James W. Watkins, III, J.D., CFP Board Emeritus™, AWMA®
 
The other day I noticed yet another publication announcing their list of top investment advisors.  I always enjoy reviewing such lists, not so much for who is on the list, but rather for who is not on the list.  Amazingly, the names of respected investment advisors are often missing from such lists. 

Unfortunately, the public is not aware of such concerns or other alleged issues involved in compiling such lists.  In many cases, the primary criterion or, in some cases, the only criterion used in evaluating an investment advisor for inclusion on the list is the advisor’s alleged amount of assets under management (“AUM”). 

I have never understood the media’s preoccupation with AUM and the presumed correlation between AUM and an investment advisor’s asset management skills.  As a securities/ERISA attorney and former securities compliance director, I can assure investors that there is no proven correlation between an investment advisor’s claimed AUM and an investment advisor’s asset management skills. 

In analyzing AUM, certain questions need to be considered.  When AUM numbers increase, how much of the increase is due to the return on existing AUM and how much of the increase is simply due to the inflow of new money?  Growth in AUM from the inflow of new money might be an indicator of an investment advisor’s marketing skills, but not necessarily their asset management skills. 

Have the AUM numbers been independently verified?  There have been a number of regulatory enforcement actions for misrepresentations of AUM.  Who actually manages the AUM?  If actual management of an advisor’s AUM is turned over to a third party asset manager, who is protecting the clients’ interests and what impact do the extra fees have on investment returns?

“Assets under management” implies that investors receive comprehensive and continuous asset management.  Anyone providing such services is required to be personally registered as an investment advisor or to be affiliated with a registered investment advisory firm.  

Investment advisors are, by law, fiduciaries.  Fiduciaries are held to an extremely high standard of care in their dealings with clients.  A fiduciary’s duties include:

• A duty of loyalty, a duty to always put a client’s interests first
• A duty to disclose any actual or potential conflicts of interest
• A duty to control fees and other costs in managing a client’s account
• A duty to manage accounts prudently

The “Value Added” Equation
Management consultants often refer to the concept of distinguishing one’s business by providing “value added” services to clients.  In the context of asset management, a client should ask what the investment advisor does in managing the client’s assets that truly creates value for the client and distinguishes themselves from other investment advisors.

A popular Wall Street saying is that “a rising tide lifts all boats.”  Studies and experience have shown that, generally speaking, at least two-thirds of all stocks rise during a bull market.  Therefore, while mutual funds and investment advisors may tout their performance during a bull market, the truth is that it is difficult not to make money during a bull market.

Another issue with regard to the value added question is the amount of fees charged for such services. While many investment advisers charge a stated fee of 1 percent of assets under management, it can be argued that the effective fee is significantly higher. Some industry experts have suggested that fees should be evaluated in terms of the benefit received since the adviser has nothing to to do with the customer’s pre-existing assets.¹ By evaluating fees in terms of the benefit provided by an adviser, customers can get a more meaningful analysis of the value added proposition of their adviser.

Active Management/Passive Management Debate
So, experience and history establish that it is relatively easy to make money during a bull market.  Investment advisors may counter with the argument that the “value added” service that they provide is helping clients choose the “right” investments.  But do they?

Many investment advisors recommend that their clients purchase actively managed mutual funds that impose expensive loads and/or high annual fees, even though studies have consistently shown that most actively managed funds consistently underperform less expensive and passively managed index funds.  Furthermore, the value provided by actively managed funds is questionable, as a number of these funds have been shown to be “closet indexers,” funds whose performance can be largely explained by the performance of passive investment management rather than the contributions of active investment management. 

Investors can determine to what extent a mutual fund is a “closet indexer” by checking the fund’s R-squared rating.  R-squared is a statistical measure that reflects the percentage of a mutual fund’s performance that can be attributed to the movement of the relevant benchmark index rather than the contributions of active management.  R-squared scores range from zero to one.  The higher the R-squared rating is, the higher the fund’s “closet indexer” qualities.  An R-squared rating of 0.95 and above is generally considered to be indicative of “closet indexing,” although some consider an R-squared rating of 0.80 and above to be significant.

“Closet indexing” by actively managed mutual funds raises questions regarding the true costs incurred by investors in the fund and the reasonableness of such costs.  Since investors can easily purchase passively managed no-load index funds that assess low annual expenses, the relative cost of active management may be higher than the fund’s quoted annual expense ratio.

Professor Ross Miller of the State University of New York addresses this issue in his paper, “Measuring the True Cost of Active Management by Mutual Funds.”² Professor Miller has developed a formula, known as the “active expense ratio,” to determine the true cost of actively managed mutual funds.  By using a fund’s R-squared rating to represent the percentage of passive management in the fund, and then comparing the annual expense ratios of available index funds to the quoted annual expense ratio of the actively managed fund, Professor Miller calculates the true cost of the active management provided by the fund.

For example, consider an actively managed mutual fund that has an R-squared rating of 0.90 and a quoted annual expense ratio of 1 percent.  The high R-squared rating indicates that approximately 90% of the fund’s performance can be attributed to factors other than the fund manager’s active management skills. 

Assume that the actively managed fund has a five-year annualized risk adjusted return of 12 percent, while a comparable index fund has an five year annualized return of 11 percent and a stated expense ratio of 0.20 percent. Using the AER metric, the implicit expense ratio would be 4.50 percent, over 300 percent higher than the active fund’s stated expense ratio.

While Professor Miller’s process is much more complex than this simple example, his general findings are that the effective true cost of active management is often significantly higher than the actively managed fund’s quoted annual expense ratio.  Professor Miller provides numerous examples of actively managed funds whose effective true cost is 400-500 percent, in some cases even higher, than the fund’s quoted annual expense ratio, including some of the largest and most popular mutual funds 

Consequently, an investment advisor’s claim that the “value added” service they provide is assistance in choosing the “right” investments may not be accurate if they recommend actively managed mutual funds to their clients.  Recent revelations that some investment advisors may be recommending mutual funds to clients based upon the investment advisor’s revenue sharing arrangements with a mutual fund, rather than a client’s best interests, also cast doubt on the “value added” aspect of such recommendations.        

If an investment advisor is causing a client to incur unnecessary costs by recommending expensive, actively managed “closet index” mutual funds instead of less expensive index funds with a similar performance record, legal and ethical issues may arise regarding the investment advisor’s fiduciary duty to put a client’s interests first and to control and reduce investment costs.  Legal and ethical issues may also arise if an investment advisor is “double dipping,” charging a client both an asset management fee and receiving commissions for product sales and purchases involving the client’s asset management account. 

The True Value of an Investment Advisor
If it is hard not to make money in a bull market, and if inexpensive, passively managed index mutual funds generally outperform fee-laden actively managed mutual funds, what value, if any, does an investment advisor contribute to asset management?

Remember the Wall Street saying that “a rising tide lifts all boats?”  Warren Buffett goes one step further, adding that “a rising tide lifts all boats, and when the tide goes out, everyone finds out who has been swimming naked.”

In the context of asset management, “swimming naked” is equivalent to managing assets without having an effective risk management program in place.  Investors often get so caught up in returns that they fail to protect against downside risk.  Bull markets become bear markets and vice versa.  The bear market of 2000-2002 and 2008 taught many investors about the value of an effective risk management plan. 

Enter the investment advisor.  Forget the claimed amount of assets under “management,” the fancy titles, the company plaques and trophies, and the fancy marketing materials.  Look at your investment advisor’s performance record and determine how effective your investment advisor has been at avoiding significant losses in your investment portfolio.  What, if any, risk management strategies has your investment advisor discussed with you and actually implemented?  Are you possibly a victim of the Wall Street “the firm made money, the broker made money, two out of three ain’t bad” trap?

Money for Nothing?
Some investment advisors believe that the only risk management program needed is an occasional re-balancing of the investor’s portfolio to restore the original asset allocation percentages.  Investment advisors who advocate this type of static approach dismiss any sort of active asset re-allocation, either as to the type of asset classes used or to the allocation percentages, as “market timing.”  These investment advisors maintain that market timing does not work and that the cost of missing even a relatively few “best” days of the market can be significant.

This type of static asset allocation strategy raises several issues.  First, it presumes that the original asset allocation was appropriate.  The asset allocation software used by most investment advisors is based upon a process known as means-variance optimization (“MVO”).  Experience has shown that MVO-based software can be unstable, resulting in asset allocation recommendations that are counterproductive. 

The instability of MVO-based software is due to questions regarding the reliability of the input data used in the software program and the inherent bias in the calculation process used by such software.  This “black box” approach to asset allocation totally ignores (1) the dynamic nature of the stock market and the economy, and (2) the fact that the risk, return and correlation numbers typically used in asset allocation computer programs are not static, but are constantly changing. The cumulative effect of these shortcomings has led one noted critic of MVO-based asset allocation software to label such software as “error-maximization optimizers.”³ 

Most asset allocation/portfolio optimization software is based on the work of Dr. Harry M. Markowitz and/or Dr. William F. Sharpe, Nobel laureates for their work in the area of asset management.  Interestingly, neither Dr. Markowitz’s nor Dr. Sharpe’s work advocates a static approach to asset allocation.  In fact, Dr. Sharpe has criticized some of the current practices in asset allocation as “financial planning in fantasyland”⁴ and has emphasized the need for flexibility in asset management in order to respond effectively to changes in the stock market and/or the economy.⁵

Another issue regarding the quality of computerized asset allocation has to do with the fact that certain asset classes may not be available in the asset allocation software, including asset classes that historically have performed better when markets are in a downward trend.  In many cases, the asset classes in asset allocation software programs are primarily growth oriented, with few or no alternative asset classes available to use to hedge the investor’s portfolio against downside investment risk. 

In most cases, the absence of such alternative and hedge asset classes is blamed on the difficulty in determining the appropriate risk and return input data to use for such assets.  Whatever the reason, the absence of such alternative and hedge asset classes taints the computerized asset allocation recommendations, potentially leaving an investor exposed to unnecessary investment risk due to an over-concentration in growth oriented assets classes. 

The characterization of defensive risk management strategies as market timing is misleading.  The classical definition of market timing refers to the short-term movement of assets to being either 100% in the market or 100% out of the market, with no middle ground. 

However, an effective risk management program does not require such a radical “all or nothing” approach.  The goal of risk management is not to call the exact short-term turning points in the stock market in an attempt to maximize investment gains.  The odds of successfully using such an approach on a consistent basis, as well as the costs that would be involved, would be overwhelming. 

The goal of risk management should be to re-allocate assets defensively in the face of intermediate or long-term indications of deterioration within the stock market and/or the economy in order to preserve an investor’s investment capital.  In most cases, the defensive re-allocation would take place on a gradual basis based on developments in the stock market and/or the economy.  The value of such a risk management approach has been validated by a recent study that shows that avoiding significant losses in the stock market has a far greater impact on an investor’s long-term total returns than the impact of possibly missing a few of the stock market’s “best” days.

In “Black Swans, Market Timing and the Dow,” Professor Javier Estrada of the IESE Business School states that over the period 1900-2006, missing the best 10, 20 and 100 days on the Dow Jones Industrial Average Index (“DJIA”) would have reduced an investor’s terminal wealth by 65%, 83.2% and 99.7% respectively.⁶ Conversely, avoiding the 10, 20 and 100 worst days on the DJIA over the same time period would have increased an investor’s terminal wealth by 206%, 531.5% and 43,396.8% respectively. 

Professor Estrada also performed a similar best days/worst days analysis on the DJIA for the period 1990-2006, finding that missing the best 10, 20 and 100 days on the DJIA would have reduced an investor’s terminal wealth by 38%, 56.8% and 93.8% respectively.  Conversely, avoiding the worst 10, 20 and 100 days on the DJIA over the same period would have improved an investor’s terminal wealth by 70.1%, 140.6% and 1,619.1% respectively. 

The purpose of presenting these numbers is not an attempt to justify short-term market timing. In fact, Professor Estrada points to his study as evidence of the difficulty of successfully timing the market.  However, the numbers do support the potential advantages of implementing effective risk management programs to avoid significant market losses, especially when intermediate and/or long-term market and/or economic indicators indicate the possibility of a secular bear market. 

The wide disparity in the best day/worst day returns also emphasizes the fact that actual losses of capital are far more costly than reduced returns due to missed opportunities.  For example, an investor suffering a 30% loss would not only have to achieve a return of 42.8% in order to recover from the original loss, but would also suffer the opportunity cost incurred in having to use the 42.8% return to make up for such loss.

Critics of active asset re-allocation may point to possible taxes generated by such a risk management approach.  The potential tax impact of any proposed investment activity should always be considered.  However, since the active asset re-allocation activity contemplated herein involves intermediate or long-term holdings, most taxes would presumably be taxed at the favorable capital gains rate rather than the higher ordinary income rate, thus reducing the impact of such taxes. 

In hindsight, investors who lost forty percent or more of their investment portfolio during both the 2000-2002 and the 2008 bear markets would probably have preferred to pay fifteen percent in capital gains taxes in exchange for preserving twenty-five percent or more of their investment capital.  Defensive active asset re-allocations within tax-deferred accounts such as IRAs and 401k accounts raise no tax issues since such trades are not taxed at the time such changes are made.   

Investors and their investment advisors must avoid falling prey to letting the tax “tail” wag the investment “dog.”  Investors and their investment advisors must not forget why the investor invested in the first place – to make money to achieve their financial goals. 

The failure of an investment advisor to react to significant changes in the overall stock market and/or the economy in order to protect their clients’ interests is arguably a breach of the investment advisor’s fiduciary duty.  If the client’s portfolio includes investments that pay ongoing commissions to the investment advisor, such as 12b-1 fees, fiduciary questions regarding potential conflicts of interest and failure to control costs may also need to be addressed.

Wealth “Mismanagement” and Investment Performance Reporting
Investors inquiring about losses in their investment portfolios are often told that “it’s the market, everyone is losing money.”  Not only is the statement not true, it points out one of the main problems with the current approach to asset management – investment performance evaluation based upon relative returns rather than absolute returns.  

Again, investors should never forget why they chose to invest in the first place.  Investment ads and the media like to talk about how many times a mutual fund has beaten an index such as the S&P 500 Index.  If an investor suffers a 20% loss while the S&P 500 Index drops 21%, the investor has still suffered a significant loss.  Relative returns are irrelevant unless the investor’s reason for investing was just to beat market indices or other mutual funds.

Absolute returns focus on earning positive investment returns regardless of market conditions.  Absolute return investors adhere to Warren Buffett’s two rules of investing: “Rule Number One – Don’t lose money; Rule Number Two – Don’t Forget Rule Number One.” 

Effective risk management programs help absolute return investors avoid losing money at all or, at a minimum, to avoid significant losses.  Investment advisors can help investors by explaining and implementing risk management techniques such as dynamic asset allocation, tactical asset allocation, and hedging through the use of strategies involving exchange traded funds and options.

Risk management also requires an understanding of the misleading relative returns/absolute returns marketing games that mutual funds and money managers play.  During bull markets, investment ads tout actual return numbers.  During bear markets and other periods of poor performance, investment ads tout a mutual fund’s relative performance figures such as the number of Morningstar stars for their fund or their fund’s performance ranking within their asset category. 

Morningstar Mutual Fund’s materials are an excellent resource for mutual fund information.  However, even Morningstar has stressed that since their star system is based on past performance, the star system has no predictive power and should not be used for such purposes in selecting mutual fund investments.  Studies have also documented the danger in using Morningstar’s stars to evaluate funds given the lack of persistence of such ratings.⁷ 

As discussed earlier, relative performance numbers can be extremely misleading.  A mutual fund that suffers significant losses can still truthfully state that it outperformed an index or the majority of fund in its asset category as long as it lost less than the referenced index or funds. However, the investor still lost money and must deal with the actual loss as well as the opportunity costs involved in recovering from such losses. 

Asset “Mismanagement” and Separately Managed Accounts 
Investment advisors usually operate under one of two business models.  “Asset managers” actually manage their clients’ accounts, while “asset gatherers” focus more on the accumulation of assets, turning the actual management of the assets over to a separate third party asset manager program (“TAMP”).  If an investment advisor feels that they do not have the ability to personally manage clients’ assets, then the decision to turn the management function over to a TAMP may be appropriate, even though it may add additional costs for the clients.

Assuming that full disclosure of such delegation is made and the client agrees to the delegation, the investment advisor may be acting in the client’s best interests as long as the investment advisor continues to monitor the TAMP’s performance.  Too many investment advisors fail to realize that their fiduciary duties to their clients are personal in nature and cannot be delegated away so simply, especially when the investment advisor continues to charge or receive an ongoing asset management fee. 

Investment advisors who use a TAMP usually sign “master” agreements with the TAMP.  TAMPs often try to limit their liability exposure by stipulating in the master agreement that the investment advisor shall be responsible for determining both the initial and the ongoing suitability of the TAMP.  In some cases, the investment advisor fails to review the master agreement properly and is unaware of their ongoing suitability responsibilities.  In other cases, the investment advisor may be aware of their suitability responsibilities, but they are unable to evaluate the TAMP’s performance effectively because they do not know how to manage assets, the deficiency that led them to recommend the TAMP in the first place.

Another asset “mismanagement” issue with TAMPs has to do with the degree of personalized asset management that an investor actually receives.  Investment advisors often market TAMPs, and justify their additional costs, for the alleged customized portfolio management services that a TAMP can provide as compared to mutual funds. 

And yet, many TAMPs do nothing more than periodically provide several generic, “cookie cutter” asset allocation models to a client and then ask the client to choose one of the models.  Asset management through the use of impersonal, inflexible “cookie cutter” models, as well as the negative impact on returns due to the additional costs for such services, may create fiduciary concerns.

Asset “Mismanagement” and Variable Annuities  
Variable annuities are topic for financial industry regulators. Investment advisors, insurance companies and broker-dealers have been fined and disciplined for unsuitable sales and abusive marketing of variable annuities.  It is often said that variable annuities are sold, not bought, because few people would purchase a variable annuity if they actually understood the product.  Additional information on various issues with variable annuities can be found by reading the white paper, “Variable Annuities: Reading Between the Marketing Lines,” in our “Blog” section.

Investors who either own or are considering the purchase of a variable annuity should be aware of two key asset “mismanagement” issues with the product.  First, if an annuity owner annuitizes the annuity, there will be no management issues since the owner loses control of the money in the annuity and the balance in the annuity eventually goes to the insurance company that issued the annuity, not to the owner’s designated beneficiaries.  Second, the cumulative effect of various fees and the manner in which they are calculated makes it difficult, if not impossible, for an investor to ever break even on a variable annuity, especially when compared with a portfolio of no-load or low-load mutual funds.

One of the most onerous aspects of variable annuities is the fact that the fee for the guaranteed death benefit (“GDB”) is usually based on the accumulated value of the variable annuity.  The basic GDB, however, often only obligates the insurance company to pay the annuity owner’s designated beneficiaries no less than the amount of the owner’s actual capital contributions to the annuity.

Therefore, if the annuity grows in value, the insurance company can assess the annual fee for the GDB on the higher accumulated value, even though that value may have nothing to do with the amount of their legal liability, and the annuity owner generally receives no corresponding increase in coverage under the GDB.  Furthermore, if the accumulated value of the variable annuity is greater than the annuity owner’s capital contributions, the GDB provides no benefit at all. This “money for nothing” scenario harms the variable annuity owner by reducing returns while providing a windfall for the insurance company and, possibly, the investment advisor. 

Some annuities do offer an option for periodic adjustments in the GDB. However, variable annuity owners are usually required to pay yet another annual fee in order to receive this benefit.  Since one of a fiduciary’s duties is to control and reduce costs, both the cumulative effect of the various variable annuity fees and the GDB fee calculation issues raise genuine asset “mismanagement” and breach of fiduciary duty questions.

One recent development in the variable annuity industry has been the introduction of certain “living benefit” guarantees. These riders basically provide certain minimum return/withdrawal guarantees in exchange for an additional annual fee.  What many investors may not understand is that these “living benefits” usually do not become effective until a period of time has passed and the variable annuity owner has annuitized the annuity. 

I have seen too many variable annuity owners who claim that they never had any intention of annuitizing the annuity and that they told the variable annuity salesperson as much. However, they discovered that they had paid unnecessary “living benefit” fees for years simply because they never understood the concept or were misled.

Those who already own or are considering the purchase of a variable annuity should always carefully review the annuity and the accompanying prospectus to determine the terms of the annuity, especially with regard to what fees apply and how such fees will be calculated.  If an investor feels unsure about their ability to understand such documents, the investor should consult with a fee-only investment advisor or an attorney familiar with variable annuities.

Conclusion 
The term “assets under management” has become an important criterion for many investment advisors, both in terms of profitability and public recognition.  However, the value of the term for evaluative purposes and the true nature and value of such asset “management” services is open to debate.  Various studies and actual experience suggest that the true value of an investment advisor lies not in their ability to accumulate assets or their ability to generate returns in bull markets, but rather in their ability to manage investment risk and to preserve a client’s wealth during market downturns. 

As a fiduciary, an investment advisor’s risk management duties include not only using risk management strategies to protect against unnecessary risk exposure and significant portfolio losses, but also controlling and reducing various investment costs and fees that can reduce their clients’ investment returns. 

The impact of unnecessary fees on an investors has been documentd by both the General Accountability Office and the Department of Labor. Their studies concluded that each additional I percent in fees/costs reduce an investor’s end-return by approximately 17 percent over a twenty year period.⁸

By taking a proactive approach and addressing the “assets under management” issues presented herein either prior to choosing an investment advisor or during an evaluation of an existing investment advisor, an investor can hopefully avoid unnecessary losses due to assets under “mismanagement.”

This article is not designed or intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances.  If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.

Notes 
1. C. Ellis, “Investment Management Fees Are (Much) Higher Than You Think,” available online at http://blogs.cfainstitute.org/investor/2012/06/28/investment-management-fees-are-much-higher-than-you-think/; B. Malkiel, “You’re Paying Too Much for Investment Help,” available online at http://online.wsj.com/news/articles/  SB10001424127887323475304578502973521526236
2. R. Miller, “Measuring the True Cost of Active Management by Mutual Funds,” available online at papers.ssrn.com/sol3/papers.cfm?abstract_id=7469264
3. R. Michaud, Efficient Asset Management: A Practical Guide to Stock Portfolio Optimization and Asset Allocation (Boston, MA: Harvard Business School Press, 1998), 36
4. W. Sharpe, “Financial Planning in Fantasyland,” available online at www.stanford.edu/~wfsharpe/art/fantasy/fantasy.htm
5. W. Sharpe, Investors and Markets: Portfolio Choices, Asset Prices and Investment Advice (Princeton, NJ: Princeton University Press, 2006), 206-209.
6. J. Estrada, “Black Swans, Market Timing and the Dow,” available online at papers.ssrn.com/sol3/papers.cfm?abstract_id=1086300, 3-7.
7.  Pension and Welfare Benefits Administration, “Study of 401(k) Plan Fees and Expenses,” (DOL Study) http://www.DepartmentofLabor.gov/ebsa/pdf; “Private Pensions: Changes needed to Provide 401(k) Plan Participants and the Department of Labor Better Information on Fees,” (GAO Study).
8. M. Warshawsky, Mary DiCarlantonio, and Lisa Mullen, “The Persistence of Monringstar Ratings,” Journal of Financial Planning (September 2000), 110-128.

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This article is not designed or intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances.  If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.