When people ask me what kind of law I practice, I tell them that I am a wealth preservation attorney. To me, wealth preservation consists of three separate areas of wealth management – accumulation, protection and preservation. Wealth preservation involves estate planning, asset protection, retirement distribution planning and other related areas of wealth management.

There is a popular saying that “knowledge is power.” Nowhere is that truer than in the world of investing. Knowledge allows an investor to be proactive and protect their financial security.

In my experience as a securities compliance director and a securities and wealth preservation attorney, I have seen a lot of “games” often used by the financial services industry. In most cases, the “games” are employed to provide more compensation to the financial adviser at the investor’s expense.

Five of the most common “games,” or deceptive practices, used in the industry are:

1. Inverse pricing by variable annuities – This refers to the practice by the variable annuity industry to base their annual fees on the total value of the variable annuity rather than the cost of their legal obligation to the annuity owner, commonly referred to inverse pricing since the fee is not based on the actual potential cost to the variable annuity issuer. Most variable annuities obligate the variable annuity issuer to pay the annuity owner’s heirs the greater of the value of the variable annuity or the owner’s actual contributions.

Given the historical trends of the stock market, it is unlikely that the value of the variable annuity will be less than the owner’s contributions. Consequently, inverse pricing essentially guarantees the variable annuity issuer a substantial windfall at the owner’s expense. Most variable issuers charge an annual fee of 2 percent or more, despite the fact the fact that one well-known study estimated that the actual value of the protection for which the fee is charged is approximately 0.10 percent.

The annual fee charges is even more egregious when one considers that each 1 percent of additional 1 percent of investment fees reduces an investor’s return by approximately 17 percent over a twenty year. When you add the additional fees for a variable annuity’s sub-accounts, the total fees on variable annuities often exceed 3 percent or more, effectively reducing an investor’s end return by over 50 percent or more. For more issues with variable annuities, read our white paper, “Variable Annuities: Reading Between the Marketing Lines,” and “Stuart Berkowitz’s article, “5 Reasons you Should Be Wary of Variable Annuities.”

A recent addition to the annuity product line is the so-called fixed-income or equity-based index annuity. While these products have a number of negative issues, the leading issue if that fact that such products come with various features that seriously limit the real return that investors can achieve. A more comprehensive analysis of these products is available here.

Wealth preservation “best practice”: Variable annuities and indexed annuities…just say no!

2. “Pseudo” or false diversification – This refers to the practice of providing investors with investment recommendations among various types of investments, e.g., large cap growth funds, small cap value funds, international funds and leading an investor to believe that the recommendations will provide the investor with with a diversified investment portfolio and protection against downside risk. But looks can be misleading.

True diversification provides investors with both upside potential and downside protection against substantial losses.  However, given the high correlation of returns among most equity-based investments, both domestic and international equity-based investments, the recommendations often do not provide the protection supposedly provided by diversification at all.

Looking at the five-year (2009-2014) correlation data for five equity-based categories often used in asset allocation recommendations, (large cap growth, large cap value, small cap growth, small cap value, and a popular international index, MSCI’s EAFE), the pattern of high correlation is obvious:

94% correlation between LCG-LCV
91% correlation between LCG-SCG
90% correlation between LCG-SCV
87% correlation between LCG-EAFE
90% correlation between LCV-SCG
94% correlation between LCV-SCV
86% correlation between LCV-EAFE
97% correlation between SCG-SCV
75% correlation between SCG-EAFE
76% correlation between SCV-EAFE

Looking at the ten-year (2005-2014) correlation data for the same categories further demonstrated the high correlation pattern for equity-based investments:

92% correlation between LCG-LCV
92% correlation between LCG-SCG
87% correlation between LCG-SCV
87% correlation between LCG-EAFE
88% correlation between LCV-SCG
93% correlation between LCV-SCV
87% correlation between LCV-EAFE
95% correlation between SCG-SCV
79% correlation between SCG-EAFE
77% correlation between SCV-EAFE

Bottom line, in most case, “pseudo” or false diversification simply provides an investor with nothing more than a false sense of security and an unnecessarily expensive index fund, with reduced returns due to the excessive fees.

Wealth preservation “best practice”: Investors should always ask their financial adviser to prepare a correlation of return analysis for both their existing investment portfolio and the investment portfolio being recommended by their financial adviser. After all, without a correlation of returns analysis, how can a financial adviser know whether his/her recommendations are in the best interests of the investor?

3. Closet index funds – Mutual funds with high R-Squared ratings are often referred to
“closet index” funds, as their high R-Squared rating indicates that investors may be able to achieve similar or better returns at a significantly lower cost by using index-based investments.

Morningstar defines R-squared as a measure of the correlation of the portfolio’s returns to the benchmark’s returns. An R-squared of 100 indicates that all movements of a portfolio can be explained by movements in the benchmark. Conversely, a low R-squared indicates that very few of the portfolio’s movements can be explained by movements in its benchmark index. Effective diversification involves combining investments with low correlations of return so that the investments provide downside protection against large losses, regardless of economic or market conditions.

There is no universally accepted R-squared rating level for classification of a fund as a closet index fund. Some use a rating of 95 as the threshold rating, while some us 80-85 as a threshold R-squared rating.

InvestSense classifies any mutual fund with an R-squared rating of 90 or above as a “closet index” fund.  This position is based upon our belief that the ability to achieve the same or similar returns of a benchmark index fund without the higher fees generally associated with actively managed mutual funds, often 3-4 times higher than a comparable index fund, is more more conducive to effective wealth management and preservation.

Wealth preservation “best practice”: Do not invest in “closet index” funds, funds with R-squared ratings of 90 or higher.

4. Cost inefficient actively managed mutual funds – One of my specialities is fiduciary law. One of the primary duties of a fiduciary is to manage any money entrusted to them in a prudent manner, always putting the best interests of the client first. One of the primary aspects of prudence is to avoid unnecessary fees and expenses.

There are two ways of evaluating the fees charged by actively managed mutual funds. The first involves calculating the effective cost of such fees based up on the actual active management component of a fund. The higher the R-squared rating of a fund, the lower the actual active management component of such fund.

Since closet index funds have a small active management component, their effective fees will be significantly higher than their stated annual fees. A study by Professor Ross Miller found that the effective cost of active management generally exceeded a fund’s stated annual expense, often by as much as 300-400 percent.

A second way of evaluating the fees of actively managed mutual funds is to use our proprietary metric, the Active Management Value Ratio 2.0™ (AMVR) to evaluate the cost efficiency of a mutual fund. The AMVR is a powerful, yet simple, cost/benefit analysis that requires nothing more than the ability to perform simple subtraction and division. And yet, the AMVR often indicates that actively managed mutual funds are cost inefficient, as the incremental, or extra, return provided by actively managed mutual funds, if any, is exceeded by the fund’s incremental , or extra, costs.

Wealth preservation “best practice”: Avoid “closet index” mutual funds and take the time to calculate the AMVR 2.0 rating for mutual funds currently owned and/or being considered as potential investments. 

5. Relative returns – aka the “we’re number 1” scam. Investment ads and advisers like to tout that their product has had the best performance compared to their competitors. This comparative, or “relative,” performance allows an investment company or financial adviser to make such a claim, even though the actual return was lackluster or even negative.

This is a common practice after a down year for the stock market, such as the bear markets of 2000-2002 and 2008, when many mutual funds suffered losses of 30 percent or more. The fact that one’s mutual fund suffered a 30 percent return while another fund suffered a 32 percent is hardly cause for celebration.

Investors need to focus on funds that have provided consistent absolute returns. Absolute returns are simply the actual returns that an investment has provided over time. An investment with a consistent history of positive absolute returns means that an investor has not benefited from the returns themselves, but also from the benefit from the compounding of such returns over time.

Wealth preservation “best practice”: Ignore mutual fund advertisements touting their relative returns and focus purely on a fund’s ability to provide consistent and positive annual absolute returns.