Tuesday, August 3, 2010

Advisors

Disclaimer: this blog is my personal opinion only. Information presented are accurate to the best of my knowledge. This blog does not provide any personal financial advice, or solication to buy/sell securities or financial services. I do not take any responsibility for any actions you take as a result of reading this blog.

Garth when asked/challenged about making 6% return from a diversified portfolio often tells his readers that they need to find a good advisor to handle their investments for them. Furthermore, he often states that do it yourself investing is almost a recipe for disaster as well as missing out on securities not available to the average investor. So just how important are financial advisors, what do they do, and does the average investor need one?

In my opinion, if you want to be successful in investing, you absolutely need an excellent investment manager. Preferably a dedicated investment manager to manage your assets and hiring sub managers for specialized investment needs. However, there is a problem, a huge problem for the average investor. That is unless you have over $5M, you will not be able to hire someone like that.

Also notice I said an investment manager, not an investment advisor. Why the distinction? To me an investment manager is a professional whose main focus is on asset management and making investment decisions. An investment advisor usually is more focused on client facing, servicing, liaison and sales than making actual investment decisions and portfolio management. This is a big difference.
To illustrate the difference it is important to first explain the investment management industry and job a little bit. At risk of sounding harsh, the vast majority of financial advisors are basically just salesperson selling products. For example, financial advisors working at a bank generally are only allowed to sell for that bank's mutual funds and have a quota to meet. Same with financial advisors associated with mutual fund companies like Freedom 55. Even many so called independent financial advisors are really just sales people as they sell mutual funds and collect a big commission doing so. They are independent in the sense they sell funds from multiple companies. Even some fee only advisors, who are supposed to be professionals like lawyer and offer their advices for a fee only, often double dip by charging their clients an hourly fee and also collect commissions on mutual funds they sell to clients.
Lastly there are financial advisors who are really just stock brokers who make money based on stock/bond trading commissions. While they may provide advice on what to buy, ultimately if you don't trade they don't make any money. So again, they are really just sales people. There have been more than a few cases where brokers with discretionary trading power on clients account engage in churning (ie. doing a lot of trades) simply to make more commissions for themselves at the expense of their clients.
For an average person with less than $500K to investment, these are the only type of financial advisors they have access to. Sales people motivated more by commission than anything else. There is another tier of financial advisors generally referred to as private client portfolio managers. These are generally investment professional who will only take clients with a minimal of $500K to $1M+ to invest. These might be the kind of investment advisor Garth talks about and they are suitable for boomers who have sold their house and sitting on a hundred thousand to $1M+ in cash. However, even with this type of advisors, there are still some important distinctions.
You see, almost all investment professional make their money based on assets under management since they charge a fee that's based on how much assets they manage. So the goal is to get as much assets under management as possible. You can do this by either having lots of clients each with small assets (say $500K) or fewer clients with large assets (eg. $5M+). When it comes to portfolio management, managing $5M is not any more difficult than managing $500K, possibly even easier as it is a lot easier to be properly diversified with a $5M portfolio than a $500K portfolio. Off course, a $5M account pays a lot more in fees than a $500K account, yet has similar work and expenses required to service the account. So who do you think good investment professional going to choose to work with?
What this means are financial professionals who see clients with $500K to $5M in assets generally having up to 100 or more clients. Thus they don't actually do much investment research, portfolio management, and related activities themselves. Rather the companies they work for have a separate research team that performs these functions, sets out model portfolios for various risk levels, recommended stock buy lists, etc. What these portfolio managers actually do is more about client relationship management, keeps up to date with clients’ changing financial needs and circumstance, and updates their risk level and use appropriate model portfolio. Generally these managers have limited ability to deviate from model portfolios created by their company's research team. This can be a good thing since one person cannot do everything required in portfolio and investment management. Having a good independent research team is essential. What it does mean is that the client needs to be aware of exactly what their portfolio account manager does and that the bulk of investment decisions are done by others.
Finally we have investment professionals that cater to ultra-wealth clients generally with $5M+ to invest. These are generally the best investment professionals that an individual or family can access. They generally do a lot of investment management decisions themselves with a dedicated support team of professionals for research. They also generally have good long term track records and most often find clients by word of mouth rather than mass advertising. They also have very demanding clients who don't like losing money and thus their focus is more about preserving wealth, followed by generating income and growing wealth as a secondary concern.
The last statement in the preceding paragraph is an extremely important statement. Go back and read it again! The wealthiest people who can most afford to take risk are more worried about preserving wealth and to a lesser extent generating income than gaining more of it. While the average person who have much lesser ability to take risk and lose money are often focused exclusively on growth through capital gains. Think about that for a minute and then rethink that tale about a rabbit and a turtle. As well, investment professional serving wealthy clients in generally are also less likely to tell their clients that it’s easy to achieve a 6% return with little risk using a diversified portfolio. Those serving clients with less than $500K seem to be more eagerly telling their clients to invest in equity/funds/etc to increase the chances to make 8%, 10% or even higher annual returns with just a little extra risk that will decrease if you invest for the long term.

With regard to advisors having access to investments not available to individual investors, this is true to a certain degree. A lot of private client managers (eg those who has clients with more than $1M+ to invest) have access to private placements, venture capital, RE investments, etc that the average person don't have access to. However when it comes to bonds and stocks, there really isn't much difference. Whatever bond and stocks your portfolio manager can buy; you can generally buy directly in discount brokerage as well. The only caveat is that for bonds, generally investors who buy/sell regularly in large amounts will have price advantage over the retail investors who would only buy/sell bond in smaller amounts. However when I say big amounts, I mean at least $500K or $1M bond face value. Most investment managers for personal accounts cannot purchase that much for a single bond issue. So while they have advantage over retail investors, it’s not that much.
I have now gone through the 3 general classes of investment advisors/professionals that individuals can hire to manage their money. They range from purely sales people for people with less than $500K to invest, to professionals for affluent with $500K to $5M to invest, and for ultra-wealthy with $5M+ to invest. Where you fit in that wealth scale determines what kind of investment professionals you are going to get. Having a good investment manager is no guarantee you can achieve 6% with little risk (more on that in a later post). So you still think Garth's advice that getting a good financial advisor will solve all your investment headaches and make you 6% minimum with little risk applies to you?