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.

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.

Original post at pwlcapital.com

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.

BondVsStock.png

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.

What the Automotive Industry Can Teach Us About Mutual Funds

Up until General Motors (GM) went bankrupt in 2009, their business practices created a beautiful juxtaposition for the business practices of Toyota.  GM had been able to rely on their size, market share, and Japan's non-existence to remain profitable for many years.  This fostered an environment of complacency in their ability to perform their core activity...creating vehicles.  In 2006, GM's profitability was mostly derived from financing the sale of their vehicles while they lost an average of $2,300 on each sale; their core activity had become financing while they were still stuck with making cars.  They were using inefficient manufacturing techniques to create a wide array of uncompetitive vehicles.

In contrast, it's no secret that Japanese automotive manufacturers have absorbed the market share that GM was slowly giving up; in 1960 GM held 50% of the North American market, while they only held 19% in 2009.  There were some very clear factors that contributed to this shift in the market, and, strangely enough, I believe that the same principles can be applied to the current state of the mutual fund industry.  The principles are very basic; efficient manufacturing practices, and competitive products.

Efficient manufacturing practices were revolutionized by the Japanese with Just-in-Time manufacturing (JIT).  American manufacturing methods employed economies of scale to keep the cost of machine hours down; they would have a large production run of a single part and then change the machinery to produce the next part.  The problem with this was that the time and cost associated with changing the machinery was cumbersome.  In the event that a manager suddenly needed a small run of rear doors when the machines were set up for front doors, they would be paying a premium for those machine hours.  JIT made the manufacturing process flexible by implementing production machinery and a labour force that was interchangeable; managers no longer had to pay a premium for unexpected production runs because multiple machines could be quickly set up for a small production run of any part.  These interchangeable parts in the manufacturing process eliminated the high fixed costs of any single production run.  Parallels can be drawn between JIT in auto manufacturing and the trading done within a mutual fund.  

Active fund managers will conclude through research that it is the right time to purchase a certain amount of a given security.  When they fill this order, they will be paying a premium to obtain the specific amount of securities at a specific time due to the nature of bid-ask spreads; at a given time spreads will vary, and filling the kind of large market order that an active mutual fund would place will result in paying varying prices for different available lots.  In contrast, a portfolio designed with holding diversified across asset classes and geographies would not need to accept an undesirable bid-ask on any individual security because they would not be looking to purchase any particular security at any exact time.  A mandate may require a certain weighting of domestic small cap stocks, but the individual securities could be anything fitting that description.  This approach lowers overall trading costs; trading costs are not something to be overlooked either.  It would not be unusual to see an actively managed small cap fund with a trading expense ratio as high as 1%.

Lowering the costs associated with producing either a car or a mutual fund is beneficial to both the customer and the manufacturer, but if the product is not competitive, the cost savings do not drive any value.  In 2006, consumer surveys about vehicle value showed that people perceived Toyota vehicles as being better designed and built, costing less to own, and lasting longer than GM vehicles.  This higher perceived value combined with lower manufacturing costs allowed Toyota to grow its margins while GM’s margins became negative.  GM boasted a massive portfolio of brands and vehicles, each one with a wide array of available features.  This lack of focus and internal competition made it very difficult for GM to produce any single excellent product; in contrast, Toyota has only two brands (Toyota and Lexus), and the vehicles that each brand produces have fewer options.  Toyota’s focused approach to the continuous development of excellent products combined with their low costs allowed them to surpass GM as the number 1 auto manufacturer in the world.  As GM’s margins were squeezed by high manufacturing costs and competition with Toyota’s low prices, the quality of their products continued to suffer.  Near the end, and since their re-birth, GM has eliminated or sold many of the brands in their portfolio.

In the context of mutual funds, the industry is in a similar state as GM was before they went bankrupt.  Current funds in general are not of a high quality, they are costly to produce and costly to own.  Much like GM, fund companies are managing massive amounts of mutual funds.  On average, mutual fund companies manage 117 funds, a huge contrast to the average of 1.7 funds managed in 1951.  Just as GM had to eliminate many of their brands to pursue a more focused effort, mutual fund companies have been going through the same kind of consolidation.  Between 2001 and 2012 there was a 7% per year failure rate for mutual funds; failing funds would be absorbed into funds with strong records to mitigate the evidence of their poor performance.  If a mutual fund company were to take the same approach to their product portfolio that Toyota has taken in manufacturing vehicles, it would produce a few high quality, engineered, and focused products.

So, I have drawn a comparison between the automotive industry and the mutual fund industry.  Why do we care?  We care because those who cannot learn from history are doomed to repeat it.  If I went back in time and had a choice between investing in GM and investing in Toyota, I think it’s obvious where my money is going.  If I wanted to use this analogy to decide where to put my money today? Dimensional Fund Advisors would be my Toyota.

Investment Evolution

I have spent the last two weeks doing a lot of reading.  I will soon be entering a new professional environment with new philosophies on investing, and I made it a priority to educate myself on the broad governing concepts that form the investment style of this new firm.  In the readings that I have done I have come across information that I already knew, information that I did not know, and new implications of concepts that I already understood.  Below is a summary of my thought process as I gained an understanding of three-factor asset class investing:

The Efficient Markets Hypothesis (Fama, 1966) asserts that current securities prices reflect all available information and expectations.   Based on this theory, stock mispricing should be considered a rare condition that appears with randomness, and active management strategies cannot consistently achieve alpha

The Efficient Markets Hypothesis states that investors may be best served through passive, structured portfolios using asset class diversification to manage uncertainty and position for long term growth

Diversification helps reduce uncertainty and control risk

Diversification across asset classes allows for efficient portfolio management and flexible trading

Global diversification of overall investment strategies (conservative, moderate, aggressive etc.) created by combining asset classes can minimize the volatility caused by the inherent randomness of returns

A globally diversified portfolio should include asset classes that are exposed to different macro risk factors, with different dimensions of risk and return across the globe

Using the size of a country’s stock market relative to the world’s total market value rather than economic data (population, GDP, consumption etc.) to assign asset classification removes emotional distortions caused by economic statistics

Severe negative volatility (7% or greater decline in monthly value) has, historically, been experienced simultaneously by domestic large cap, domestic small cap, international developed markets, and emerging markets equities only 3.4% of the time between 1988 and 2009.  This negative correlation shows the importance of global diversification

In any given year, a small subset of stocks may contribute a large portion to the market’s overall return; with the CRSP 1-10 Index from 1926 to 2012 as a sample, removing the top performing decile of stocks reduces the total return from 9.6% to 6.3%.  Because it is impossible to consistently pick winners before the fact, it is logical that the optimal portfolio will maintain broad diversification

The three dimensions of stock returns are the equity market (complete value weighted universe of stocks), the company size (market cap.), and company price (BtM)

Returns of the CRSP 1-10 Index show that the smallest capitalization stocks produce both superior returns, and also the highest standard deviation in returns

The size effect of superior returns has been established over the longest available time period (1926-2012), but over shorter periods returns of small caps have been significantly above, and below the S&P 500

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.