Why a robot will never take my job

The growth of algorithm based investing services in the US has raised questions about the future of the professional financial advisor.  These automated services provide investors with a high level of convenience in building a sophisticated portfolio at a low cost.  Two of the largest providers are Wealthfront and Betterment.  Wealthfront charges a .25% advisory fee, while Betterment charges .15-.35%. These fees are charged over and above the fees attached to the ETFs used in portfolio construction, and they cover the cost of advice, transactions, trades, rebalancing, and tax-loss harvesting (on accounts over $100k).  Both services have succeeded in automating important processes, but there are elements missing that will not soon be replaced by a machine.

Clarity on your whole financial situation – a human advisor is able to have a meaningful conversation around things like deciding to use an RRSP vs. a TFSA, renting or buying a home, and how much income to take in retirement.  If all an advisor/robo-advisor is advising on is optimal portfolio structure, there could be missed opportunities in other areas.

Knowledge of more than just your money – managing a portfolio is one thing, but good financial advice goes beyond tax-loss harvesting and rebalancing.  A financial advisor should know your personality, your family situation, your dreams, and your frustrations.  This type of relationship ensures that recommendations are in line with all aspects of your life, and it also gives continuity to your finances in the event that something happens to you.

Integration with other professionals – an established advisory practice will have relationships with professionals in adjacent fields.  When you are considering something as important as your financial situation, having a team of professionals that trust each other and have experience working together is highly valuable.

Peace of mind – it’s great to have a robust algorithm making sure that your portfolio is being managed efficiently, but that does not mean that your overall financial situation is optimized.  The knowledge of an experienced advisor overseeing all aspects of your financial situation is not something that a computer can effectively replace.

For a .15-.35% fee robo-advisors offer great value, and take the DIY investor to a new level of sophistication.  When (if) these services do arrive in Canada they could become a tool that firms use to make their portfolio management processes more efficient, but they will not replace the high level work that well trained professional financial advisors do for their clients.

Original post at pwlcapital.com

Does Canada need more investor education, or more advisor education?

At the end of a recent meeting, a client asked me if I ever wonder why everyone in Canada isn’t investing in low cost index based funds.  The conversation usually goes that way when people hear the story of a passive investment philosophy and fee based business model, but it isn’t something that I wonder about.  The vast majority of Canadian investors use a financial advisor to invest, and about 75% of Canadian financial advisors are only licensed to sell mutual funds.  Getting mutual funds licensed is much easier than getting securities licensed, and finding a commission based job selling mutual funds is much easier than finding a job with an independent fee-based brokerage firm.  I started my career in financial services as a commission based mutual fund salesperson.  I will be forever impressed by the quality of sales and financial planning training that was given to newly recruited financial advisors, but there was a massive disconnect when it came time to make an actual investment recommendation. 

Advisors with next to zero knowledge of financial markets are expected to choose from thousands of available funds while under pressure to make commissions.  Making it worse for the client is the fact that only high-fee mutual funds pay the commissions that new advisors need to make a living.  With strong sales skills and a knowledge of financial planning the product becomes less important and being a financial advisor becomes a matter of managing relationships, something that people with little to no knowledge of financial markets can do successfully.  A highly skilled and motivated sales force that does not always fully understand what they are selling, and an investing public with minimal financial education, make it obvious to me why Canadians have been relatively slow to adopt low-cost tools like index mutual funds and ETFs.  I meet plenty of people who are fed up with the fees they have been paying and the service they have been receiving, but the market is still slow to get away from high fee mutual funds sold by commission hungry financial advisors.

Original post at pwlcapital.com

How does your financial advisor decide what to invest your money in?

Financial professionals are obligated to offer their clients a suitable investment, but there are many things that can affect which suitable investment your advisor will recommend.

Licensing is one constraint that has the potential to affect a recommendation; some advisors are only licensed to deal with specific types of products such as segregated funds or mutual funds.  In some situations an advisor may be mandated or strongly encouraged to deal exclusively with proprietary products produced by their firm - this can be seen with bank advisors or firms that operate with a captive sales force.  Once an advisor has established the pool of investment choices that they are able to offer you, how do they narrow it down?  Many financial products will pay the advisor for recommending them to a client, and some products pay more than others.  If there are two similar products to choose from, it is possible for an advisor to be swayed by higher compensation.

If we eliminated all of those outside influences, then what would they invest your money in? It's still not an easy question to answer.  Some advisors might pay for research to find the fastest growing companies, or the most undervalued companies.  Maybe they would recommend a dividend strategy, or a portfolio of bank stocks.  They might cite the latest economic data with the intention of directing you towards the most profitable country to invest in.  There are countless ideas and methods of investing that an advisor might pitch, and they will likely be based on some level of prediction.

When you are building your investment portfolio, you don't need to be able to predict the future.  It is important to be very wary of making investment decisions based on the financial news or Jim Cramer's latest tip.  There is a wealth of data and peer reviewed academic research that can serve as a guide in building a robust portfolio that does not rely on prediction.  It is possible to use the whole market as a tool rather than trying to guess which company or geography you should invest in, and by building a globally diversified and rebalanced portfolio the emotion is removed from making investment decisions.

So next time your advisor makes a recommendation, make sure you know what they are licensed to offer you, how they are being paid, and the logic behind their final decision.  If there seems to be a conflict of interest, or they start talking about how China's economic growth is going to affect their favourite stocks, run far, and run fast.

Commentary on the CSA's recent status reports (CSA Staff Notice 33-316 & 81-323)

The Canadian Securities Administrators have been reviewing two different, but related issues for over a year now.  Both of the topics receive a significant amount of coverage in the media; they are Mutual Fund Fees and the Appropriateness of Introducing a Statutory Best Interest Duty When Advice is Provided to Retail Clients (making it the law for advisors to act in the best interest of the client).  I just want to express what I feel were the highlights of both of these papers, and offer my commentary.  I have been on three sides of this equation (investor, mutual fund salesperson, and fee based investment advisor), and as such I think that I can offer some unique insights.  The stakeholders in this discussion have been identified as the mutual fund industry, and the investors.  Their points of view are summarized below.

The Mutual Fund Industry

  • There is no evidence of investor harm that warrants a change to the mutual fund fee structure in Canada
  • A ban on embedded compensation will have unintended consequences for retail investors and the fund industry, including:
    • a reduction in access to advice for small retail investors,
    • the elimination of choice in how investors may pay for financial advice, and
    • the creation of an unlevel playing field among competing products and opportunities for regulatory arbitrage; and
  • We should observe and assess the impact of domestic and international reforms before moving ahead with further proposals.

The Investors

  • Embedded advisor compensation causes a misalignment of interests which impacts investor outcomes and should be banned;
  • Investors should at a minimum have the true choice to not pay embedded commissions;
  • We need to implement a best interest duty for advisors; and
  • We need to increase advisor proficiency requirements and regulate the use of titles.

The statement that there is no evidence of investor harm that warrants a change to the mutual fund fee structure is just about the worst reason that I have ever heard to allow a regulatory policy to remain the same.  A practice should not be allowed to continue because no harm has yet been caused by it.  My point here is especially salient when we consider that other countries across the globe are changing their mutual fund compensation structures because they have had problems in this area.  The UK and Australia have prohibited conflicted advisor remuneration "in response to unique consumer protection gaps and situations including mis-selling scandals causing harm to investors, which are not present in Canada."  So despite serious problems with the exact same thing in other countries, we don't need to change it in Canada because nothing has happened yet...seems like a good idea.

I do agree that changes to the regulations could have ramifications beyond the scope of their intentions, but I do not think that these ramifications would be a bad thing.  There is some merit to the statement that unbundled mutual fund fees would reduce access to financial advice for people with small (less than $100K) portfolios.  It would not be beneficial for either the client or a fee for service advisor to enter into a relationship with only a small amount of capital to invest.  As it stands today, small retail investors are in a situation where they are limited in their options beyond investing in mutual funds with high expense ratios if they want financial advice - the only reason that financial advice is affordable with the current embedded commission model is due to the existence of the deferred sales charge (DSC).  The DSC is exactly what it sounds like; instead of paying a bunch of money (5-6% of the account) up front, you pay it behind the scenes over five or six years and never even notice that the advice you received cost anything.  This is a great idea for the advisor as they receive remuneration at the time of the sale.   It also seems to make sense for the investor because they never see the money leave their wallet, until they want to move their account or withdraw their funds before the six years is up.  If the money does not stay invested for the full deferral period, the client is on the hook to pay the fund company back for the money that their advisor received at the time of the sale.  Another issue in this area is that not all mutual funds have the DSC option; in my experience, funds with low fees that do not involve predictive management or large amounts of trading cannot be purchased in this manner.  So... small investors that want advice are likely to have their money invested in expensive funds that allow their advisor to apply the DSC to make it worth their while.  Knowing that information, I'd say that  although small investors can afford advice in the current environment, the advice that they are getting is highly biased towards funds that can be sold with the DSC.

The industry has stated that they do not think that there are conflicts of interest with the embedded fee structure because all types of mutual funds in Canada have comparable trailing commissions.  On this topic, I can speak from direct experience.  When I was operating on the MFDA platform I was very limited in the funds that I was able to offer.  Yes, there were hundreds upon hundreds of mutual funds with high expense ratios claiming to be able to beat the market available to me and the people in my office, but as I started to shift my thinking towards the use of ETFs and index tracking mutual funds I learned that I could not access them.  I remember discovering TD's index funds and being told I shouldn't use them because I couldn't make any money, and I wasn't able to use Dimensional Fund Advisiors because my dealer did not acknowledge them as a supplier.  It is true that most equity mutual funds with high fees have the same trailing commissions, but I would argue that when advisors are limited to using these funds it is difficult to act in the best interest of the client.  Based on my experiences I can safely say that the clients' best interests are not being put first.  Of course, this shouldn't come as a surprise.  In the current regulatory environment investment recommendations only have to be deemed suitable for the advisor to be legally off the hook.

This lack of a requirement to act in the best interests of the client, or lack of a fiduciary standard, is an issue on more than one level.  To open the discussion of the lacking fiduciary standard I first need to explain the educational requirements in place for an advisor to begin operating in this industry.  In order to sell mutual funds, and call yourself an advisor, it takes one exam requiring a 60% to pass and a 90 day supervised training period.  The exam is designed to take between 90 and 140 hours to prepare for.  So with that said, how is someone supposed to know if they are acting in the best interests of their client when they barely know what they are selling? During the 90 day training advisors aren't even trained to put the interests of the client first, they are trained to make suitable investment recommendations. Using the UK as an example, when they prohibited embedded commissions and increased regulations there was a drop in the number of advisors because some of them could not meet the proficiency standards put in place.  To compound this issue, the CSA cited a study stating that most investors already think advisors have a legal duty to act in their best interest.

The fact that there is a debate around whether or not advisors should have a legal duty to act in their clients' best interests is a little bit silly right?  How is this even a question?  The industry argues that the cost of an investment product should not determine suitability; although an advisor may place their client's investments in a more expensive fund they may have done so because the more expensive fund is expected to perform better in the long run...what?  I don't even want to touch that one.  History tells the story of expensive funds outperforming the market better than I can.  The industry also poses that the introduction of a fiduciary standard will give people less incentive to educate themselves on investments and place more reliance on their advisor.  We certainly wouldn't want clients to forgo educating themselves in favour of taking advice from their professional advisor.  I of course say that in jest, but it may hold more truth than it should with proficiency standards at their current level.  

Another argument that the industry poses against implementing a fiduciary standard is that it would be expensive, and these costs would be passed to the client.  To this I say that clients are better off paying more for advice when the advice has their best interests in mind than getting cheap advice that quietly pads the pockets of their advisor.

One of the biggest problems the mutual fund industry would face if a fiduciary standard and unbundled commissions were implemented is that they only sell...mutual funds.  If the most suitable product for a client was not a mutual fund, or like in my experience the most suitable product was a mutual fund without embedded commissions, how can the client's best interests be served?

Personally, I think that the fact that there is a debate around these issues at all is ridiculous.  I worked with some great people when I started in this business on the MFDA platform, but it did not take me long to realize that there were many pieces missing if I was going to be acting in the best interests of my clients.  There a lot of good people in this industry that genuinely think that they are doing what is right for their clients; it is an issue of education on the part of the advisor. I look forward to seeing how all of this turns out, though it doesn't make any difference to me.  I am already operating on a fee-only basis within a firm that has a self imposed fiduciary standard.  

Everyone else will get it right eventually.


Where is the Value?

The information systems that have become fully integrated in our lives have changed the nature of business.

The ability that people have to do their own research about the best product for their needs, how to implement it, and where to find it at the lowest cost has created a new type of business; the idea of cost-cutting discount stores has taken off.  These establishments cut their operating costs to a bare minimum so that they are able to pass the savings on to the customer.  This idea works well for commodities, and companies like Walmart have been able to position themselves in such a way that they actually add value by making consumers feel satisfied that they have made their purchase at the lowest possible price.  The cost cutting business model does, however, come with an indirect price; stores like Walmart and Costco are not full of eager employees waiting to help you.  The lack of service isn't a huge issue when it is commodities being purchased, but what if the goods become more specialized?  I know that the last time I went to buy a TV it took me thirty minutes to find an associate to help me, and when I had someone to help me they did not have the information that I needed to make an informed decision.  This lack of service and expertise is not the fault of poor management, it's the fault of the consumer.  The price elasticity of demand forces brick and mortar retailers to reduce their fixed costs to try and compete on price with online stores.  This combined with the wide availability of information tends to make people think that they can become experts and do not need to seek out the recommendation of a professional.

The same phenomena can be observed in the financial services industry.  There is a vast quantity of information available to people about the financial markets, financial planning, and the different financial products that are available to consumers, and with the development of discount brokerages, it is possible for someone to spend the necessary time doing research to put themselves in a position to successfully plan for their financial future while minimizing costs.  So if the information is available, and people are able to make their own investment decisions, why do financial advisors and financial planners exist?  They wouldn't exist if they weren't able to provide a service that people see as valuable, but where is the value?

*An important note before I discuss the value that these professionals provide is that not all of them do in fact provide value.  It is the nature of compensation in the business that makes this possible.  In my previous posting I discussed the difference between an advisor and a salesman.  With the impending fee disclosure that will be implemented in the next few years, the clients of salesmen will start to wonder what exactly they are paying for when they see the fees on their statements; these clients will start migrating away from salesmen and toward advisors.

 

Whether an advisor is fee based or commission (trailer fee) based, they will usually charge between .5 and 1% of assets as a management fee,  so what should you be expecting in return?

  1. A Plan - The single most valuable service that a financial advisor can provide to their client is the development of a financial plan.  The clarity that can be gained from understanding how much needs to be saved in order to retire with a certain level of income is unparalleled.  A comprehensive financial plan will also address the insurance needs necessary to maintain the integrity of the plan in unexpected circumstances, and government benefits that the clients expects to receive as they age.  If the plan was something that could be put in place and forgotten about it would make a lot more sense to pay an upfront fee, but this is not the case.  Market returns and changing life circumstances can have an impact on the way that the plan is carried out.
     
  2. Systematic Review - Administering a financial plan is something that requires knowledge, experience, and confidence.  When the financial markets had a downturn in 2008 the decision to stay invested was a difficult one, and how to proceed in the market in the coming years was equally difficult.  It is the responsibility of the advisor to restructure the plan to show what needs to happen to stay the course, and to provide the confident advice that will allow the client to have peace of mind.  A minimum annual review should be expected, and more frequent reviews should be available if life circumstances change.
     
  3. Expertise and Knowledge - When you are making the decision not to take your finances into your own hands, but to pay someone to advise you, it is an obvious expectation that the person you are paying should be educated in the field of finance.  The intricacies of financial planning should be fully understood by the advisor to ensure that your trust is being put in the right place.  Finding the right advisor with the right skill-set and knowledge base is a challenge in itself, but I will address my thoughts on that in another post.

When people ask me why they need a financial advisor, my answer is that they don't.  Having a financial advisor is a choice.  It is a choice to hire a professional to manage your finances and spend the time to plan your financial future with you.  This is a service that you should expect to pay for.   I would never tell someone that they need to have a dentist either, but it makes more sense to me to have my annual cleaning and maintain the health of my teeth than to wait until an emergency arises to seek out help.

When it comes to managing your money, if you can do it on your own that's great.  If you have your own life, career, and family to deal with, working with a professional can be the best option.

 

 

 

Advisors vs. Salesmen

Maxwell's.png

I was reading the brochure for a travelling tailor today and I came across a statement that made me think about how people enter the field of financial advisory.  The reason that this brochure piqued my interest was that the founding tailor of the company had "spent his early years learning the art of tailoring."  This man had started his business in 1961 equipped with the knowledge and skills that he had learned.  I started thinking about other people that I know who have started businesses.  A friend of mine owns his own engineering firm; he started it after working for a large employer for three years.  If he had tried to open his own firm right out of school he would not have had the applied skills or experience with clients to successfully operate a business.  I do know a lawyer that opened his own shop as soon as he had passed the bar, but lawyers are required to article before they can practice.  I have another friend that just finished medical school; after four years of classroom education, he has to complete another four years of residency before he is able to practice.  All of these people work in a capacity in which they hold themselves out as a professional whose advice should be taken due to their extensive expertise and training.  Financial advisors hold themselves out in the same way, but the level of training and expertise that is expected from a professional is not always present.  The 'best' financial advisors are not necessarily the people that are able to give the best financial advice, they might just be the best salespeople.  To be fair, everyone is selling something.  The difference between a lawyer and a mortgage broker is that one is selling their expertise, while the other is using their expertise to sell a product.  So what is your financial advisor selling?  This is becoming one of the most important questions to ask.

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When a new advisor enters the business it is far more common for them to receive sales training than advisory training; new recruits are taught product knowledge and sales psychology.  Performance is not measured by the quality of financial plans being produced, but by the level of sales.  To the credit of many hard working people, it is possible to get through sales training, get a client base, and become a well educated financial professional that is truly able to help people.  The issue that I have is that it is left up to each individual advisor whether they want to be a true advisor or a salesman; both have the potential to build a rewarding career.  It is possible to gain some insight and clarity into what advisors are selling when the way that they are paid is examined.  There are three main ways that a financial advisor can be paid:

  1. Commissions - the advisor is paid commissions by a third party for selling their product.  The client does not directly pay the advisor.
  2. Fixed fee - the advisor and the client agree on a percent of the assets being managed that will be paid to the advisor for their service.  The client is in full agreement with how much the advisor is being paid.
  3. Hourly rate - the advisor will charge per hour of advice, much like a lawyer would charge for billable hours.   The client is paying a one time fee for the construction of a plan, but has to pay hourly each time they need further advice.

It is very clear that an advisor that is paid by commissions is selling products.  Issues quickly and readily arise when financial companies begin competing for the business of advisors by offering more attractive compensation.  Commissions are paid to the advisor by the financial company, but the money is coming from the management fee that the client is paying.  This form of compensation has a major problem because the advisor's compensation is not explicitly disclosed to the client.  This is issue has not gone unnoticed by regulators; fee disclosure to clients is a reality, and the future of embedded commissions is in question.  With embedded commissions, trailer fees in particular, clients are not always aware that they are paying a fee for ongoing service, and as such they do not demand the service that they deserve.

Both fixed fee and hourly rate financial advisors have an agreement with the client that determines how much the advisor is getting paid for their services; this type of arrangement ensures that the client is explicitly aware how much they are paying their advisor.

An advisor that is being paid directly for the advice and guidance that they offer is much more likely to need to spend time developing their knowledge and skills before they are able to begin offering their advice.  An advisor that is being pushed by their sales manager to sell financial products is less likely to develop the professional skills and knowledge that they should have to service their clients and more likely to look for their next sale.  The argument can be made that people need to be sold financial products because they are not motivated enough to buy them on their own, but to counter this argument I believe that when the goal of the advisor is not to sell financial products but rather to sell professional advice, clients will be knocking on the door.

If doctors had sales managers in their offices, and the sales managers compensation was tied to the amount of prescriptions the doctor wrote, it would be safe to say that there would be a lot more prescriptions being filled on a daily basis.  Financial advisors are a valuable asset in anyone's life; they fit in with accountants, lawyers, and doctors in their capacity to use their knowledge and skills to help people.  To truly operate as an advisor, however, takes a significant amount of dedication, time, and effort.  As this ageing industry begins to pass to the next generation, it is more important than ever for young advisors to find the mentorship that they need in order to maintain the level of professionalism and pride that should exist in this career.