The risk story behind expected profitability

Investors demand higher returns for taking on more risk.  Small stocks and value stocks have exhibited performance that exceeds that of the broad market over the long term which can be explained by the increased riskiness of these asset classes above and beyond the risk of the market.  The science behind small cap and value is peer reviewed, evidence based, and it makes sense with relation to risk and return.  The idea of tilting a portfolio towards expected profitability in pursuit of higher expected returns does not have the same logical flow; how does profitability relate to risk?  If a company is profitable, wouldn't the market include that information in the price?  To explain this, expected profitability should be thought of as a filter rather than a standalone factor of higher expected returns.  When it is applied in conjunction with the size and value factors, the risk story of expected profitability becomes very clear.

All else equal, the market will place a higher relative price on a company with higher expected profitability.  If Company A has higher expected profitability and the same relative price as Company B, the market has priced in additional risk in Company A.  Holding size and value constant, the additional risk uncovered by expected profitability can be observed in the higher expected returns that these stocks have shown throughout time and across markets.  So you can’t treat expected profitability as an asset class like small and value, but once a portfolio has been tilted towards small and value, expected returns can be further increased using profitability as a filter.

The efficacy of this filter is directly observable as it relates to the performance of the small cap growth asset class.  This asset class was previously limited in portfolios based on its consistent underperformance and high volatility relative to other asset classes, but it was considered an anomaly that could not be explained by the three factor model.  It has now been found that the poor performance of small cap growth companies can be explained by low profitability.  This filter adds another cost effective method of pursuing higher expected returns and avoiding low expected returns based on robust data that is persistent through time and pervasive across markets, and it makes sense as related to risk and return.

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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.

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High Frequency Trading

The promotion of Michael Lewis' new book has caused a significant amount of discussion in the media around whether or not High Frequency Trading (HFT) causes harm to the integrity of financial markets.  The debate is very interesting.  One argument says that HFT makes markets more efficient and expedites the arbitrage of the occasional inefficiency, while the other says that it is a big scam causing investors to lose out on profits.

With the right investment philosophy, there is no need to be overly concerned by either side of this debate.  The ability of High Frequency Traders to rapidly create small profits using superior technology is not a new phenomena; it is an issue that is generally present when dealing with market orders and order routing.  As an example, an active manager who wants to trade specific securities within a short period time would be affected by these issues.

A market based approach to investing does not require large market orders, and it does not require rapid trade execution. Investing in asset classes rather than the latest hot issue means that individual stocks with the right characteristics become interchangeable parts in a much broader strategy.  The flexibility in this approach eliminates the need for the immediate liquidity that HFT is able to profit from.

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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.

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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.

Is Picking Mutual Funds any Different from Picking Stocks?

Today I received an email from an advisor that continues to work with actively managed mutual fund providers to serve his clients.  He sent me a document that a fund company had produced for him showing that actively managed mutual funds have consistently beaten their benchmark ETFs, and asked me what I thought.  My response follows:

Thank you for thinking to send this over.

I think it’s very interesting that the active management vs. ETF/passive debate is important enough for this fund company to have made this document.  I think it is even more interesting that they are pushing their advisors to sell their active funds while they are also making ETFs on the side.

But look, the thing you have to understand is that there will be funds that outperform just like there will be stocks that will outperform. I could go and find a bunch of stocks that have beaten a benchmark over the last ten years and say that it’s possible to beat the market.  It's important to understand that with a mutual fund, any time you are not holding the whole benchmark there can be periods when you outperform and periods when you underperform.  I could go and find a bunch of funds that have not beaten their benchmark over the last ten years just as easily as they found ones that did.

The key though, is that you or I, or even the fund managers don’t know when they will be winners or when they will be losers.  You can go and say "ok, the XX was up 11% over the S&P/TSX last year, I’m going to put my client in that one". But you know as well as I do that past performance does not indicate future performance.  You are betting on that fund doing well on your client’s behalf based on how well it did last year; you have no idea if it will be up or down in the future.  If you don’t know what the fund will do in the future, why not just accept the market’s returns and get rid of the high MER instead of hoping that the fund happens to be up during the period that your client is invested?

Picking funds is on the same level as picking stocks in my opinion.  You can say "well this manager has tons of experience and the fund has done well in the past" and so on, but that’s no better than looking at the financials of a company and saying "oh they have strong earnings, good management, and a stable dividend I will pick that one".  There is simply too much information in both cases to make an accurate prediction AND your clients are paying high fees for you to place these bets... it just doesn’t sit well with me.

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Searching for yield in all the wrong places

The current low-yield environment has made it very easy for investors to question the value of holding bonds in their portfolios.  With interest rates staying low as long as they have, concerns have surfaced around frustratingly low yields, and the fear of rising interest rates decimating the value of bonds.  If bond yields can be matched by GICs, and GICs won’t lose value if interest rates rise, why would anyone hold bonds at all?  Let’s consider this question while ignoring the interest rate environment altogether. 

Bonds reduce volatility in a portfolio and provide an asset class that does not move in lock step with equities; they are not added to a portfolio to produce higher expected returns, but to allow investors to weather the inevitable swings in the equity markets.  When an investor looks at their fixed income allocation as a source of yield rather than a source of risk reduction, they are looking for yield in the wrong place.

In a strong economy with low yields, some investors begin to feel that they can simply replace their bond allocation with dividend paying stocks.  This strategy eliminates the risk reducing effects of a fixed income allocation and leaves the investor fully exposed to fluctuations in the equity market.  When investors begin searching for yield in their fixed income portfolio, they end up taking on additional risk rather than managing it.  Looking at bonds strictly as a risk management asset class changes the nature of the yield discussion.

Nobody can predict the future.  It is obvious that interest rates are low today, but nobody knows what they will be tomorrow.  When you are building a portfolio, it is important to focus on taking risks that have proven to have higher expected returns on the equity side while keeping a bond allocation in place to manage overall portfolio volatility.  By getting your mindset away from chasing yield in bonds, it becomes possible to construct a bond allocation using investment and higher grade short-term bonds.  These securities will have lower yields than low-grade or long term bonds, but they also carry less volatility.  Implementing this fixed income strategy allows investors to reduce interest rate risk in their bond allocation while also maintaining the liquidity that is necessary to systematically rebalance - something that is lost with GICs.

Every investor should appreciate the effects of exposure to riskier asset classes with higher expected returns, but it is important to understand that regardless of their yield there is no replacement for bonds in a robust portfolio.  So what do you do if interest rates rise and the value of your bond allocation goes down?  Rebalance by buying more high quality short-term bonds at the new, higher rates.

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How Hard is it to Beat the Market?

How hard can it really be to beat the market?  If I say that all available information is included in the price of a security, it follows that someone had to act on the available information in order for it to be included in the price.  Someone had to get the information, make a decision to buy or sell the security, and then execute a trade for that information to be included in the price.  So every time someone can be the first to act on new information they must make a profit, right?

In 1945, F.A. Hayek pointed out that there are two types of information:

  1. general information that is widely available to all market participants, and

  2. specific information about particular circumstances of time and place, including the preferences and needs of each unique investor. 

As a pricing mechanism, the market is able to aggregate all information into a single metric.  That metric is the price, and it is constantly influenced by participants competing with each other to be the first to bring information to the market in order to make a profit.  As hard as they try, no single market participant can have the full set of information because new information is being randomly generated constantly.  If someone overhears a conversation between two Apple employees, they are in possession of information that nobody else has; if someone sees an oil tanker sink in the middle of the ocean, they have unique information; if a pension fund manager goes on a site visit to a mine and hears something before everyone else, they have specific information particular to their circumstances – there is an infinite amount of information like this being constantly generated, and due to the nature of the market, people want to use their information to profit.  What does this mean for investors?  It means that all available information can be included in the price of a security without any single provider of information being able to profit from the information that they contributed.

So in short, it’s really really hard to beat the market.

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Risks Worth Taking

Wealth creation takes place when cash flow is steady, there is time to recover losses, and risk is tolerable. 

It's not uncommon for the ability to take risk in the market to be confused with the desire to gamble.  There are some risks worth taking, and some risks that can turn an investment account into a sophisticated platform for placing bets.

Of course, it's a lot of fun to do research and be immersed in the latest information about a company or an industry with the hopes of taking action before the market does.  Consider, though, the amount of other individuals, and more importantly institutions and mutual funds, that are trying to do the same thing.

By the time you read a Bloomberg News headline, the market has already reacted.  By the time the company you're following discovers a new reserve, institutions have already started trading.  The ability of the collective players in the market to price a security as soon as new information develops is intimidating.

It's easy to think that with enough research, it should be possible to outsmart the market by predicting new information before it happens, but new information develops randomly.  If we could predict all new information accurately we wouldn't need the market to create wealth.

So what's a risk worth taking?   It has been proven through years of research that small cap and value stocks produce superior returns over the long term.  Constructing a portfolio tilted toward these asset classes can increase expected returns without relying on speculation.  With these tilts in place, diversifying globally, and across asset classes can almost eliminate non-systematic risk.  You may never make 200% on a speculative bet, but major losses will likewise be reduced.

In creating wealth, the sequence of returns is just as important as the returns themselves.  It's very difficult to beat the long term compounded returns of a robust portfolio with a series of speculative bets.

This may not sound exciting, and it shouldn't.  Well documented research stands behind these remarks - I'm talking about using science to invest, and science is not nearly as exciting as gambling. 

Market Based Investing

In 1991 William Sharpe wrote an article in the Financial Analyst’s Journal titled The Arithmetic of Active Management.  The main point of the article is that after costs the return on the average actively managed dollar will be less than the return on the average passively managed dollar.

Sharpe is only addressing the average actively managed dollar, so there must be some actively managed dollars that are outperforming the market.  Over the five years from 2007 to 2012, actively managed Canadian equity funds only outperformed the S&P/TSX Composite 9.8% of the time, and actively managed US equity funds over the same period only outperformed the S&P 500 4.6% of the time.  It would be great to be able to pick these outperformers ahead of time, but predicting the future would offer many other benefits, too.

I am happy to disagree with the idea of predictive investment management, but don’t condone the idea of passive investing either. I stand behind a strategy called market based investing.  It is the idea of harnessing what the market has to offer, while taking advantage of asset classes within the market that have been shown over the long term to produce higher returns than the market itself. The idea is to hold the entire market, and then increase the proportion of certain asset classes relative to the market to take advantage of their higher expected returns. Trying to determine which markets would be the best to apply this strategy at any given time would be betraying a scientific approach in favor of prediction. The solution is to build globally diversified portfolios in order to capture the returns of markets around the world while reducing the impact of any single market.

These globally diversified portfolios tilted towards specific asset classes are then rebalanced systematically to eliminate predictive and emotional tendencies as markets move. Implementing this rules-based system ensures that emotions and predictions are removed from investment decisions, and sets a market based portfolio apart from the active vs. passive debate.

Using Visual Basic for Financial Modelling

I learned a fair amount of programming when I studied mechanical engineering, and it is always fun when I get to apply those skills to problems that I see in finance.

I was recently asked to determine if a particular client would be better suited to deposit money into an RRSP or to leave it in non-registered investments.

The problems I had to solve revolved around the following issues:

  • Minimizing taxes
  • Minimizing OAS clawback
  • Maximizing net income

But which strategy would produce superior cash flows based on these parameters?  I structured my model as I would structure a discounted cash flow analysis for a company, selecting my inputs to match an individual.  Gross income became a proxy for revenue, and then I added minimum RRIF payments after age 71, and CPP and OAS benefits at age 65.  I treated taxes and OAS clawback like cash outflows .  I calculated taxes based on marginal tax rates, and OAS clawback based on 15% of any income over $70,954 in any year OAS is received.

I wrote functions in visual basic to find the appropriate tax bracket for a given income, to find the minimum RRIF payment based on age and RRIF amount, and to find the amount of OAS clawback.  The calculations in the model lead to two numbers: the present value of the free cash flow in each scenario.  I was able to link the difference between these two numbers to a sensitivity analysis; using scenario 1 (no RRSP contribution) minus scenario 2 ($31,000 RRSP contribution) shows that when the result is negative (red) it makes more sense to make an RRSP contribution, and positive means it is better to forego RRSPs.

The value of writing these programs did not come in creating the original spreadsheet; I could have realistically input all of that data by hand.  The value in coding a fully linked model is that it allowed me to perform the sensitivity analysis for varying growth rates, inflation rates, and levels of CPP income.

I had hoped that there would be a conclusive answer to the initial question, but the result shows that it all depends on what the market does.  If market performance is strong, the RRIF becomes so large that taxes and OAS clawback are overpowered, but with lower market returns, the tax savings make avoiding the massive RRIF accumulation a better option.

For some context, the client is 47 today and will live to 100.  They are making a one time $31,000 RRSP contribution.  The RRSPs value today before any new contribution is $100,000.  Earned income is $110,000.

My very boring and simple code is linked here.

What's going on with Twitter?

By special request, I am going to discuss my thoughts on Twitter and the volatility of its share price.

As anyone that reads my writing will know, I believe that markets are efficient.  The price of a security reflects all available information.  Practically, the price of a security is governed by the bid-ask spread that develops when people buy and sell it.  The collective knowledge of the people buying and selling securities is what makes markets efficient.  With that in mind, why is Twitter's share price so volatile, and why has its price appreciated so much since its IPO if it hasn't turned a profit?

To answer this, I would first like to discuss where share value comes from.  The value of any asset stems from the cash flows generated by the asset, the lifespan of the asset, the expected growth in the cash flows, and the risk associated with the cash flows.  In the case of Twitter, we are really only concerned with the expected growth rate in cash flows.  If we say that the price of a stock rises based on the feelings of investors, it is really rising because investors feel that cash flows will see significant growth in the future.

Based on the preceding information, the answer to the question regarding Twitter's volatility is obvious; the price is based on the opinions and ideas that a bunch of analysts, traders, and fund managers have regarding the company's expected growth in future cash flows, and their consensus is subject to change.  If Twitter had years of stable financial information that could be used to forecast future cash flows, these people would likely arrive at a stable price consensus because less imagination would be involved.  As for why its price has shot up so much, I would call it speculation.  There are two types of people involved; people thinking that the company will become profitable and the share price will appreciate, and people thinking that they will buy the stock today and a greater fool will buy it for more tomorrow.  The firm has not changed, it is the excitement around the firm's potential to generate cash flows in the future that has changed.  This excitement around future cash flows is what makes investing in companies like this such a poor bet.

I previously wrote about a paper that discusses the idea of investing in growth companies.  It is a dangerous game when many people are speculating on growth due to the effects that speculation has on the P/E ratio.  Even if this company increases its earnings dramatically and becomes a stable performer, the price has to increase relatively with the earnings to make this a good investment based on growth potential.  As actual earnings increase, it is not likely that the P/E will increase with them; the price will remain stagnant or grow at a fraction of the rate of the company because those future earnings are already priced in today.

To summarize, I think that it is possible that Goldman and friends had lower earnings growth built into their valuation model than what the market was willing to accept, I missed the IPO, and I would be hard pressed to believe this stock will be a sure bet.  Its price is not based on the growth of real cash flows, it is based on the guesses and estimates of the collective body of information that makes up the market.

The Grossman-Stiglitz Paradox

I have mentioned this paradox before, so I thought it deserved some discussion.  The Grossman-Stiglitz paradox states:

  1. If markets are efficient and securities' prices reflect all available information and,
  2. obtaining information about securities requires resources (time, money)


  1. Why do people commit resources to researching securities at all, and
  2. if people don't need to commit resources to researching securities, then how did the prices get right to begin with?

To me it is a very simple relationship. If there are people that do believe that there are mispricings to be exploited, they will spend their resources to exploit them. It only takes a few mispricings to make people believe that it is possible to find more mispricings. When mispricings do exist, as soon as enough people exploit them, the prices will tend toward their true value. So, markets are efficient because there are a bunch of people out there that don't think that markets are efficient. It becomes an equilibrium situation.

I remember a discussion with a Carleton University finance professor where I asked what would happen if everyone started to buy the index and stopped trying to beat the market. Following our discussion, if everyone started to buy the index, mispricings would start to develop regularly, and arbitrageurs would be able to profit. The profits that these people made would attract other people, and eventually everyone would return to chasing the dream of beating the market. It really all comes back to psychology; nobody wants to accept being average and moving with the market when there are hot shot managers out there that promise to produce double digit returns. There is a lot more emotional attraction to investing with the guy, or to being the guy that can beat the market.

At the end of the day some people will beat the market, sometimes. Statistically, it is very unlikely that anyone will consistently beat the market over a long period of time, and whenever one manager beats the market, another manager must underperform. I love the idea of active management. It is flashy, glamorous, and exciting. Nobody wants to accept being average, but it is far better to be consistently average than to outperform the market one year and underperform the next. Remember how important the effects of compound returns are in building up wealth.

I say let the stock pickers, the gurus, and the hotshot managers try to beat the market. They get to have fun spending their clients' money to make bets and predictions, and they keep the markets efficient for the rest of us.  To look at it another way, it is all of the dollars paid to active fund managers that keep markets efficient - nothing's free, I'm just glad I'm not the one paying for it.

The paradox of actively managed funds

A recent paper by two Wharton professors and a colleague at the University of Chicago discusses the effects that the size of a mutual fund, the size of the fund industry, and fund manager skill have on the performance of actively managed mutual funds.  Historical data trends in these areas were studied to gain information on two hypotheses: as the size of an active fund increases, its ability to beat its benchmark decreases; and as the size of the active fund industry increases, the ability of any given fund to outperform the market decreases.  This study finds that fund size does not have a significant correlation with performance, but the size of the active fund industry does have a significant and negative correlation with performance.  A 1% increase in the size of the active fund industry was associated with an almost 40 bp decrease in the annual performance of the sample of funds examined.  This goes along with what we know from the Grossman-Stiglitz paradox; the more people that are trying to beat the market, the harder it is to get an information edge to beat the market.

Interestingly, the study found that the returns attributable to fund manager skill have increased over the period 1979-2011.  This increase in skill can be attributed to experience, education, or better use of technology. Increasing skill has not been evident in returns because returns have been hampered by growth of the active fund industry.  The study also found that the performance of a fund suffers as it gets older due to constant industry growth and the consistent introduction of more skilled competition.

This paper confirms what we already know about how competition drives the efficiency of markets.  As more entrants compete for alpha, it becomes more difficult to generate it.  It also tells us that although new funds may have increasingly skilled management, the positive effect of this skill decreases quickly in the first few years of the fund's existence.

If growth in the actively managed fund industry decreases the performance of actively managed funds, why would any investor continue to contribute their assets to actively managed funds?

"I want to invest in actively managed funds so that I can beat the market, but by investing in actively managed funds I am decreasing the chances that my actively managed fund will beat the market." It's a new paradox.

(Link to the paper)

Insights of a First Year Mutual Fund Representative

I wrote this letter to my managers within my first four months of being an insurance and mutual fund representative.  In reflection, I find it interesting that almost exactly a year later I have found myself in a firm that recruits and trains advisors in the manner that I describe here.  In my opinion, this type of model will have to be the future of the financial advisory business, especially when the changing regulatory environment is considered.  When I wrote this, I was not aware of the fee based model.  The fee based model is far more conducive to operating in the manner that I describe below, which is likely one of the reasons why the embedded commission model is under so much fire today.


The letter:


The broad expectation that I have for my current position is that I am constantly learning and fuelled by activity.  I will go into more detail later in this document.  When I entered into the position I had a vision of it being similar to a high level law practice.  I will explain what this looks like in my mind and then draw parallels to show how it applies to a high level financial advisory practice.

After performing casual research by speaking with a corporate lawyer and two litigators (one in family law one in intellectual property law) I have learned that when entering into a firm as an associate, excess clients are passed from the partners to the associates to give the associates an opportunity to learn and build their practice.  Associates are allowed and encouraged to bring in their own clients, but the high level business from the partners is what allows them to gain the type of experience required to add value to the firm; clients passed on from the partners also allow the associates to build a client base that fits with the image and quality of the firm.  An analogy that I discussed with one of the lawyers that helped me understand how a high level law firm works compared the way that financial advisors currently enter the business to a lawyer opening up their own law firm on the street; they are starting a practice with no brand equity, no referral base, and no high level cases to work on to gain the experience needed to become a high level practitioner.  This model is not conducive to building an elite practice.  Partners have spent years, if not generations, building a name and a referral base that brings in clients.  This difference in the way that a lawyer enters the business compared to the way an advisor enters the business explain the disparity between the average level of recruit entering a law firm and the average level of recruit entering an advisory firm.  This model also increases the barriers to entry for an advisory practice.  The current model allows managers to maintain relatively low standards when they are hiring new recruits for multiple reasons: new recruits are difficult to find due to the nature of the business, and the high turnover rate is somewhat justified by the relatively low level of investment by the firm.  It is a vicious circle and a chicken before the egg type situation.  If a model representing a law firm were adopted then the quality of advisors coming into practice would increase.  In the event that advisors knew they would be getting clients upon beginning to practice the business would be far more enticing for compensation and experience purposes; referring to my previous analogy, lawyers are far more likely to join an existing firm than to start their own right out of law school.  The reasoning of a lawyer choosing not to start their own practice is similar to that of a high level professional considering financial advisory; it is necessary to start a business from the ground up.  The alternative law firm hybrid model also increases the investment from the firm which will inevitably result in higher risk, but also greater reward.  The risk of high turnover will be mitigated by replicating the hiring standards of a law firm with an articling process, and a progression into the business.  The reputations of advisors in our business are damaged by the lack of an articling period and the rapid succession into practice.  If lawyers were able to write one two hour exam and begin practicing, the public would be as skeptical of them as they are of advisors.

In our discussion yesterday we referred to the trials and tribulations that people will go through to be analysts for Fidelity.  We failed to discuss some key aspects that make this possible, and the ways that they can be applied to revolutionize our business.  The people putting themselves through hell to become analysts for Fidelity are the cream of the crop.  They are top students from top schools competing for a top position that, if achieved, is guaranteed to come with a large payout and huge opportunities for the future.  In contrast to this, financial advisors often enter into the business with little idea of what it is that they are getting into, high hopes for the potential of income, and unrealistic expectations for what the first few years will be like.  Financial advisors are often second career people looking for higher income, or university graduates that were unsure of what they would choose as a career.  It is very possible for advisors to go through their career never making one tenth of what an analyst at Fidelity will make, while continuing to scramble as if they were fighting for a spot.  It is a difficult expectation for the firm to hold that individuals with high income potential will walk into a business with such a high failure rate when they could be entering into fields with guaranteed income.  I understand the argument that the income potential in this business justifies the initial risk, but imagine the advisors that are being overlooked due to being averse to the risk.  Changing the broad business model to the law firm-like approach will make gaining a spot in this firm a cherished opportunity that graduates with high expectations for themselves and their careers will compete for.

The law firm business model sounds attractive and flashy, but is it feasible to apply this model to an advisory practice?  Lawyers are paid on a salary with an opportunity to earn a bonus based on their performance and the revenue that they are able to produce; billable hours are charged to the firm and used in analyzing the performance of associates.  In the event that associates are brought into cases with a partner their billable hours are combined with that of the partner.  The billing system records how files come in and associates are paid a bonus between .5 and 2% of the total bill for that case.   This occurs if the associate refers a case in, or if they are present in the initial meeting and throughout the case.  Associates are given “sales” targets that must be met using either billable hours or set block fees.  The cases handed to associates by partners count towards fulfilling these quotas; the same system could easily be applied to DSC sales and aum, using commissions and assets instead of billable hours.  From the samples that I took, it is common for first year associates to have to fulfill between 1200 and 1800 billable hours per year.  This does not include administrative work, so it is apparently very difficult to achieve these quotas.  Again, this system is very relatable to commissions.  Advisors would still be motivated to sell and gain clientele to meet their quotas, while having the safety of a salary.  When a lawyer is awarded a position in a firm they are required to go through a period of articling which lasts 10 months; they are paid a salary of approximately $40K during this time.  The next step is to become a first year associate, during which time they are compensated with a salary of approximately $65K and incentives based on activity.  A small percentage (.5-2%) of the business that a first year associate brings to the office is paid out to them.

I understood entering the business that it would not look like what I have described in this document, but I certainly did expect it to be somewhere between what I have described and what it is.  I believe that if we are able to build a model that operates in line with what I have described, we will be able to bring in higher level advisors and bigger clients, take advantage of the concept of functional specialists, and create young advisors that operate on a level that usually takes a life time to achieve.

Understanding that there is a small chance that any of this will actually happen, my expectation going forward is that I will be included on large cases, I will be compensated according to the level of work I am performing, which may not be directly related to premium submitted, and I will be given the type of guidance and structure that an articling lawyer would receive.  It is my preference that I am put on a salary as my current lifestyle cannot be maintained with my level of pay, and the clients that I am attracting to try and pay the bills are not conducive to building the type of practice that I envision.  A structure similar to a first year associate in a law firm, with bonus based on performance, is preferable.

A final note that I hope will make all of these ideas make sense when applied to our office:  There are a select few prestigious law firms that were built by charismatic people with affinities for both law and business.  They have built practices that bring the biggest law cases in the world to them because of the name they have built.  These firms employ massive amounts of highly intelligent and well respected lawyers which allow the firm to attract and handle even more business and bigger cases.  If every lawyer at Gowlings had opted to open their own practice instead of joining the firm, not only would they suffer from having to start from scratch, but the firm would suffer due to decreased capacity and an inability to grow.  Asking financial advisors to start from scratch every time they enter the business is inefficient.  A charismatic and talented advisor should be able to build a practice, and then continue to grow it by adding other advisors that he is able to pass his extra cases to and increase the capacity of his practice.  There is a huge difference between having people on a sales team and having people integrated fully into a practice.  Financial advisory fits so well into the model of a law firm; I believe that shifting to this model is the future of the business.

Blinded by growth

This article focuses on the idea of investing in growth.  People often get excited about companies or geographies that are growing rapidly, and their excitement leads them to invest in securities representing these growing entities.  The first point that the author makes in the article is that there does not seem to be any correlation between economic growth and equity returns.  Why doesn't this seemingly intuitive correlation exist?  The three main reasons posed in this article are:

  1. Companies benefiting from the economic growth of one country are often based in another country.
  2. The largest companies in most countries tend to sell their goods and services in the international market place, resulting in isolation from local markets.
  3. When growth prospects seem high investors are willing to pay a premium, and they may be over paying.

The idea of buying growth securities is explained by the greater fool theory; a person may realize they are a fool for buying a stock with a P/E of 100, but they expect that a greater fool will buy the security for more at a later date.  To illustrate the dynamics of investing in a growth stock we can look at the following equation representing the return for an investor of a company that does not pay a dividend:


g is the growth of EPS.  This relationship shows us that positive earnings growth will have a positive impact on returns, but if the P/E changes in the opposite direction, this positive effect will be neutralized.  The example of Google between 2006 and 2010 is used; the company had earnings growth of 358.8%, but investors only received a return of 7.3%.  The reason for this disparity is the decreasing P/E.  In 2006, the P/E was 82.6.  This high value reflects the market's high growth prospects for the company - it comes back to all available information being reflected in the price of a security.  In 2010, the P/E had dropped down to 19.3, a reflection of much of the expected growth having been realized.  The problem for investors is that the price was so inflated with excitement in 2006, that it ate away much of the opportunity to partake in the growth of earnings.

The moral of the story here is that although growing companies can offer great prospects for investors, it is extremely important to assess how much is being paid to partake in the growth.  If the premium is too high, returns will be diminished.

The direction of the article is clear, and in line with my own beliefs on investing.  There is an inherent disadvantage to investing in growth stocks and an inherent advantage to investing in value stocks.  Growth stocks tend to be well known in the media and are companies trading with high P/E, P/B, or P/CF multiples due to their potential for growth, and value stocks are less interesting and exciting and have modest potential for growth resulting in them having low multiples. Historically, it has been shown that value stocks produce superior returns to growth stocks, a phenomenon known as the value effect.

It would make sense that the value effect is just an expression of the increased risk investors face when investing in value stocks, but the author argues that value stocks are historically less volatile than growth stocks.  Other arguments are also made by the author in favour of value investing, but he goes on to discuss that it is easier said than done to invest in out of favour securities.  This comes back to sentiment and psychology.

In conclusion, although it is more glamorous to invest in well-known and exciting companies with great growth prospects, the investor has been historically proven to be better off investing in less glamorous value companies.

(Link to paper)

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 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.

How To Construct a Portfolio:

The first step in constructing your investment portfolio is determining a goal for the investment.  Setting an objective allows you to create parameters that make it possible to determine the rate of return that you will require.  The return will be the number that is required to bridge the gap between the amount of capital that you will invest, and your ultimate goal.  Once this model has been created, the parameters and the required rate of return can be adjusted in order to arrive at a required rate of return that is plausible, and that fits with your investment style.  As an example, if you begin with a principal investment of $5000, make a $100 monthly investment, have a 20 year time horizon, and a goal of saving $100,000, you will require a compound annual growth rate of 8.7%.  If it is determined that 8.7% is not feasible, or if it does not fit with your preferred investment style, the parameters can be adjusted.  Following the same parameters, if we increase the principal to $10,000 and the monthly investment to $200, we only require a 3.8% annual return to achieve the goal.  In the charts below, the green bars are the invested principal and the blue bars are investment returns.  Take note of how heavily the person on the left is relying on investment returns to achieve their goal, if the market does not perform as expected they will have a much greater shortfall than the investor on the right.

$5000 principal, $100/month, 20 year horizon, $100K Goal

$5000 principal, $100/month, 20 year horizon, $100K Goal

$10,000 principal, $200/month, 20 year horizon, $100K Goal

$10,000 principal, $200/month, 20 year horizon, $100K Goal

Armed with an idea of the rate of return that you will need to achieve your goal with your given parameters, the next step is to determine your tolerance for risk.  Risk and return are very closely related in that an intelligent investor will not assume more risk than is necessary to achieve a given return, and when more risk is assumed the investor expects to be compensated for assuming it.  If we look at the performance of the S&P 500 since 1950, the general volatility of the equity market can be observed.

S&P 500 Performance  - 1950 - 2013

S&P 500 Performance - 1950 - 2013

This chart shows the potential for gains, but it also shows the that capital can be lost in large amounts.  If an investor is able to stay invested when the market is in a dip, history tells us that the market will rise again with time.  This idea gets much more complicated when we factor in psychology and the time horizon of the investor.  If you panic when the market is low and liquidate your investments, you will miss the gains when the market recovers and be stuck holding your losses; similarly, if you have a set date where the capital will be needed and the market is low when you need it you will either be stuck with the losses or not be able to access the capital until the market recovers.  The above chart shows the S&P 500 index which is only an example of a group of stocks.  An investor can build a different portfolio of stocks that is subject to less risk, they can invest in bonds, they can invest in real estate - there is no shortage of investment opportunities, the challenge is building a portfolio that fits your individual needs and investment style.  The following chart from Vanguard illustrates the average returns, and the variability of returns for various portfolios consisting of stocks and bonds from 1926 through December 2012.  Selecting a mix of equities and fixed income securities is called asset allocation - asset allocation is how a portfolio is constructed to fit a risk profile.


With the ideas of setting a goal, determining an acceptable level of risk to achieve that goal, and the right asset allocation to meet that risk level, we are ready to begin selecting the securities.  Picking individual securities is like going to the casino, or like flipping a coin.  The prices of securities reflect all publicly available information, and trying to guess at the new information that may affect the price is not a particularly effective practice.  I once had a pension fund manager tell me that even the best analysts are only right 70% of the time.  It is, however, possible to reduce the risk and increase the expected return of a portfolio through diversification.  Historically, returns of any asset class vary considerable from year to year, and combining assets classes in a portfolio can mitigate this volatility.  To further reduce volatility, global diversification reduces the effect of any single asset class or market.  The figure below shows the variability of returns across asset classes and geographies, common sense tells us that by combining securities across these asset classes and geographies in a meaningful we can reduce the overall volatility of that portfolio.

Variability of Returns.png

At this point we have taken the following steps to construct a suitable portfolio:

  1. Determined an objective for the investment
  2. Determined a time horizon and required rate of return to achieve the objective
  3. Determined a tolerance for risk
  4. Established an optimal asset allocation based on, time horizon, required return, and risk tolerance
  5. Diversify away the risks of investing in any single asset class, market, or geography
  6. The final step is determining a management strategy.  There are two ways that a portfolio can be managed; read after the jump.

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


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.


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.