie, thanks for agreeing to participate in this month’s insider series interviews. This month we tackle mortgage financing. Why don’t you tell us a little about yourself and what your organization does?

First off, I’d like to say thanks to you Thicken.  The insider’s series is a fun idea and we appreciate the chance to participate. 

To answer your question, myself, Robert McLister (my partner and “other half”), and our team at Mortgage Architects are mortgage planners.  We identify and secure the optimal financing for our clients, and make sure the process is educational and as hassle-free as possible.

The thing that I guess separates us the most is our interest in education and advocacy.  Our overriding objective has always been to ensure people know we have their best interests at heart.  Whether we get their business is absolutely secondary because we eat or starve based on our reputation.  In fact, we often do what some in our business find illogical:  we send clients to non-broker lenders that happen to have a better offer that day.

Last fall’s HSBC Prime – 1% variable-rate special was a prime example.  We sent dozens of clients to HSBC branches and didn’t get paid a dime.  But it was the right thing to do, and that’s how we feel an advice-based business should be built.

Walk me through a typical mortgage application from a lender’s perspective. After a lender vets the initial data, what type of process do they undertake internally? How many people touch an application and who makes a call on whether to proceed to loan- is it one person or a committee?

 The process is a different with every lender, but here’s an example.

After a lender receives an application, it goes to an underwriter.  The underwriter scans the application and checks the borrower’s key details against the lender’s guidelines.  For example, if the lender’s minimum credit score for a product is 680, the underwriter will look at the applicant’s credit score to ensure this key metric is satisfied [TMW note: any credit score over 720 is considered the ideal score for obtaining the best mortgage rates].

The lender than analyzes the applicant’s credit report, job history and debt ratios to ensure the borrower can service the mortgage payments without problem.

If the main guidelines are met, the underwriter then reviews each detail of the application to check for inconsistencies or red flags.  They also do things like call the applicant’s employer to confirm employment.

If no issues are found, the underwriter might then issue a conditional approval.  The conditions of the approval will be based on things like submitting a satisfactory property appraisal and all the proper documentation (e.g.  an employment letter and pay stub).

For typical residential deals there is only one underwriter assigned to a file.  If it’s a big or complex deal, or the mortgage planner questions the lender’s decision, the file might be escalated to senior underwriters for further review.

Can you answer a question that always bugs me? Assume I am a long standing client at XYZ bank. Why do they not give me the best deal when I apply for a mortgage? I can see this happening if I approached a new bank but I bank with XYZ Bank! So much for client loyalty!

Banks have found that it is more profitable to negotiate with their customers instead of quoting their lowest rate up front.  In general, this is because bank reps have more experience and preparation in the negotiation process than the average consumer—many of whom accept the bank’s first “discounted” offer at face value.

In a lot of ways it comes down to a matter of principle.  I don’t like to badmouth banks because they’re in business to make a profit too.  Moreover, we send them a lot of business and have close friends in the banking channel. 

Nonetheless, banks are known for coming in at the 11^th hour to try and snatch clients from brokers.  They miraculously come up with “revised discounts” to their prior highball offers.  It’s a game that wastes everyone’s time.  In the end, assuming the rates are similar, who deserves the business?  A bank who knowingly tried to convince a client to take an overpriced rate, or the mortgage planner who pledged the best rate, and a fair rate, up front–and then took hours to counsel the client and put the deal together?

To dovetail on the above question, a friend of mine used to be an assistant branch manager at a bank. He had the discretion to discount the listed mortgage rate by up to 0.5% How much discretion does a financial institution have to discount the listed interest rate?

Every lender is different.  If you go through a mortgage planner, you’ll typically be quoted a lender’s lowest published rate up front.  In some cases, planners might even be able to do better than this.  Quick-close specials are a prime example.  As of today, April 14, 2008, the best deals (for fixed rates at least) are for people who are closing in 30-45 days.  These are unpublished specials available only through mortgage planners.

In most cases, Canada’s big banks have more ability to discount their rates because their rates are almost always much higher to begin with.  Their net rates, however, are usually not the best in the industry (although there are exceptions).

On the topic of rates, here’s one key point.  Always ask your broker if there is another lender who might have better rates or terms than the one they’ve recommended for you.  Some brokers deal with only a handful of lenders.  If they’ve recommended one of their preferred lenders, you’ll want to make sure they’re doing it out of benefit to you, and not because the broker is incentivized to do so.  (By the way, it is often beneficial to use a lender that your broker has preferred status with, but it depends on the case.)

So, the lesson to be learned is to ask your broker which financial institution they are preferred with in order to get the best deal. In other words, not all mortgage brokers have the same access to the same lender…Let’s talk about the top three things someone can do to make sure they obtain a mortgage for the first time.

 These are very general but here goes…

1.      Maintain excellent credit and a pristine repayment history

2.      Be prepared to put more money down, or get a co-signor, if you cannot qualify with the downpayment you had planned.

3.      Use a mortgage planner to identify the lenders that have the most lax qualification criteria for your circumstances.  Mortgage planners are also very good at preparing applications properly the first time, so as to meet lenders guidelines, and avoid needless red flags.  This is important because once a lender turns you down, it’s very hard to convert that decline into an approval.

I believe on your blog, you mentioned that a staggering percentage of people never ask for a lower rate when they renew a mortgage. How much money are they leaving on the table? Is the discount on a renewal that significant?

Many lenders often send out renewal letters with “discounted” renewal rates.  However, these rates are almost always higher than you could find by having a mortgage planner shop around for you.  The difference depends on the lender but I’ve seen cases where a client’s renewal offer was over 1.25% above the going rate at the time.

Just as importantly, there are always new products in our industry.  It’s very likely that a new mortgage has come out with even better features and perks than your present lender can offer.

I don’t want this next question to imply that you or I are supporting anyone defaulting on mortgage payments because we are clearly not but let’s address a reality today- what should someone do to minimize their “damage” when they start to fall behind on mortgage payments? Should they pay something rather than nothing?  Can a mortgage broker help someone in this situation? If so, how?

This is best decided on a case-by-case basis.  I would strongly advise a person in this situation to contact a mortgage planner first to evaluate potential solutions.  Refinancing or a getting second mortgage is sometimes a solution if you have the equity.  Or, if you have fallen onto hard times (e.g.  Become ill and cannot work) your lender or insurer may be able to create a “workout plan” with you.  Genworth’s Default Management program is one such example.

This is really a last resort however.  In Genworth’s case, they will not consider a workout plan if the following apply (quoted from Genworth’s guidelines):

·         When borrowers have the capacity to make payments and there has been deliberate default or mismanagement.

·         When borrowers are uncooperative and unwilling to resolve the situation.

·         When it is unlikely that borrowers will be able to return to making regular principle, interest and tax payments within a reasonable time (i.e. 6 to 12 months).

·         When borrowers have sufficient liquid assets such as RRSP’s, investment certificates, etc. These funds must be applied towards the mortgage payments prior to obtaining assistance from Genworth’s Default Management program.

In general, if you miss a mortgage payment your options diminish considerably.  Therefore, never avoid the pain of facing the problem.  Always act proactively and focus on finding a solution.

Two quick observations about that list: (i) attitude does matter when you are in trouble- it appears if you are willing to “play ball” with lenders, you may have a better chance of negotiating a good deal in hard times; and (ii) you have to show you are willing to bail yourself out too by putting some skin in the game. You can’t expect the lender to do all the work for you

I know you can’t speak for an industry but there has been a lot of criticism in wake of the subprime meltdown that mortgage brokers encouraged low income borrowers to obtain unsuitable mortgages. Do you have any comments to this and is the solution more regulation as some have suggested?

I’m guessing you’re referring to U.S. mortgage brokers.  To date, there have been few such improprieties evident in the Canadian brokerage industry.  Canadian brokers are governed by different rules and lending guidelines.  The difference between the American and Canadian mortgage industries is therefore night and day.

 As for U.S. brokers, the whole process obviously needs to be (and is being) reviewed by regulators.  In some case, more regulation may be the answer.  In others, borrower education is the key.

Last question- tell me why someone should hire a broker rather than do it themselves?

 Here are 10:

1.      Mortgage planners generally charge nothing to plan a typical residential mortgage (they are paid by the lender the client chooses)

2.      Professional mortgage planners always know who has the best deal, out of dozens of different lenders.

3.      Mortgage planners can fill out and manage all the paperwork for you, saving you a boatload of anxiety and hassle.

4.      Some clients–especially subprime clients–have a greater chance of getting approved through a mortgage broker, who can properly structure their application [TMW note: “subprime clients” and “subprime mortgages are two different concepts.  One does not necessarily equate the other.]

5.      Good mortgage planners help clients develop strategies that minimize interest and reduce amortization time.

6.      Professional mortgage planners are impartial.  They owe allegiance only to the client, not to any particular lender, a branch manager, or to shareholders.  In addition, most planners rely on referrals.  Their future success is closely linked with doing a great job for their clients.

7.      For tough deals, mortgage planners can sometimes suggest valid creative financing methods to get deals done.

8.      Mortgage planners are typically only a phone call or email away.  If you need advice, it’s often a heck of a lot easier to call your broker than to try and reach a lender.

9.      Mortgage planners just do mortgages.  As a result, they’re excellent at counseling borrowers on all the various mortgage procedures, the current interest rate climate, the latest and greatest products, and the best type of mortgage terms to choose.

10.  Mortgage planners do all the negotiating for you, saving you one of the most stressful parts of the process.  They also often get faster responses on applications because they have existing relationships with many lenders.

 
Thanks for your time and valuable insight Melanie. Melanie’s blog is listed above  and here is her  related mortgage site.

I am partially appalled and partially impressed by the financial industry’s ability, facilitated by the willing media, to repackage old and discard ideas and sell them as new benefits to average Joe and Mary investor. As the possibility of dividend increases diminishes, there’s been a lot of emphasis and coverage on share buybacks as an alternative to dividends. But is a share buyback really that great or should we, as shareholders, lobby for greater dividends?

A share buyback, as the term implies, is a buyback of shares by the company. It is typically done in one of two ways. The company can make a formal offer to all of the shareholders (called a “normal course issuer bid”) offering to buy back the shares at a premium to the trading price on the day the offer is made. For example, if ABC Corp. is trading at $20.00 on April 1, it offers to all of its shareholders an offer to buy back the shares at $21.50. The other method of carrying out a share buyback is known colloquially as “sweeping the street” whereby the company simply asks a stock broker to buy all the shares tendered for sale on the stock market; the price of the buyback depends on the day’s trading price.

The typical advantage of a share buyback is that it increase earnings per share (EPS) since there are a fewer number of shares. The theory being that since EPS goes up, the stock price should as well. A buyback is also management’s way of telling the world that it believes that its stock is under-valued.

But here are the larger issues with share buybacks:

• It has traditionally been seen as a “kitchen sink” remedy to appease shareholders. It is the last tactic a board of director utilizes to keep shareholders happy usually after fierce shareholder lobbying “to do something.” A share buyback has historically been viewed as a sign that management has lost all creativity and doesn’t know how to grow the business anymore. Thus, it seems strange that it has been repackaged as some new great thing for shareholders. But such is the sign of the times.

• A share buyback can be a round-about way of compensating the board and management in tough times without attracting shareholder scrutiny. Boards of directors and senior management are often granted options at prices below the stock’s price on the day of the option grant. Thus, to use the above example, ABC Corp. grants the board options to purchase at $16.00/share when the stock is trading at $20.00. If you trigger a buy-back at $21.50, the board can exercise their options at $16.00/share and immediately sell for a $5.50 gain per share. For companies that issue a lot of options (high-tech and small-cap companies), this can be a back-door method of enriching the option holders and not the shareholders.
• Unlike a dividend, a buyback does not have to be fully completed. If the company sweeps the street, it can pick and chose when to buy back shares. In a normal course issuer bid, not everyone has to take the buyback offer. Unlike a dividend increase, there is no certainty money will end up in shareholders’ pockets.
• RESEARCH SHOWS BUYBACKS IN ISOLATION DO NOT INCREASE SHARE PRICE: A Morgan Stanley study found that companies which increased dividends outperformed companies which engaged in buybacks. In fact, share buybacks are only beneficial in falling markets but suffer from the above disadvantages.

A share buyback is not necessarily bad; there’s obviously money in the bank to undertake the buyback but, in isolation and without accompanying dividend increases, it is not as great of a benefit as the companies may make it out to be. If I had to pick between a share buyback and a dividend increase, I pick a dividend increase. There is certainty of payment, management confidence of future performance (since you only increase a dividend if you know you can pay it for many years forward) and studies show that high-dividend stocks perform better than their non-dividend paying counterparts.

On the scale of things, companies that can both increase dividends and engaged in share buybacks are your ideal companies. Companies with no dividend increases engaging in share buybacks are warning signs to me (they may lack imagination and it sends out warning signals that it is trying a band-aid short term solution). Companies engaged only in share buybacks should be looked at very carefully.

According to Standard & Poor’s, the largest buybacks in 2007 (by dollars) were as follows:

1. Exxon Mobil Corp.
2. Microsoft
3. IBM
4. GE
5. HP

…the short-end of dual-class share structure company. Ask anyone who invested in Hollinger during the Conrad Black era. Dual-class shares refer to publicly traded companies that have multiple classes of shares: one class of shares are not publicly traded but entitle the shareholders to a controlling vote; they are typically held by the founding family, the founders of the corporation or loyal executives. The other class of shares, which you and I buy, have no entitlement to vote or, even if all of us voted en masse, we would still be out-voted by the founders. For example, the Class B shareholders of Google (held by the founders and top executives) have 10 votes for 1 vote a Class A share would have (the class of shares which are traded publicly).

The primary disadvantage of a company with a dual-class share structure is there are no effective checks and balances to management excesses such as excessive executive compensation. My trader friend made an interesting observation during the Conrad Black criminal trial- the shareholders got what they deserved. You invested in a company where Black, a notorious egomaniac and over-spender, held 73% of the voting shares with only 30% of the issued equity and shareholders were shocked when he did not behave in the best interests of the company? Who was going to stop him? In these types of companies, the vote is stacked against the average investor.

The larger issue is that companies with dual-class structures tend to be poorer performing stocks than their single-class structure counterparts (ask someone who invested in shares of Ford). The notable exception being Berkshire Hathaway; the company run by Warren Buffet (but there are questions how well the company will perform after Buffet). Part of this is human nature; there is a Chinese saying that wealth never survives three generations. In dual-class companies founded by a family, the first generation may have the drive to build the company but that talent and drive may not translate to subsequent generations (trust fund kids don’t necessarily make good management material). The other part is there isn’t any real incentive to listen to shareholders. The company could go sideways for years and the founders can never be voted out. Finally, the founders tend not to like issuing more equity to fuel expansion since they do not want to be diluted so the company tends to borrow a lot more which makes the company very debt heavy.

You can usually tell if a stock has a dual-class structure if the stock has an “A” and a “B” ending to it. For example, Rogers Communications Inc. has a stock symbol of RCI.A and RCI.B. The class of shares which have little to no trading activity is the founder shares and shares with a lot of trading activity is the one that you and I buy.

I like avoiding dual-class structure stock. Obviously, there are good stock which have dual-stock structures but, by in large, I am uncomfortable with the fact the shareholders cannot throw out management even if it tried. As always, do your due diligence before buying anything.

Several months ago, I entertained investing in a rental property. After much thought, meetings, spreadsheets and more meetings, we decided to take a break from looking for a rental property (I don’t use “we” in the royal sense; I had several potential partners; if you are one of my American readers, lest you think I have lost my senses, Canadian real estate has managed to hold its value- for now although things are really softening- and we started looking when values were still relatively high late last year). It was more a matter of timing than the concept itself. We may come back to looking at investing in real estate.

But as we were looking, we started getting into a real conceptual debate about what was a greater priority- cash flow or appreciation.  I believe we found the right urban area to target (Waterloo/Cambridge/Kitchener- home of Research in Motion and the real Silicon Valley North- sorry Ottawa) which, assuming the assumptions are correct, appreciation would take care of itself since a sufficient amount of people would be moving into the area to raise demand. The concern was increasingly becoming that the acquisition price kept going up but the rental rates were not increasing at the same rate. If you are an owner, this is great since your house is appreciating but, assuming interest rates do not rise significantly on a variable rate mortgage, your debt to income ratio (% income to cover debt) remains relatively constant. Without increasing costs, you have a paper gain.

But the game is different in real estate investing. Low interest rate environments are bad for real estate investors- it means that there is a low barrier of entry into the housing market which decreases the rental pool as renters become owners and an increasing number of people, with cheap mortgages, are bidding up real estate prices. Decreasing renter base + increasing property prices = unhappy real estate investor. An investor ends up getting less bang for the buck as it costs more to acquire a property renting for approximately the same amount as the year previous (remember that as the number of renters decrease, rents decrease as well; in Toronto, landlords are giving out free LCD TV’s to entice renters since everyone started buying condos instead of renting and, you guessed it, property prices in the “good” parts of the city began to reach unaffordable levels for most middle class families).

Ideally, a real estate investor wants to avoid the south Florida housing trap- lots of real estate being bidded up, no real renter base relative to the number of new homes going up and an over-supply of most types of housing (I may call this the Vancouver trap in a few years). No one is happy- home owner or real estate investor.

The other approach we looked at was to look purely at a cash flow property. This meant looking at old dumps (I believe that’s the technique term) with multiple units which could be rented out or duplexes and triplexes which were not dumpy (again, a technical real estate term). For duplexes and triplexes, we ran into the same issue- appreciation was too high even with multiple units. We had to put a lot down and still not yield that much rental income relative to acquisition costs. The issue with trying to purchase duplexes and triplexes in appreciating areas is that purchasers are buying for both appreciation potential and the cash flow multiple renters provides which adds a premium to pricing. Whatever gain you get from multiple sources of rental income is being off-set by the amount of money you have to put up to acquire the property. With respect to investing in a dump and becoming a slumlord, no one wanted the headaches. Enough said. Perhaps, we were looking too soon and with the market softening, a wait and see attitude may be the most prudent one.

…and so we wait for the market to hopefully soften….and I may fall into the arms of my old reliable of dividend yield stocks (yes, even the banks). If you are interested in become a real estate investor, try this blog on real estate investing. To be continued?

This tends to be one of those times of the year where we collectively do a lot of navel gazing into our financial lives. Will we have enough for retirement? What do I invest in now? How come my mutual funds perform so badly? Undoubtedly, as part of this internal dialogue, those of us with investment advisors begin to ask ourselves if we have the right advisor and whether they can really help us. There are a lot of horror stories about investment advisors but remember that the good ones never get press- only the bad ones attract attention.

There has been a lot of ink (bytes?) split on selecting a financial planner and/or an investment advisor (including my own two part piece on finding a good lawyer/accountant/financial advisor) but here’s the hard truth: you get what you deserve in life. Crying to the heavens that you have a bad investment advisor really isn’t going to help your portfolio’s performance. You have to take pro-active action.

Having said that, there seems to be a general perception that all investment advisors are bad. I would disagree. The individuals in the industry who actually advise and plan are key professional allies to have; they can, in some instances, be literally worth millions to you. The individuals who are nothing more than salesmen are bad since their primary motivation is to sell and not advise. How can you differentiate the two?

In the movie “Wall Street,” perhaps the seminal movie on the inner workings of 1980’s corporate greed, Martin Sheen’s character is a blue collar worker who keeps calling his son (played by his real life son Charlie Sheen) a “salesmen.” This really irritates Charlie Sheen’s character since he works on Wall Street, wears nice suits and talks the talk. But before he hatches an illegal insider trading scheme, his character is a salesmen- he works the phones selling to the vulnerable. Remove the suit and the ritzy office and his job was no different than selling encyclopedia sets (with all due respect to encyclopedia sales people).

The moral of the story is that it is not the looks, its the actions that define advisors from salesmen…

ADVISORS HELP you pick a long-term strategy and attempt to determine whether a particular product fits into that strategy.

SALESMEN SELL you product without regard to an over-arching strategy. This is how a portfolio ends up with 10 different mutual funds with over-lapping holdings and no regard to asset allocation.

ADVISORS REVIEW your portfolio at least once a year with the intention of seeing whether you are on the right track and not to sell you more product (if you don’t do this now- demand it. If they balk, you know if they are advisors or salespeople).

SALESMEN IGNORE you until they need the next commission and then they call to pitch you the product du jour. Thus, you either end up selling in a down market (since sales are drying up for your investment advisor and needs a quick commission) or buying in an up market (since the advisor is just piling on sales at that point).

ADVISORS DISCUSS the risks and rewards of each investment decision with you in order for you to gain a greater understanding of what exactly you are doing.

SALESMEN SAY “trust me, this product will be great” and attempt to sell on your emotions rather than on an analysis of the product (if there was truly a trusting relationship between two persons, why would someone say “trust me”? Wouldn’t it be implicit between the parties that one would look out for the other?).

ADVISORS CALL you during uncertain times (like now) to reassure you to stay the course and not to react emotionally and to keep the long term in mind (the best piece of advice I got this year was from my investment advisor who told me to stop over-thinking, stick my money in a high interest account and wait until whether the market is definitely going up or down).

SALESMEN HAVE disappeared because they sold you junk during good times (and are now hiding) or trying to create additional panic in order to induce you to do something (which will make them a commission). Be concerned if an investment advisor has moved cities several times in their career without a good explanation- they could be running from a mess they made somewhere else.

…it is said that a true mark of character is what someone does during bad times. This year may be a good litmus test for investment advisors everywhere on whether they are truly advisors or salesmen. But, to reiterate my initial point, it is your life and your money, take responsibility for it. An advisor is there to help you not to run your financial life for you.

Anyone care to share stories (good or bad) about investment advisors?

Today continues my occasional “insider conversation” series. The goal of this series is to pick the brains of insiders who deal with the business of money and to try to dig beyond the headlines. Last month, I had an opportunity to discuss a wide variety of topics surrounding the investment advisors and financial planners. My guest today is Richard Wilson who took time out of his day to discuss the largely misunderstood world of hedge funds, its excesses and careers in the financial industry. As usual, my questions are in bold and Richard’s answers are in italics. Richard was kind enough to share his email address if you had any questions about hedge funds. As a courtesy to Richard, please only email him if you have serious questions and remember he is not a financial planner or advisor.

Tell me a little about yourself and what you do?

My name is Richard Wilson and I am a hedge fund consultant and founder of the Hedge Fund Group (HFG). I work for a third party marketing firm and our job is to find new investors for unique and top performing hedge fund managers. We look at over 300 hedge funds a year, sift through those, and then work with around 1% of those for 3-5 years at a time.
As a pretense to everything else said in this interview I just want to make it clear that I’m not a financial advisor and nothing I write about here or in my blog should be taken as financial advice, guidance or recommendations. I simply write about hedge funds and enjoy networking with financial advisors and consultants.

Hedge funds are perhaps one of the most misunderstood investing products in the market today. Some believe they are controlled by a Connecticut based Cabel manipulating the financial markets. Others think they are the greatest thing since sliced bread. Let’s try to demystify the product and industry. What is a hedge fund?

A hedge fund is a private investment pool of capital which has few restrictions in what types of assets it can invest in. Hedge funds are often ran by a small teams of experienced portfolio managers, traders and analysts. Hedge funds earn money by typically charging investors a 2% management fee plus 20% of positive returns past a set point which is often referred to as a hurdle rate. While the hedge funds you often here about in mainstream media are very large with over $10B in assets they represent only .5% of the total universe of well over 12,000 hedge funds. You can find out more about hedge funds in this video.

Who ideally is best suit to investing in hedge funds?

Well, in the United States you have to be an accredited investor to invest in hedge funds. If you are an accredited investor than those with a large enough portfolio and enough financial knowledge or guidance from a financial planner are potential good fits for hedge funds. That is a broad statement because once you take the time to start looking at the 10,000 hedge fund products you’ll find low, moderate and high risk options that use vastly different investment strategies and a range of assets from collecting art, buying real estate or using a very sophisticated quantitative model to buy and sell options. There are really several hundred hedge fund strategies to pick through, that is why the real prerequisite is simply taking the time to figure out which might work best for your situation.

[TMW note: An “accredited investor” is a term used in securities law to define persons or institutions who, by means of their net worth or sophistication, are deemed eligible to purchase higher risk securities not available to the public. The definition of an accredited investor is different jurisdiction to jurisdiction so please consult a securities lawyer or your investment advisor/planner if you think you an accredited investor]

If hedge funds are only suited for accredited investors and, thus, by definition, open to 10% of the population at most why the disproportionate amount of the media attention?

While hedge funds are only open to 10% of the general population almost any institution can invest in hedge funds. Endowments, foundations and pension plans all have access to these types of products if they wish to use them for managing their own portfolios. For example, there are over 450,000 foundations in the United States, while many do not use hedge funds a percentage of them do and each group’s assets are generally many times the size of the portfolio of an individual. In aggregate these institutional assets add up quickly. Over the last 5 years institutions have typically been allocating 6-12% of their portfolios to hedge funds or alternative investments (generally private equity and hedge funds). Now the trend is to start allocating 12-20% of their total portfolio to hedge fund managers and alternative investment options.

The short answer is that hedge funds make up a large percentage of the equity trades each day within the stock market and are often involved in activist proxy battles and takeover attempts that seem to make the headlines on a weekly basis nowdays.

For those who are accredited investors and what exposure to hedge funds, what is the ideal percentage of one’s portfolio that should be invested in hedge funds?

I can’t make this type of recommendation since it comes to close to providing financial advice, but every major publication has recently disclosed that institutions have been gearing up to allocate 12-20% of their portfolio to hedge funds and alternative investments. This could or could not be too aggressive for an individual; it really depends on your situation in terms of both age and level of assets.

I know you can’t answer for your entire industry but do you have any comments to the criticism that the hedge fund community unnecessarily focuses on short term gains (because a large portion of its compensation is based on annual profit) sometimes to the detriment of publicly traded companies? For example, two hedge funds publicly lobbied for the merger of TD Ameritrade and E*Trade against the wishes of management. It was perceived by some columnists that the lobbying was to create a short term gain in share price. Of course, we all subsequently found out that E*Trade had significant exposure to subprime mortgages.

While some hedge funds are pushing for short-term performance most are shooting for long-term returns. Anyone who has been in the industry for more than 3-5 years know that sophisticated and un-sophisticated investors alike don’t really take a hedge fund manager seriously until they have 5-7 or even 10 years of a track record of running money. If you shoot only for short-term returns you are dead. Hedge funds do try to make money though, that’s how they earn their out-sized bonuses each year.

I think the real question is why are so many people invested in mutual funds? If you could manage equities for a mutual fund for $400,000 a year or manage equities for a hedge fund for $5 million a year where do you think the majority of talent is going to flow? It is like playing basketball professionally in Canada or being on a team in the NBA. The talent flows to where the money is. Also, the reason why good stock pickers can make more money at a hedge fund is that the interests of hedge funds are aligned with their investors…hedge funds typically take a 2% base fee and 20% of upside performance. 90% of profits are usually made off of that 20% upside performance and that just doesn’t exist in the world of mutual funds. Mutual fund managers and companies in general earn money based on total assets under management.

Do you believe that the negative publicity of the industry is self-inflicted? The community clusters in a relatively remote (albeit really nice) part of the country, rarely speaks public except to grill board of directors (whether justified or not, the public statements have a negative tone to them).

I believe it is SEC inflicted. Hedge funds are restricted by current laws not to do any marketing or sales. Most hedge funds avoid all media contact and public exposure in general. The reason why you only hear them grill boards of directors and nothing else is because as public companies that information has to be made public. This is partially why I keep writing in my blog, hedge fund managers can’t write much to the public on their own industry and the WSJ and NY Times like to either focus on activist hedge funds or draw conclusions on the hedge fund industry as a whole based on what the 10 largest hedge fund managers are doing. There are 10,000 hedge funds out there now, 80% of what you read in mainstream media is not true for the vast majority of those managers.

Financial Times wrote an article commenting that it was the banks, and not the hedge funds, that were affected by market shocks. The implication of the column was that hedge funds, which are typically managed by few key decision makers and not committees, had structural advantages to other institutions. As hedge funds get larger and larger, will there be a reversion to means for hedge funds?

I love that article, it’s a great opinion piece on how hedge funds have faired vs. banks in the recent market turmoil. I think it is true that hedge funds are leaner, more profit driven and hungry than large banks who need four levels of approval to expense their lunch. To your point on reversion to the mean as hedge funds grow, I think we are already there now with over 10,000 funds. In this case I think that overall returns might return more to average as the number of hedge fund managers grow, but I think we are a long way off from having more than a handful of hedge funds build in the type of lethargy you find in large banks. A side note to that, most hedge funds weren’t directly impacted by the sub-prime meltdown.

Every industry has its excesses. If you had to name one for the hedge fund industry what would it be?

Besides the total number of hedge fund managers possibly approaching excess, I would say base management fees run high. They are typically 2% of total funds managed and I think that should come down to 1 or 1.25% or hopefully 0. If you are not making money for your investors than don’t run a hedge fund, there are enough hedge fund managers out there already.

Let’s take about careers. There’s increasing talk that the future in sell side is limited and the place to be is buy side (for definitional purposes, sell side are the retail brokers who sell securities; whereas buy-side refers to the portion of the financial industry, such as pension funds, who buy assets and manage them). If someone wanted to start a career on the buy-side, what are 3 pieces of advice you would give them?

1. The day you graduate from college start studying for and earning your Chartered Financial Analyst (CFA) designation.
2. Never do anything un-ethical. If you are sharp and passionate you have no need to ever cut corners. Avoid people that do like the plague.
3. Do you own compliance and due diligence research. Look up your potential or current boss within the FINRA or SEC records to see if they have marks against them. Meet with a compliance lawyer yourself to make sure your activities are all legal with securities laws. Do your own homework because many times nobody is going to do it for you.

As usual, here’s your opportunity to plug your blog and your new book.

If anyone has more questions regarding hedge funds they can email me directly at Richard@RichardCWilson.com or read through some of the 250 hedge fund articles within my blog. If you hate clicking dozens of times to read multiple hedge fund articles please download my free hedge fund blog book.

Thanks for your time Richard.

Thank you.