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“Hidden” Assets – Potential Liability Implication of the LaRue Decision for Attorneys, Fiduciaries and Their Clients

Posted on November 26, 2013 by investsense

During a recent deposition of an executor, I asked the executor, a bank trust officer, whether the bank had evaluated the defined contribution plan in which the deceased had participated. The trust officer replied that the funds in deceased’s account had been distributed pursuant to the beneficiary form for the account. When I repeated my original request, the trust officer became upset and his attorney objected to my question, the old “ask and answered’ objection, saying the trust officer had answered my question.

I explained that my question had nothing to do with the distribution of the deceased’s pension account, but rather with whether the executor had evaluated the defined contribution plan in terms of compliance with ERISA’s requirements. The attorney quickly responded that the bank had no duty to perform such an evaluation.

But does an executor and other fiduciaries have such a duty? I would suggest that in certain circumstances the LaRue decision does create a duty upon certain attorneys and other fiduciaries to evaluate a pension plan’s compliance with ERISA. LaRue recognized the right of an individual participant in a plan to sue the plan for losses sustained in an account due to imprudent acts or other wrongdoing.

Legally, the right to sue constitutes a “chose in action, ” a property right and an asset of the individual involved. An executor has a legal duty to collect all of the deceased’s property/assets and properly distribute them in accordance with the law. Given the fact that various ERISA experts have opined that most 404(c) pension plans are not in compliance with the applicable ERISA requirements, the question of whether an executor or other fiduciaries have a duty to evaluate a pension plan with regard to LaRue rights is a legitimate question, not only in terms of losses suffered, but also in terms of possible breaches of the plan’s fiduciary duties due to non-compliance with ERISA, e.g, excessive fees, conflicts of interest.

In discussing this theory with other attorneys, some have claimed that exploring such an action would unnecessarily delay the administration of the estate. That simply is not true. An executor could quickly administer the estate’s assets on hand and simply leave the estate open pending the resolution of the potential LaRue claims. The executor or other fiduciary would simply need to conduct a cost-benefit analysis to evaluate the merits of pursuing a LaRue claim. Given the potential recovery in a LaRue claim it can be argued that the prudent course of action would be for the executor or other fiduciary, at a minimum, to conduct the cost-benefit analysis and meet with the heirs to discuss the situation.

This situation came up shortly after the LaRue decision was handed down. One of the services that I perform is a forensic prudence analysis of investment portfolios and pension plans. A fellow attorney, noting the wide-spread belief that most 404(c) pension plans are not compliant with ERISA, asked me to perform a forensic analysis of a plan for an estate for which he was serving as executor. As a result of my analysis, the attorney and the heirs decided to file a LaRue claim. The case survived a summary judgement, based largely on the “chose in action”/property right issues previously discussed, and is waiting to be tried or settled.

As a wealth preservation attorney, I focus on both proactive strategies to preserve and protect asset and reactive strategies to recover wealth loss due to improper activity, fraud and similar misconduct. Issues such as potential LaRue claims are what I refer to as “hidden” assets, assets that may only be recognized by thinking “outside the box.” They are valid assets which may not be recognized by attorneys and other fiduciaries due to a lack of understanding of or experience with a particular type of assets. LaRue is a perfect example of this, as many simply the decision as an ERISA decision without recognizing the “chose in action”/ property right issues created by the decision.

Forensic analysis of portfolios and/or pension plans can also be useful in connection with other types of litigation. While divorce cases are usually more time sensitive than probate cases, attorneys involved in cases involving high net worth clients may want to consider performing a forensic analysis to determine the potential recovery that may result from pursuing such an asset. Divorce attorneys that I have worked with have reported that a forensic analysis helped them negotiate a better settlement for their clients, both in terms of the potential asset and the leverage provided by the analysis with respect to a possible LaRue claim.

Many professionals that I have spoken with on this issue have stated that they do not know how to evaluate the value of a “chose in action.” My response is that the first issue should be to determine whether there are improprieties justifying liability to support the “chose in action.” If so, then the process of evaluating the potential value of the “chose in action” should be undertaken.

There are numerous factors which may come into play with regard to evaluating the value of a “chose in action.” While the process necessarily involves consideration of both objective and subjective analysis, the goal should always be to avoid “throwing good money after bad.” Each case necessarily depends on its individual set of facts.

The purpose of this post has been to alert attorneys and other fiduciaries, as well as their clients, of the potential “chose in action”/property right issues that LaRue has created and the need to consider same in order to properly gather and administer all of a deceased’s property in order to ensure that the estate is properly administered, that the heirs receive all of the assets due to them, and that professionals involved in administering the estate avoid unnecessary liability exposure.

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.

Posted in Asset Protection, ERISA, pension plans, Wealth Management, Wealth Preservation | Tagged asset protection, divorce, Fiduciary, financial interests, investment losses, investor protection, InvestSense, Pensions, retirement plan participants, retirement planning, wealth distribution, wealth management, wealth preservation, wealth recovery | Leave a comment

Pimento Cheese Sandwiches and Investor Protection

Posted on October 30, 2013 by investsense

Yesterday I was in North Georgia in connection with a possible case. I took the opportunity to have lunch with a high school classmate who now lives in the area. Both the company and the food were excellent, but both gone too soon. Then again, I’ve never met a pimento cheese sandwich I did not like.

I took the opportunity to take the long way back to Atlanta so that I could enjoy the fall foliage. Once I left the mountains and got back to the highway, my phone exploded with all kinds of bells and whistles. I pulled into a fast food restaurant and checked my phone. Twenty-seven voice mails! So much for what had been a good day.

As I checked the voice mails, they were all meant to alert me to the House of Representatives’ decision to vote on a bill to delay the proposed fiduciary standard for pension plan service providers. In effect, the pension plan service providers have led Congress to believe that the financial services industry cannot operate profitably unless the industry is allowed to continue to put their financial interests ahead of the public’s interests. And the House obviously bought it hook, line and sinker, voting to prevent adoption of a fiduciary standard that would protect the investing public by requiring that the financial services industry always put the public’s interests ahead of their own.

I have written several posts and articles about the Active Management Value Ratio™ (AMVR), a proprietary metric that uses simple subtraction and division to allow investors and fiduciaries to perform a cost-benefit analysis on actively managed mutual funds. In most cases, the AMVR shows that the incremental cost of actively managed mutual funds far exceeds the incremental benefit of such funds, often by at least 300-400 percent. The results of calculating a fund’s AMVR often indicates that the fund in question is not a prudent investment decision. And yet, most pension plans choose actively managed mutual funds as the primary, if not only, investment option for plan participants.

The current debate is largely over imposing a fiduciary standard on advice regarding IRA investments, specifically the recommendation to put one’s pension funds in a variable annuity within an IRA . In many cases one’s pension fund is one of the largest assets a person owns.

Variable annuities are one of the most oversold, most abused and least understood investment products sold to the public. The saying in the industry is that “variable annuities are sold, not bought.” I addressed the marketing tricks used to sell these products in a popular white paper, “Variable Annuities: Reading Between the Marketing Lines.” The paper has been used by the Financial Planning Coalition in connection with its lobbying activities before Congress in support of a universal fiduciary standard for the financial services industry. I highly recommend that anyone who owns a variable annuity or is considering purchasing a variable annuity read the article.

The financial service industry want to protect their right to abuse pension plan and IRA owners for one reason, greed. During my compliance days, I would estimate that 90 percent of my objections had to do with recommendations involving variable annuities. The sales assistants would dread bringing me the paperwork, as they knew I would probably reject the trade as presented with my signature mantra – “All God’s children do not need a variable annuity.”

Variable annuities usually pay commissions in the range of 7-8 percent, approximately twice the commissions of mutual funds. Various annuities typically use an equitable method of computing a variable annuities annual fees, producing a significant, albeit unmerited, windfall for the annuity issuer at the annuity owner’s expense.

The typical annual fee runs in the range of 2-2.5 percent a year. Given the fact that each additional 1 percent of fees reduces an investment owner’s end return by 17 percent over a twenty year period, many variable owners are losing a third or more of their returns to variable annuity fees alone. Throw in another 1 percent for an advisor’s fee and the annuity owner has thrown away over half of the investment’s return!

The proposed fiduciary standard generally discussed would not prevent financial services salesmen from selling reasonable investment products or from receiving reasonable commissions from the sale of such products. The only change would be that the sale of such products would have to always be in the customer’s best interests. The financial services industry knows that it is not, and cannot, meet that standard, as evidenced by their continuous objection to the adoption of the proposed fiduciary standard.

Check the voting records of your representative and your Senator. If they voted against providing you with the protections that a fiduciary standard would provide, if they basically told you that they care more about the financial services industry and their money than you and your financial security, I strongly suggest that you consider sending them a message the next time they are up for re-election, a message that you want them to serve and protect you rather than special interest groups.

My five-year-old “agent” just walked into my office. Someone stole her jacket so we are going to “de-stress” and buy her a replacement jacket. Then it’s to our favorite restaurant for pimento cheese sandwiches, Arnold Palmers and probably a sundae with tons of sprinkles. The fiduciary fight will have to wait until tomorrow. After all, there’s more than one way to skin a cat. To quote the unsinkable Molly Brown – “Nothin’ nor nobody wants me down likes I wants me up!”

Posted in Asset Protection, Investment Advice, Investment Advisors, Investment Fraud, Investment Portfolios, Investor Protection, IRA, Portfolio Construction, portfolio planning, Portfolio Planning, Retirement, Retirement Distribution Planning, Retirement Plan Participants, Retirement Planning, Variable Annuities, Variable Annuity Abuse, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged 401k Investing, abusive practices, investing, investment advice, investment advisors, investment portfolios, investment scams, investor protection, IRAs, Pensions, portfolio construction, retirement plan participants, retirement planning, variable annuities, variable annuity abuse, wealth management, wealth preservation | Leave a comment

Financial Planning vs. Financial Plans

Posted on October 9, 2013 by investsense

Many financial planners charge $5,000 or more to develop a retirement plan, or a five-year plan, for you and your family.

You will receive a nice, thick brochure with numbers in it.
Separate each page carefully.
You now have a high number of potential paper airplanes.

And unless you like expensive paper airplanes, you will be wasting your time and money trying to find value within your plan’s hallowed pages of statistics and graphs.(1)

Various financial planning firms offer financial planning/retirement planning/asset allocation plans (hereinafter “financial plan(s)”). The price typically ranges from a couple of hundred dollars to thousands of dollars. What the public is not told and does not realize is that such plans are virtually worthless. At best, such plans are a simple snapshot of an investor’s situation at that particular day. At worst, they are a sophisticated scam.

Technically speaking, the quality of such plans depends on the accuracy of the assumptions and other data entered into the software program used to produce a plan. Most of such programs are highly unstable, where slight errors can produce significant errors. As William Jahnke has stated, “the instability of the return-generating process rips the theoretical guts out of the practice of static asset allocation.”(2) Furthermore, many of these programs are based upon Microsoft Excel, which was never intended to handle the numerous interrelated calculations used by most financial planning software.

When I am asked to review a financial plan, the first thing I do is review the data and assumptions that were used in preparing the plan. The second thing I do is to reverse engineer the complete plan to see where errors were made in the calculations and/or advice provided by he plan. After twenty-five years of dealing with financial planning quality of advice issues, most errors that investors would miss are readily apparent and easy to discern to me.

Financial plans assume a constant rate of growth for investments. This simply does not portray reality. Historically, the stock market suffers one down year for every two positive years. Losses suffered during bear markets such as the 2000-2002 and 2008 definitely one’s financial situation.

Financial plans use either past performance or projected performance, or “guesstimates,” of investments to prepare the financial plan. The problem with past performance data is that, as the required disclosure for investments states, “past performance is no guarantee or future returns.” The problem with projected performance, or “guesstimates,” is that they are just that, guesstimates, which can be easily manipulated to convince investors to make decisions that benefit the party that prepared the financial plan.

An investor should always ask the planner who prepared the plan to provide the investor with all the data and assumptions that were used in preparing the plan. One common scenario we see is manipulation of the assumptions to ensure that certain investment purchases are made.

One common example of this involves small cap investments. Most people have portfolios that are heavily invested in large cap, blue chip stocks. One reason for this scenario is that blue chip stocks are often stocks that people are familiar with (e.g., AT&T, Coke, McDonald’s). Since most financial planning software favors investments with certain characteristics (e.g., high returns and low risk/standard deviation), a planner can ensure that the plan recommends such products by using assumptions meeting such criteria. So, if a planner wants to ensure that purchases of small cap products are recommended to produce commissions for the planner, they can manipulate the data to ensure such results without the investor suspecting anything.

Another common scenario I encounter is where the planner blindly relies purely on the financial planning software’s output and lacks the knowledge and or experience to identify software mistakes or poor advice. a situation commonly referred to as “black box” financial planning. As Harold Evensky, one of the nation’s most skilled and respected financial planners has opined,

One of the most frequent criticism of wealth manager optimization is the use of a complex computer program, frequently referred to as a black box. This pejorative description suggests that the wealth manager is implementing an asset allocation policy without understanding how the allocations were determined. The presumption is that the black box, not the wealth manager, is making the decision. Unfortunately, this is often a valid criticism.(3)

As usual, Mr. Evensky is right on point. Whenever I question planners about the quality of their plans and the advice provided, more often than not the first response is the “deer in the headlights” look, followed with an admission of simply following whatever the software produced and/or a meritless, legally insufficient explanation based on inaccurate interpretations of financial theories such as Modern Portfolio Theory. The quality of advice issues with regard to financial plans is so bad that Nobel laureate Dr. William F. Sharpe has deemed the situation to be “financial planning in fantasyland.”(4)

What investors need to understand is that proper financial planning involves more than a financial plan. Proper financial planning is a process, an ongoing process, not a product. CFP® professionals are taught a six-step process that includes

(1) determining your current financial situation
(2) developing financial goals
(3) identifying alternative courses of action
(4) evaluating alternatives
(5) creating and implementing a financial action plan, and
(6) reevaluating and revising the plan.

Given the limitations and issues inherent in prototypical financial plans, more and more true financial planners are forging the formalistic financial plan and focusing on an effective financial planning process, sans a written plan. Given the need to reevaluate and revise the plan as needed, this puts the focus on the client’s best interests and allows the planner and client to focus on building a meaningful and trusting relationship.

If you are an investor who has already had a financial plan prepared, I issue the same challenge to you that I make in my wealth preservation challenges. Review the various spreadsheets and check the accuracy of the calculations of the first ten rows on the spreadsheet. Unfortunately, the other forms of deception used in connection with financial plans are often subtle and difficult for the public to detect without the help of someone experienced in such matters.

For what it’s worth, whenever I point out the calculation errors in a financial plan, the planner and his company often respond by saying that they were simply calculating future value, so the last line of the spreadsheet only needs to be correct. When I ask if the customer, who paid for the plan, was informed that the planner knew that most of the numbers were wrong and were simply to fool the customer into thinking a lot of work went into the plan, I usually get more blank stares.

Likewise, when I ask whether the customer was informed of whether past performance or “guesstimates” were used in making the asset allocation recommendations, as well as the inherent issues with either approach, I often get more blank stares or a defense that the plan disclaimed liability for the contents of the plan. So the planner asked the customer to pay for the plan, then basically added a disclaimer to the effect that the planner and his company was not liable if the plan was worthless. So much for developing a relationship of trust. Your honor, the prosecution rests.

In conclusion, financial planning, when done properly, can be a valuable process to investors. So say yes to the process of financial planning. However, when it comes to financial plans, save yourself some money and just say “no.”

Notes

1. Gary Marks, “Rocking Wall Street: Four Powerful Strategies That Will Shake Up The Way You Invest, Build Your Wealth, and Give You Your Life Back,” John Wiley & Sons, Hoboken, NJ (2007): 159-160
2. William Jahke, “Getting a Grip,” Journal of Financial Planning, April 2002, 28-30.
3. Harold Evensky, Stephen M. Horan, and Thomas R. Robinson, “The New Wealth Management: The Financial Advisor’s Guide to Managing and Investing Client Assets,” John Wiley and Sons, Hoboken, NJ (2011): 187
4. William F. Sharpe, “Financial Planning in Fantasyland,” available online at http://www.stanford.edu/~wfsharpe/art/fantasy/fantasy.htm

Posted in Asset Protection, Investment Advice, Investment Advisors, Investment Fraud, Investment Portfolios, Investor Protection, Portfolio Construction, portfolio planning, Portfolio Planning, Retirement, Retirement Distribution Planning, Retirement Planning, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged 401k, 401k Investing, asset protection, black box investment fraud, financial interests, financial planning, investing, investment advice, investment losses, investment portfolios, investment scams, investor protection, InvestSense, portfolio construction, retirement planning, stockbrokers, wealth management, wealth preservation | Leave a comment

The Active Management Value Ratio 2.0 Worksheet

Posted on September 3, 2013 by investsense

I have had a lot of people ask me if could provide a simple worksheet that would allow them to quickly calculate the AMVR. Ask and ye shall receive. I have also provided an example of a completed worksheet. All you have to do is obtain the necessary data from an online source such as morningstar.com or yahoo.finance.com and you’re good to go.

The Active Management Value Ratio™ allows investors to evaluate an actively managed mutual funds in terms of its efficency, both in terms of cost and performance. WordPress will not let me insert a table, but the steps are simple:

(1) Obtain the current expense ratios and the turnover ratios for the actively managed fund in question and an appropriate benchmark, such as the Vanguard S&P 500 Index.
(2) Calculate each fund’s trading costs (See note below). Add each fund’s trading costs to its annual expense ratio to get the funds total expenses
(3) Subtract the index fund’s total expense ratio from the fund’s total expense ratio to obtain the actively managed fund’s incremental cost, the added cost of the actively managed fund.
(4) Obtain the 5-year annualized return for the actively managed fund in question and the benchmark used in Step 1.
(5) Subtract the index fund’s 5-year annualized return from the fund’s 5-year annualized return to obtain the actively managed fund’s incremental benefit, the added benefit, if any, provided by the actively managed fund. If the fund does not provide any incremental benefit, the fund should be excluded from consideration.
(6) Calculate the actively managed fund’s AMVR™ score by dividing the actively managed fund’s incremental costs by the actively managed fund’s incremental benefit.

Example:
Actively managed fund: Annual Expense Ratio – 1.00%, Annual Turnover Ratio 100%, and 5-Year Annualized Rtn – 20%

Benchmark Fund: Annual Expense Ratio – 0.17%; Annual Turnover Ratio 3%, and 5-Year Annualized Rtn – 18%

Incremental Cost = Active (1.00 + 1.20) – Passive (0.17 + .03)= 2.00
Incremental Return = 20.00 – 18.00 = 2.00

AMVR™ Score = 2.00/2.00 = 1.00

Therefore, an investor is effectively paying an expense ratio of 100% for the active management component of the actively managed fund.

Another way of looking at the analysis is by an analogy. Which is more prudent, paying $20 for an annual return of 18 percent, or paying $200 dollars for an annual return of 2 percent?

Yet another way to analyze the AMVR™ Score is to compare cost to relative contribution. In our example, 90 percent of the actively managed fund’s cost is only providing 10 percent of the fund’s return.

Bottom line, as to these two investments, it would be hard to justify an investment in the actively managed fund as a prudent investment in comparison to the passively managed fund.

Note: Mutual funds are not required to provide the actual trading costs of the fund. To calculate trading costs for the purposes of the AMVR™, we used a formula created by John Bogle. Bogle’s formula is (Turnover Ratio x 2) x 0.60. In our example, (100 x 2) x 0.60 gives us the 1.20 number. Another method of computing trading costs would be to simply take 1 percent of the stated turnover ratio. The calculation would simply involve multiplying the stated turnover ratio by .o1. In our example, 100 x 0.01 would result in a trading cost of 1.00 percent

	Annual Fees	Total Annual Fees	Annual Returns
Actively Managed Fund			20.00
Annual Expense Ratio	1.00
Annual Trading Expenses	1.20
Total Active Expenses		2.20
Passively Managed Fund			18.00
Annual Expense Ratio	0.17
Annual Trading Expenses	0.03
Total Passive Expenses		0.20
Incremental Costs/Expenses		2.00	2.00

This article is neither designed nor 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.

Posted in Asset Protection, Investment Advice, Portfolio Construction, portfolio planning, Retirement, Wealth Accumulation, Wealth Preservation | Tagged 401k, 401k Investing, Active Management Value Ratio, Advice, asset protection, financial planning, investing, investment advice, investment portfolios, investments, InvestSense, IRAs, Pension Planning, portfolio construction, retirement plan participants, retirement planning, wealth management, wealth preservation | Leave a comment

Why Wall Street and Insurance Industry Oppose a Fiduciary Standard

Posted on August 26, 2013 by investsense

Excellent article from Forbes and author John Wasik on the real reason that Wall Street and the insurance industry are fighting so hard to prevent the establish of a universal fiduciary standard. As usual, a battle of the best interests.

http://www.forbes.com/sites/johnwasik/2013/08/23/why-wall-street-insurers-dont-want-fiduciary-duty/

Posted in Investment Advice, Investment Advisors, Investment Portfolios, Investor Protection, Portfolio Construction, portfolio planning, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged 401k Investing, abusive practices, asset protection, investment advice, investment portfolios, investments, investor protection, portfolio construction, wealth management, wealth preservation | Leave a comment

CommonSense InvestSense: Accumulating and Preserving Wealth

Posted on August 21, 2013 by investsense

Facts do not cease to exist because they are ignored – Aldous Huxley

Your account is a brokerage account and not an advisory account. Our interests may not always be the same as yours. Please ask us questions to make sure you understand your rights and our obligations to you, including the extent of our obligations to disclose conflicts of interest and to act in your best interest. We are paid both by you and, sometimes, by people who compensate us based on what you buy. Therefore, our profits and our salespersons’ compensation may vary by product and over time.

This was a disclosure proposed by the Securities and Exchange Commission (SEC) a part of the so-called “Merrill Lynch Rule” that would have allowed brokerage firms to be exempt from registering under the Investment Advisers’ Act of 1940, and thus avoiding the fiduciary duty of always putting a customer’s interests first. Fortunately, the Financial Planning Association FPA sued the SEC to prevent the SEC from implementing the Rule and the U.S. District Court of Appeals for the District of Columbia overturned the rule in 2007, thereby requiring brokerages to register as investment advisers in connection with certain types of accounts.

Unfortunately, overturning the Rule also meant that stockbrokers are not required to provide customers with the referenced disclosure. Be honest, how many of you knew the information contained in the disclosure? How many of you believe that requiring such a disclosure would be helpful to investors?

In 2006, the SEC sponsored a study by the Rand Corporation to assess the public’s understanding of the investment industry. That study found that most investors mistakenly believed that stockbrokers, rather than investment advisers, had a fiduciary duty to always put their customers’ interests first.

The fact that there are two different standards for those providing investment advice to the public is currently being discussed in Congress. The issue is whether there should be a universal fiduciary standard requiring that anyone providing investment advice to the public should always be required to put the customer’s interest first.

Seems simple enough, yet the debate has become quite heated and, in some cases, dirty. Proponents of a universal fiduciary standard argue that it is only fair and is need to protect investors against some of the wrong-doings of Wall Street. Opponents of a universal standard argue that requiring them to always put the customer’s interests first will result in some people having access to investment advice and will result in higher compliance costs for brokerage firms, costs that they will have to pass on to customers.

Yes, you read that right. The investment industry is essentially arguing that if they have to put a customer’s interests first, ahead of their own financial interest, their business model cannot function properly. Let that admission sink in.

Each week I receive requests from individual investors, trusts, pensions plans and other groups asking me to do a forensic analysis of their investments. My metric, the Active Management Value Ratio (AMVR), allows anyone to evaluate the cost effectiveness of their investments. In performing a forensic analysis, I actually calculate four metrics, including the AMVR, to provide a thorough analysis.

Confucius once said that “life is really simple, but we insist on making it complicated.” I submit that the same holds true for investing. Famous investor George Soros has been quoted as saying that “good investing is boring.” Famous economist Paul Samuelson echoes that point, saying that “investing should be more like watching paint dry or watching grass grow.”

As a wealth preservation attorney, I stress to clients the three primary reasons for loss of wealth – bad investments and/or investment management, taxes, and events resulting in liability losses. In working with clients and speaking to groups, I like to review my short three-step investor protection program.

Step 1 – Ask your financial advisor whether they will be acting as a fiduciary in connection with your account. If they answer yes, ask them if they are will to put their representation in writing and have the document and approved by their broker-dealer’s compliance department. Seems like a lot of trouble? Trust me, it can save you a lot of time and trouble if the stockbroker fails to honor their representation. Getting compliance’s approval prevent s them from coming back and attempting to deny liability by claiming that the stockbroker did not have the authority to make such promises. Trust me, common tactic.

Step 2 – My experience has been that too many investors fail to perform a cost-benefit analysis on proposed investment and therefore fail to realize the true impact of an investment’s fees and other costs. Step 2 actually involves three separate screens.

First, check Morningstar or another online resource to determine if the mutual fund that you are considering has outperformed an appropriate benchmark such as an appropriate market index or market index fund. I recommend that investors compare three, five and ten-year returns to evaluate the consistency of a fund’s performance. Morningstar provides a simple-to-use format that easily allows such comparisons.

This screen will eliminate a lot of funds. Studies have consistently shown that the majority of actively managed mutual funds fail to outperform similarly based index mutual funds. Standard & Poors produces the SPIVA reports which compare the performance of actively managed mutual funds to the performance of index funds. These reports are free online.(1)

The 2012 year-end SPIVA report once again documented the under-performance of actively managed mutual funds. For calendar year 2012, 66.08 percent of all domestic equity funds underperformed their respective indices. More specifically, 63.25 percent of large-cap equity funds, 80.45 percent of mid-cap equity funds, and 66.50 percent of small-cap equity funds underperformed their respective indices.

The results were equally disappointing when reviewing three and five-year periods. For the three-year period 2010-2012, 74.35 percent of all domestic equity funds underperformed their respective indices. More specifically, 86.49 percent of large-cap equity funds, 90.22 percent of mid-cap equity funds, and 83.05 percent of small-cap equity funds underperformed their respective indices.

For the five-year period 2008-2012, 75.37 percent of all domestic equity funds underperformed their respective indices. More specifically, 90.03 percent of large-cap equity funds, 82.76 percent of mid-cap equity funds, and 79.16 percent of small-cap equity funds underperformed their respective indices.

Even when actively managed mutual funds do manage to outperform their relative benchmark, the risk-reward benefit is disappointing. A famous study analyzing the performance of actively managed mutual fund over two decades, ending on December 31, 1998. (2) The study concluded that actively managed mutual fund investors faced poor odds of winning the investment battle.

Over a ten-year period, the study concluded that the odds of outperforming a similar index fund was only 14 percent, with the average margin of victory approximately 1.9 percent and the average margin of defeat 3.9 percent. Over a fifteen year period, the study concluded that the odds of outperforming a similar index fund was only 5 percent, with the average margin of victory approximately 1.1 percent and the average margin of defeat 3.8. Over a twenty year period, the study concluded that the odds of outperforming a similar index fund was only 22 percent, with the average margin of victory approximately 1.4 percent and the average margin of defeat 2.6 percent percent

And yet, despite such information, the 2013 Investment Company Institute Factbook reports that 82.6 percent of all amounts invested in equity-based mutual funds is invested in actively managed mutual funds instead of less expensive, better performing equity-based index funds. Common sense tells you that those those numbers should be reversed. Further evidence of the need for improved education and information for investors, trusts and pension plan participants.

Second, check the R-squared ratings for the funds you are considering. Many actively managed mutual funds have high R-squared ratings, suggesting that their performance is more the result of the performance of an underlying market index rather than the skills of the fund’s management team. Funds with high R-squared ratings are referred to as “close index” funds due to the extent that their performance tracks the performance of less expensive index mutual funds. There is no “official” R-squared rating number that designates a “closet index” fund. For my purposes, I use a rating of 90, although others use even lower numbers. Why pay a fee 4-5 times for basically the same results?

Which brings us to the AMVR. The AMVR basically allows individual investors and investment fiduciaries to perform a simple cost-benefit analysis on actively managed mutual funds. The AMVR only requires the ability to perform simple subtraction and division using data easily obtainable online from Morningstar, Lipper, Yahoo!Finance or similar source. Rather than go through the calculation process again, I will refer you to the post that details the calculation process. (https://investsense.com/the-active-management-value-ratio/) With a little practice, the entire calculation process for a fund should take only 1-2 minutes.

Based upon my experience, the AMVR often indicates that the incremental cost of an actively managed mutual fund far exceed the incremental benefit, if any, derived from such fund. In fact, it is not unusual to the incremental costs of such funds exceed the incremental benefit by 300-400 percent, or more. Hardly in an investor’s best interests and the reasons you do not see stockbroker’s or other “financial advisors” offering to calculate the AMVR on the actively managed mutual funds they recommend.

Step 3 – Just say “no” to variable annuities! I provide an in-depth analysis of variable annuities in my variable annuities white paper at my blog, investsense.com.(3) In short, the pricing system used by most variable annuity companies produces an unmerited windfall for the variable annuity company at the variable annuity owner’s expense. Studies have shown that it may take as long as thirty years or more, perhaps never, for a variable annuity to break even on their investment. Furthermore, in order to receive the unlimited lifetime income payments spiel used to market variable annuities, the variable annuity owner has to give up ownership and control of the variable annuity, resulting in the annuity company, not the variable annuity’s heirs, receiving any balance in the annuity upon the owner’s death.

Conclusion

I go back to the quote from Confucius – “life is really simple, but we insist on making it complicated” – and my assertion that the same can, and should apply to investing. In my opinion, the problem lies with an inherent battle of the best interests, with stockbrokers and other financial advisors not wanting investors to have the benefit of certain useful and important information that would expose the trust about some of their practices, and investors needing such information to make informed and appropriate investment decisions.

As the fiduciary debate continues in Washington and special interests push their anti-consumer agenda, investors should consider contacting their U.S. senators and representatives to let them know that they want to be treated fairly, that they want anyone providing investment advice to the public to be required to always put the customer’s financial interests first, ahead of those of the financial advisor. Enough is enough.

Notes

1. http://www.spindices.com/documents/spiva/spiva-us-year-end-2012.pdf
2. Robert Arnott, Andrew Berkin and Jia Ye, “How Well Have Taxable Investors Been Served in the 1980s and 1990s?” Journal of Portfolio Management, Summer 2000, Vol 26, No.4.
3. https://investsense.com/variable-annuities/

Posted in Asset Protection, Investment Advice, Investment Advisors, Investment Portfolios, Investor Protection, Portfolio Construction, Portfolio Planning, Retirement, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged 401k, 401k Investing, abusive practices, Active Management Value Ratio, asset protection, financial planning, investing, investment advice, investment advisors, investment losses, investment portfolios, investment scams, investments, investor protection, InvestSense, portfolio construction, retirement planning, stockbrokers, wealth management, wealth preservation | Leave a comment

A Matter of Trust and Wealth Preservation

Posted on August 5, 2013 by investsense

As many people know, I have been a very outspoken advocate for a universal fiduciary standard for the financial services industry. As a securities/wealth preservation attorney and a former compliance director, I am well aware of the questionable practices that some in the financial industry employ. Just this weekend another story has come out about improper conduct on Wall Street which hurt investors, especially pension plans.

One of my fellow deacons died recently. His wife, Mrs. A, has always been a faithful volunteer to help with our weekend sports programs, serving as a co-manager of our concession stand. I had told her to take a week off and relax. She insisted on coming, saying it would help her.

A couple of us had gone to get more soft drinks from the supply room. As we returned, I saw Mrs. A point to me and tell a gentleman at the stand, “that’s Jim Watkins and he handles all my affairs. I only trust him.” I pulled the gentleman aside, confirmed that he was a broker, and informed him that if he attempted to solicit Mrs. A or anyone else on church grounds, I would file a complaint against with FINRA, the securities industry’s regulatory body, and obtain a restraining order if necessary. Being the sports commissioner can be fun.

I may be in the minority, but I believe that there is no greater compliment than to hear someone tell you that they trust you. Unfortunately, we all know that are numerous cases where advisers, even those required by law to always act in the best interests of a client, have taken advantage of a client’s trust. Matthew Hutcheson, a well-known advocate of the fiduciary standard, was recently sentenced to prison for defrauding his clients.

From a client’s perspective, it is hard to decide who to trust and whether an adviser is truly acting in their best interests. A study commissioned by the SEC and conducted by the Rand Corporation found that most investors polled mistakenly believed that stockbrokers were required to always put a client’s interest first, but registered investment advisers were not required to do so. In truth, it is just the opposite. However, this misunderstanding may have allowed many investors to suffer unnecessary investment losses due to misplaced trust.

Congress, the SEC, and the financial services industry have yet to answer my long-standing question – “What is so unfair or onerous about requiring that anyone who provides investment advice to the public must always put the public’s interest first?” I am still waiting for an honest answer.

Unfortunately, the current situation requires that investors take a more proactive stance in managing their financial affairs. I have provided several article on this blog to help investors toward that goal. My article on variable annuities, “Variable Annuities: Reading Between the Marketing Lines ,” has been read by thousand of visitors to this blog and was cited by the Financial Planning Coalition in hearings before Congress in connection with the need for a fiduciary standard.

When I speak at conference or talk to the public, I stress the need to become more proactive in managing one’s investment affairs. Sadly, the elderly are often targets for unethical financial salesmen. Financial fraud is the leading crime against those age sixty-five and older. This is an area of the law that has been under-served by elder lawyers.

Financial fraud and abuse come in various forms. However, based on my experience, there are three scenarios that appear frequently and cost investors dearly – unnecessary fees and expenses, pseudo-diversification, and the myth of buy-and-hold portfolio management. A simple understanding of these three issues can help avoid becoming a victim of investment fraud.

Fees and Expenses

We all know that management fees are high. Poor performance does not come cheap. You have to pay dearly for it. – Rex Sinquefield

Fees and expensesobviously reduce one’s investment returns. Each 1 percent of fees and expenses reduces an investor’s end wealth by approximately 17 percent over a period of twenty years. Investment advisors often charge 1 percent annually for their services. If the advisor is recommending mutual funds that also charge an annual fee of 1 percent, the investor is losing over a third of his end return. If the advisor recommends the purchase of a variable annuity, with a typical 2-3 percent annual fee and a typical 1 percent annual fee for the annuity’s subaccounts, you can find situations where an investor will lose almost 70 percent of their end wealth to fees alone.

Investment advisors and other financial fiduciaries are required to only recommend investments that are prudent and in an investor’s best interests. As mentioned earlier, stockbrokers are not necessarily held to this same standard.

While there may be various factors in assessing the prudence of an investment. I developed a metric, the Active Management Value Ratio™ (AMVR), that allows both investors and financial fiduciaries to perform a cost-benefit analysis and quantify prudence through a calculation that only requires simple subtraction and divisions. An explanation of the AMVR with examples can be found in various posts and white papers on this blog.

My experience with the AMVR has shown that very few actively managed mutual funds are cost efficient and would be not be considered prudent investments for most investors. And yet, most stockbrokers only recommend expensive actively managed mutual funds for their clients. According to the Investment Company Institute, based on 2012 data, approximately 90 percent of the money invested in equity based mutual funds is held by actively managed mutual funds, with only 10 percent in less costly, but equally or more effective, index funds. To quote Voltaire , “common sense is not so common.”

Even more disturbing is that many actively managed funds have high R-squared ratings, indicating that the majority of their performance can be attributed to the performance of their underlying benchmark rather than the skills of the fund’s manager. Funds showing a high R-squared rating are called “closet index” funds since their performance can be attributed to an appropriate stock market index. This is yet another argument for investing in inexpensive, yet effective, index funds.

CommonSense InvestSense: Calculate an actively managed mutual fund’s AMVR rating and compare to an index mutual fund with a similar objective before investing. The ask you financial advisor to calculate the AMVR ratings for you. If they will not do so, take that as a red flag.

Pseudo-Diversification

To reduce risk it is necessary to avoid a portfolio whose securities are all highly correlated with each other. – Harry Markowitz

Harry Markowitz introduced the concept of Modern Portfolio Theory (MPT) in 1952. Prior to MPT, portfolios were generally constructed based on an investment’s returns and standard deviation. With MPT, Markowitz suggested that an investment’s correlation of returns with other investments should be a factor in constructing an investment portfolio. While legitimate questions have arisen regarding some of the assumptions behind MPT and MPT’s calculation process, the value of factoring in correlations of returns between investments is indisputable.

By effectively diversifying one’s investments among investment with various levels of correlations of returns, an investor can provide their investment portfolio with both upside profit potential and downside protection against substantial loss. Unfortunately, many investors are led to believe that they can effectively diversify their portfolios by just combining various types or categories of investments (e.g., large cap growth, small cap value, international funds).

Assume that an investment portfolio is equally divided among a large cap investment (the Standard & Poor’s 500 Index), a small cap investment (the Russell 2000 Index), an international investment (the MSCI EAFE Index), and a fixed income investment (the Barclays U.S. Aggregate Bond Index). The portfolio is obviously allocated among four different asset categories. However, the portfolio is not effectively diversified in terms of risk management due to the high correlation of returns between the three equity based investments. For the five-years period between 2007-2011, the assets showed the following correlation of returns:

S&P 500 and Russell 2000 – 95 percent
S&P 500 and MSCI EAFE – 92 percent
Russell 2000 and MSCI EAFE – 84 percent
EAFE and Barclays Bond – 20 percent
S&P 500 and Barclays Bond – 10 percent
Russell 2000 and Barclays Bond – 2 percent

Therefore, the portfolio would show a 75 percent allocation to highly correlated equity based investments and 25 percent to fixed income investments, an allocation that may not be suitable for many investors given high degree of potential risk. A review of other five-year period of returns shows similar results.

CommonSense InvestSense: Before deciding on an investment portfolio, have your financial advisor prepare a correlation of returns matrix for all investments being considered. If you already have an investment portfolio, have your financial advisor or another qualified investment professional prepare a matrix for you. If the matrices differ or the advisor refuses to prepare a matrix, take that as a red flag.

The Buy-and Hold Myth

One of my favorite references to a buy-and-hold approach to investing was to re-name it as the buy-forget-and-regret approach to investing. The most common form of buy-and- hold investing calls for allocations to be made to various investments and to strictly adhere to such allocations, save for an occasional re-balancing to restore the original allocation percentages.

The primary problem with a buy-and-hold approach to investing is that it ignores the fact that history shows that the market is cyclical, alternating between up and down periods in the market. Just before the bear market of 2008, the price/equity (P/E) ratio on the S&P 500 stood at 42, well beyond historical norms and clearly unsustainable. Nevertheless, many investors did nothing in terms of wealth preservation and suffered devastating losses.

Proponents of buy-and-hold investing point to a historic study, the BHB study, that stated that approximately 93.6 percent of the variability in a portfolio’s investment returns is due to asset allocation. In many cases the financial services industry has deliberately misrepresented the study’s findings by stating that the study shows that allocation decisions account for 93.6 percent of a portfolio’s returns. The BHB study never made such a representation, as the study looked at variability of returns, which is significantly different from the returns themselves.

Unethical financial advisors point to BHB in support of not making changes to one’s portfolio. Such advisors dismiss the thought of making changes in one’s portfolio as market timing, which is difficult to execute successfully. However, truth be told, one could argue that the rebalancing advocated by the buy-and-hold approach is market timing.

The truth is that classic market timing is defined as moving one’s investments so as to be 100 percent in a particular investment based upon one’s perception of market conditions. The 100 percent is dangerous, both in terms of returns and costs. Taking a proactive approach to investing and making adjustments in one’s portfolio when market and/or economic conditions merit such strategies is simply good sense.

A dynamic approach to portfolio management is in accord with strategies suggested by investment legends. Benjamin Graham, suggested an allocation of 50 percent stocks and 50 percent bonds, with an allowance for sliding between 25 percent minimum and 75 percent maximum, depending on the market and economic conditions. Nobel laureate Dr. William F. Sharpe has recently proposed the use of adaptive asset allocation policies, with adjustments in asset allocation to reflect as changes in total market values.

Advocates of the buy-and-hold approach to investing point out that making changes in a portfolio may result in a taxable event. This is true, although there should be no tax consequences in making changes within a tax-deferred account.

Even if changes did result in a taxable event, the potential benefits in making such changes should be considered. Professor Javier Estrada of the IESE Business School studied the impact of missing the best and the worst days on the Dow Jones Industrial Average (DJIA) for the period 1990-2006. The study found that missing the best 10, 20 and 100 days on the DJIA would have reduced an investor’s terminal wealth by 38 percent, 56.8 percent and 93.8 percent, 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 percent, 140.6 percent, and 1,619.1 percent, respectively.

To ignore the cyclical nature of the markets is foolish. As the Chinese philosopher Lao Tzu once said, “the easiest way to control something is to take advantage of its natural tendencies.” Or. as Will Rogers once said, “even if you’re on the right track, you’ll get run over if you just sit there.”

CommonSense InvestSense: Construct an effectively diversified investment portfolio, then monitor changes in the markets and the economy and act proactively to preserve wealth by reallocating your resources properly when market and/or economic conditions indicate such a move is prudent.

Conclusion

Thomas Jefferson once wrote, “knowledge is power, knowledge is protection, knowledge is happiness.” As the byline on our blog states, the proactive investor has the power to protect his/her financial security. By taking the time to learn the strategies discussed herein, an investor can better protect themselves and avoid unnecessary financial loss due to unethical individuals and practices.

This article is for informational purposes only, and 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.

Posted in Asset Protection, Investment Advice, Investment Advisors, Investment Fraud, Investment Portfolios, Investor Protection, Portfolio Construction, portfolio planning, Portfolio Planning, Retirement Planning, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged abusive practices, Active Management Value Ratio, asset protection, financial planning, investing, investment advice, investment advisors, investment losses, investment portfolios, investments, investor protection, portfolio construction, retirement planning, stockbrokers, wealth management, wealth preservation | Leave a comment

“CommonSense InvestSense™”…Account Management

Posted on June 6, 2013 by investsense

“Don’t gamble. Take all your savings and buy some good stock and
hold it ’til it goes up then sell it. If it don’t go up, don’t buy it.
Will Rogers

If only it were that easy. While no one can guarantee how an investment will perform, there are certain precautions an investor should take to protect their financial security.

1. Always keep copies of all forms and documents that are filled out and/or signed. Documents have been known to disappear or change when questions come up.

2. Never sign blank documents, leaving it to someone else to fill the document in.

3. Never give anyone discretionary control over investment accounts. Abuse of discretion is one of the leading complaints regarding stockbrokers and investment advisors. The potential risks simply outweigh any alleged benefit. If an investor is asked to sign a trading authorization so that a brokerage firm can accept orders from the investor’s broker or advisor, the investor should write “NO DISCRETION” on the form to avoid any confusion as to the power being authorized.

4. Read all account statements and correspondence received from a brokerage firm, a broker or an advisor. If wrongdoing is going on in an account and is reflected in the account statements or correspondence, failure to promptly notify the brokerage firm and to object to such questionable activity may prevent an investor from recovering any losses resulting from such activity.

5. Ask questions. Ask the financial adviser whether they will be serving in a fiduciary capacity in advising you or managing your portfolio. If they indicate that they will be acting in a fiduciary capacity, ask them if they are willing to put that in writing and sign the document.

Ask why certain investments are being recommended. Ask whether a purchase of a recommended investment product would result in a commission for the broker or the advisor making the recommendation and, if so, what the amount of the commission would be. Ask whether the recommended investment product is a proprietary product of the company that the broker or the advisor is affiliated with and, if so, ask whether the broker or the advisor can recommend similar non-proprietary products.

Ask whether the recommended product has ongoing fees and, if so, how much those fees are. Even if an investor is turning the management of their investment account over to a money manager, the investor should continually ask questions in order to protect against losses due to “black box” asset allocation.

6. Consider all aspects of an investment. Some investors only look at the historical or projected return of an investment before making an investment decision. Investors should always consider factors such as the risk/volatility of an investment, the fees associated with an investment, and the tax aspects of an investment. This is particularly true when considering the purchase of an annuity. (See “Common Sense InvestSense…Variable Annuities”) Calculate the Active Management Value Ratio on all investment recommendations before you actually invest in order to ensure that your investments are cost efficient.

7. Avoid “closet index” funds. Closet index funds are actively managed mutual funds that closely track the performance of their underlying market index, thus their designation as “index huggers.” The problem with closet index funds is that you basically get the same return as with a typical index fund, but at a much higher cost, often 300-400 percent higher than the index fund’s annual fee. Since each additional 1 percent in fee and other costs reduce an investor’s end return by approximately 17 percent over a twenty year period, closet index funds are an imprudent investment choice.

7. Be alert to brokers and advisors possibly “working their book.” When business is slow, brokers and advisors may be advised to “work their book.” This may explain unexpected phone calls suggesting that an investor review their investment portfolio and reallocate their assets, switch mutual funds to buy funds from a different fund family, or perform an annuity exchange.

It is illegal for a broker or an investment advisor to make investment recommendations for the purpose of generating commissions. Certain practices should raise red flags for investors. Recommendations that an investor sell funds of one mutual fund company and buy the same or similar type funds of another mutual fund company should be questioned. Recommendations that an investor sell funds of one mutual fund company and buy different types of funds from another mutual fund company should be questioned if the original mutual fund company offers the same or similar type funds as those being recommended, as most mutual fund companies allow an investor to make internal fund exchanges without incurring new commissions.

Recommendations that an investor exchange one annuity for another annuity should always be questioned since the exchange will result in new commissions for the broker or the advisor. Recommending that an annuity owner exchange annuities is especially suspicious when the current annuity is still subject to surrender charges, as the client would lose money as a result of having to pay surrender charges for the exchange. An investor who becomes aware of such practices should promptly notify the appropriate regulatory organizations.

8. Use breakpoints, when possible, to reduce the commissions on mutual fund purchases. Most mutual fund companies offer investors a discount on front-end sales charges once an investor has invested a certain amount of money in their mutual funds. Most mutual funds begin to offer such discounts once an investor has invested a cumulative total of $50,000 in their funds, with additional discounts for certain levels of additional investments. Recommendations spreading investments among a multitude of asset classes may be cause for questioning, especially when large amounts of money are being invested and/or the recommended amounts are just below breakpoint levels.

9. Choose appropriate classes of mutual fund shares to reduce expenses. In most cases, A shares and B shares are the only type of mutual fund shares most investors should consider. Many investors immediately lean toward B shares since they do not require the investor to pay front-end sales charges, or commissions. B shares, however, may not be the best choice for the long-term investor due to the higher annual fees associated with B shares.

Generally speaking, A shares are often a better deal for a long term investor due to the fact that annual fees for A shares are typically less than the annual fees charged by B shares. If an investor has a large amount of money to invest, A shares often offer breakpoints to reduce any applicable sales charges. Breakpoints are not generally offered on B shares. B shares are often a better deal for short term investors, since B shares do not impose a front-end sales charge.

While B shares generally carry higher annual fees and often impose deferred sales charges if an investor redeems the shares within a specified period of time, the holding period during which deferred sales charge are applicable is usually relatively short. The investor’s ability to redeem B shares without penalty within a short period of time also allows the investor to minimize the effect of the higher annual fees of the B shares. Some mutual fund companies offer to convert B shares into A shares after a certain period of time has elapsed. Each investor must evaluate their own situation to determine the choice that is best for them.

Investors with managed accounts should always check to see whether their advisor is using A shares or B shares in the management of their account. In most cases, it is generally agreed that advisors should only use A shares in managed accounts due to the lower annual fees charged by A shares and the fact that most mutual funds offer to waive sales charges for A shares held in managed accounts. Another factor favoring the choice of A shares over B shares in managed accounts is the deferred sales charges on B shares. Since managed accounts often involve frequent reallocations of the account’s assets, holding B shares in a managed account may ensure that the value of the investor’s account is reduced by the payment of deferred sales charges.

If your financial adviser recommends C shares, walk away, as your financial adviser is putting their financial self-interests ahead of your best interests. C shares are essentially the same mutual fund as A and B shares. The difference is that C shares typically charge investors an annual 12b-1 fee of 1 percent or more.

12b-1 fees are charges that funds typically charge for a financial advisors ongoing serving of an account and for the fund’s marketing services. As a former compliance director, I can personally state that C shares are nothing more than an attempt by unethical financial advisors by avoid registration as an investment adviser and the strict fiduciary standard impose on investment advisers, namely to always put an investor’s best interests ahead of the financial advisor’s financial interests. Evidence of that is the fact that the 1 percent 12b-1 fee charged by funds is the standard fee charged by investment advisory firms.

10. Don’t be lulled into a false sense of security by an advisor’s credentials or designations. The number of letters after an advisor’s name does not ensure the skill or the integrity of the advisor. The most widely respected and recognized designation in the financial planning industry is the CFP® designation conferred by the CFP Board of Standards. The CFP® designation signifies that an individual has a certain level of experience in financial planning, has completed an extensive examination, and has complied with continuing education requirements.

Always ask for both Parts I and II, and all schedules, especially Schedule F, of an investment advisor’s Form ADV. Take the time to read the material to find out about the planner’s background and qualifications. Although registered investment advisors are allowed to use a disclosure brochure instead of their Form ADV, insist on the investment advisor’s Form ADV. Most disclosure brochures are nothing more than glorified marketing brochures, while the Form ADV contains the information the investment advisor filed with regulatory officials. Also check the planner’s records at FINRA’s web site (www.finra.org).

11. Get more than one opinion. Medical patients are often advised to get a second opinion on major medical decisions. Decisions affecting one’s financial security are equally important. Unsuitable investment advice can drastically affect one’s life. Unfortunately, some people holding themselves out as financial planners and investment advisors may be more interested in selling insurance and investment products than in the quality of the financial advice they are providing.

12. Avoid the variable annuity trap. Without question, variable annuities are one of the most over-hyped, most oversold, and least understood investment products. FINRA and the SEC are investigating various complaints regarding the sale of these investment products and have already imposed sanctions in some cases. The high fees and expenses associated with variable annuities, along with their lack of liquidity and their negative tax aspects, make them an unwise investment choice for most investors. Annuities can also have devastating effect on an investor’s estate plan, resulting in most of the investor’s money going to the company issuing the annuity rather than the investor’s heirs and loved ones.

13. Don’t buy life insurance for investment purposes. A popular mantra among insurance agents is that variable life insurance is the “swiss army knife of financial planning.” Anyone who hears such advice should look for another financial adviser. If an investor needs life insurance, then they should buy life insurance that guarantees the amount of protection they need, which is the intended purpose of insurance.

Life insurance is neither intended for or appropriate for investment purposes. The high fees and expenses associated with insurance are totally inconsistent with one of the basic tenets of investing, namely to minimize loss of principal so as to maximize the amount of money working for the investor. While it is illegal for an insurance agent to misrepresent the nature of an insurance product, recent cases involving the alleged misrepresentation of life insurance as retirement/ investment programs demonstrate the need for investors to get advice from more than one investment advisor to better protect their interests.

Posted in Asset Protection, Investment Advice, Investment Advisors, Investment Portfolios, Investor Protection, Portfolio Construction, Retirement, Retirement Planning, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged 401k Investing, abusive practices, Active Management Value Ratio, asset protection, black box investment fraud, Closet Index Funds, financial planning, investing, investment advice, investment advisors, investment losses, investment portfolios, investment scams, investments, investor protection, InvestSense, portfolio construction, retirement planning, wealth distribution, wealth management, wealth preservation | Leave a comment

Special Investor Alert-Questions About New “Barron’s Advisors”

Posted on May 29, 2013 by investsense

In February, 2012 I wrote a post regarding the value of Barron’s “Top 1000 Advisers List,” citing the questionable criteria used and lack of transparency on the calculation process used in preparing the list. Barron’s has just published a new list of designated “Barron’s Advisors.”

In the preface to the list, Barron’s states that the publication ranks financial advisors “with the goal of shining a spotlight on the best people in the business.” The preface goes on to claim that the advisors ranked by their publication represents the top 1 percent of their profession.

As a securities attorney, an RIA consultant and a former RIA compliance director, I always view such “best” lists with skepticism. The people on Barron’s new list may be the best financial advisors in the country. However, the criteria that Barron’s claims is not client-centric and therefore is highly questionable in evaluating the skills or performance of the advisors on the list.

Barron’s justifies its list “based on hard numbers: an advisor’s assets under management and annual revenue generated, as well as the length of time in the business, client retention, and philanthropic work. None of these criteria translate into truly reliable indicators of a financial advisors skill as a financial advisor.

Assets under management and annual revenues may indicate marketing skill, but simply does not necessarily reflect the skills or abilities of a financial advisor. Furthermore, has Barron;’s actually verified an advisor’s representations regarding assets under management and annual revenue. Recent FINRA notices have addressed the problem of misrepresentation of assets under management;
Length of time in the business addresses longevity, but longevity does not necessarily reflect the skills or abilities of a financial advisor, as evidenced by the recent conviction of industry leader Matthew Hutcheson for securities violations;
Client retention could be based on client satisfaction, or based on my legal experience, it could also be based on a client not really understanding or being aware of a financial advisor’s actual activity. I use a proprietary metric, the Active Management Value Ratio, to assess the cost effectiveness of an investment and a financial advisor’ recommendations. Approximately 75 percent of my analyses indicate investments and/or advice that is not cost effective for the investor. In many cases I find situations where the relative cost of the investment or recommendation greatly exceeds the relative benefit by as much as 300-400 percent;
Philanthropic work simply makes no sense as a criteria for the skills and abilities of a financial advisor.

The new Barron’s list does include a new disclosure – that advisors must pay a fee to be included on the list. Barron’s assures the public “that the fee has no effect on [an advisor’s] in ranking or continued placement on the list.” Right. Hopefully Barron’s will understand those who view such statement with skepticism, as it sounds like something we have heard repeatedly coming out of Washington.

I have been reading Barron’s for almost forty years and consider it a valuable resource. At the same, as an attorney and RIA compliance consultant, these lists are extremely troubling, as they are arguably based more on marketing skills rather than client-centric criteria, as well a new “pay-for-play” requirement that, despite Barron’s claim to the contrary, raises valid questions as to the legitimacy and value of the list.

While Barron’s criticizes other stories as providing “little benefit” to the public, legitimate questions regarding the evaluation criteria and the “pay-for-play” requirement raises the question is actually unintentionally doing the public a disservice by creating both false representations and a false sense of security, either of which could potentially result in unnecessary financial losses due to advisors who prove undeserving of their designation as a “Barron’s Advisor.”

Posted in Asset Protection, Investment Advice, Investment Advisors, Investment Portfolios, Investor Protection, portfolio planning, Portfolio Planning, Retirement, Retirement Plan Participants, Uncategorized, Wealth Preservation | Tagged abusive practices, Active Management Value Ratio, asset protection, investing, investment advice, investment advisors, investment losses, investment portfolios, investments, investor protection, InvestSense, portfolio construction, wealth management, wealth preservation | 3 Comments

“Humble Arithmetic,” Prudence, and Successful Investing

Posted on May 22, 2013 by investsense

Facts do not cease to exist because they are ignored. – Aldous Huxley

In 2005, John Bogle, of Vanguard fame, spoke at the 60th anniversary conference of the Financial Analysts Journal. Mr. Bogle’s presentation, entitled “The Relentless Rules of Humble Arithmetic,” suggested that the argument over the EMH, the efficient market hypothesis, was essentially meaningless and that time would be better spent examining the CMH, the Cost Matters Hypothesis.(1)

In support of the CMH, Bogle referenced a quote from Louis Brandeis, one of America’s great legal jurists. Brandeis, in addressing issues within the investment industry and the rampant investment speculation at that time, commented on the “relentless rules of humble arithmetic.”(2) Bogle noted that “the relentless rules of humble arithmetic” devastate the long-term returns of investors.”(3)

In addressing “the relentless rules of humble arithmetic,” Bogle stated that

No matter how efficient or inefficient markets may be, the returns earned by investors as a group must fall short of the market returns by precisely the amount of the aggregate costs they incur. It is the central fact of investing.(4)

Costs matter, period. Far too many investors see a 1 percent annual fee for a mutual fund and dismiss it as only 1 percent. Throw in an additional 1 percent advisory fee and now the investor is looking at a cumulative fee of 2 percent. If the investment is a variable annuity, throw in an additional 1-1.5 percent, for a cumulative 3-3.5 cumulative fee.

Some investors will still believe that it is only 3 percent without calculating the actual dollars and costs involved. If we assume no taxes and a tax-deferred account, a starting principal of $50,000, an annual return of 7 percent, and an investment period of twenty years, our end wealth would be approximately $193,484.22. Increasing the fees by 1 percent (reducing the annual return to 6 percent) would reduce the investor’s end wealth to $160,356.77, or a reduction of 17.1 percent.

Add another 1 percent of fees (reducing the annual return to 5 percent) and the investor’s end return is reduced to $132,664.89, or a reduction of 31.4 percent. And finally, add yet another 1 percent of fees (reducing the annual return to 4 percent) and the investor’s end return is reduced to $109,556.16, or a reduction of 43.4 percent.

Costs matter.

Charles Ellis, noted industry leader, has recently suggested that the value of active management should be evaluated based upon the investment’s fees as a percentage of incremental return rather than as fees as a percentage of assets under management.(5) Ellis correctly points out that investors already own the assets in their accounts, so such assets should not be evaluated in terms of an advisor’s services or in computing advisory fees.

Ellis also suggests that evaluating fees based on the incremental return investors receive from an advisor’s services can also prevent misleading representations. As an example, Ellis points out that a stated fee of 1 percent,based on assets under management, can actually be considered as an effective fee of 12.5 percent if the incremental return to the client is only 8 percent, since the real contribution of active management would only be the incremental return.

The investment industry often counters with the argument that the additional fees allow for professional money management and improved returns for investors. And yet, the evidence on historical performance seems to indicate otherwise. Standard and Poor’s publishes various reports comparing the performance of indices and actively managed funds. The reports, known as the SPIVA reports, have consistently shown that the majority of actively managed funds do not outperform their relative indices.

The SPIVA end-year 2012 reports found that

Performance lagged behind the benchmark indices for 63.25% of large-cap funds, 80.45% of mid-cap funds and 66.5% of small cap funds.

The performance figures are equally unfavorable for active funds when viewed over three-and five-year horizons. Managers across all domestic equity categories lagged behind the benchmarks over the three-year horizon. The five-year horizon yielded similar results, with large-cap value emerging as the only category that maintained performance parity relative to its benchmark.(6)

Other studies have produced similar reports of the underperformance of actively managed mutual funds. One of the most detailed studies ever conducted reported analyzed the twenty year period ending in 1998. The study found that

Over the twenty year period, the average actively managed mutual fund underperformed the Vanguard S&P 500 Index Fund by 2.1 percent a year;
Over a fifteen year period, the average actively managed mutual fund underperformed the Vanguard S&P 500 Index Fund by 4.2 percent a year; and
Over a ten year period, the average actively managed mutual fund underperformed the Vanguard S&P 500 Index Fund by 3.5 percent a year.(7)

Now go back and look at the previous data on the impact of lower returns. Is paying higher fees for less return than a simple index fund prudent?

The same study examined the pre-tax performance of actively managed mutual funds and found that

Over the twenty year period, investors had a 14 percent chance of beating the Vanguard S&P 500 Index Fund, with an average margin of outperformance of only 1.9 percent and an average loss of 3.9 percent.
Over the fifteen year period, investors had a 5 percent chance of beating the Vanguard S&P 500 Index Fund, with an average margin of outperformance of only 1.1 percent and an average loss of 3.8 percent.
Over the ten year period, investors had a 2 percent chance of beating the Vanguard S&P 500 Index Fund, with an average margin of outperformance of only 1.4 percent and an average loss of 2.6 percent.(8)

Do those numbers present evidence of prudent investment choices? I actually have the report’s findings of performance on an after-tax basis. Rather than list more statistics, let’s just say the results do not improve.

Costs matter, whether such costs are in terms of fees or the opportunity costs that result from a fund’s underperformance. One study estimated that between 1996 and 2002, the underperformance of broker-sold actively managed mutual funds cost investors approximately $9 billion dollars a year, with such funds producing an annual return of 2.9 percent over the time period, as compared to an annual return of 6.6 percent for directly purchased index funds.(9) Another study estimated that for the period 1980-2005, actively managed mutual funds produced an annual return of 7.3 percent, compared to an annual return of 12.3 percent for index funds.(10)

The last example of the value of humble arithmetic is my own proprietary metric, the Active Management Value Ratio (AMVR). Given the evidence that suggests that even when actively managed equity-based mutual funds do outperform similar index funds they only do so by a slim margin, a logical question is whether the actively managed funds are cost efficient for investors.

Rather than go through the entire calculation process again, I will direct readers to my previous posts and white paper on this blog. Using simple subtraction and division, an investor can evaluate the cost efficiency of an actively managed mutual fund in approximately one minute. And yet, this humble arithmetic process can result in significant savings for investors.

In one analysis, I used the AMVR to evaluate the performance of twenty-three of the most common actively managed mutual funds used within pension plans. I calculated the AMVR score for the funds for both a 5-year and 10-year period, setting an AMVR score of 1.5 or lower as the acceptable standard for cost efficiency. An AMVR score of 1.5 or less would indicate that the active portion of a fund’s annual fee was less than 50 percent greater than the portion of the fund’s return attributable to active management

The 5-year AMVR analysis resulted in only nine of the funds qualifying for an AMVR score at all, and only four of the twenty-three funds having an AMVR score of 1.5 or less. The 10-year AMVR analysis resulted in twelve funds qualifying for an AMVR score, and only four of the twenty-three funds achieving an AMVR score of 1.5 or less.

Costs matter with regard to cost efficiency.

Those who promote actively managed mutual funds will offer various arguments against the evidence presented in this post. I suggest that investors perform the easy calculations required by the AMVR. Perhaps Upton Sinclair summed up the active management opposition best when he noted that “it is difficult to get a man to understand something when his salary depends on his not understanding it.”

So it is easy to understand the motive behind proponents of actively managed funds promoting such funds. However, in light of the evidence presented herein, what is not so easily understood is the fact that according to the 2013 Investment Company Factbook, 82.6 percent of the money invested in equity-based mutual funds was invested in actively managed mutual funds!

Whether this fact is due to salesmanship skills or lack of information, the disparity between investments in index funds and actively managed fund suggests that investors may be suffering millions of unnecessary financial losses annually due to both the high costs usually associated with actively managed funds and the underperformance often shown by actively managed mutual funds. As David Swensen, the highly respected chief investment officer of Yale University, has pointed out

at the end of 2007, index funds accounted for only slightly more than 5 percent of mutual fund assets, leaving almost 95 percent of assets in the hands of wealth-destroying active managers. In a rational world, the percentages would be reversed.(11)

While the disparity has improved to 17.4 percent of investors’ assets invested in index funds, the statistics indicate that investors are still acting irrationally and fiduciaries using actively managed mutual funds may be violating their fiduciary duty of prudence.

What I have provided in this post is essentially the same prudence/due diligence strategy that I use in litigating or providing expert witness services in ERISA and breach of fiduciary duty cases. While the nature of such cases often requires extensive use of statistics, the beauty and strength of the strategy is its simplicity and easy verification using “humble arithmetic.” With an increasing number of actively managed mutual funds having high R-squared numbers and, in essence, acting as “closet index” funds, it is becoming more common to see situations where the active component of the fund’s annual expenses greatly exceeds the benefit derived from such active management, in many cases by 300-400 percent, or more.

Winston Churchill once said “men occasionally stumble over the truth, but most of them pick themselves up and hurry of as if nothing ever happened.” Hopefully, this post will help some investors realize the “truths” discussed herein and the need for a closer evaluation of mutual funds in terms of cost and its impact on returns, opportunity cost, and cost efficiency, by using the resources referenced herein. For those who value their financial security, the relatively small time required for such analysis will prove to be time well spent.

Notes

1. John Bogle speech, “The Relentless Rules of Humble Arithmetic,” available online at https://personal.vanguard.com/bogle_site/sp20060101.htm.
2. Louis D. Brandeis, Other People’s Money, New York:F. A. Stokes (1914).
3. Bogle Speech.
4. Bogle Speech
5. Charles D. Ellis, “Investment Management Fees Are (Much) Higher Than You Think,” Financial Analysts Journal, May/June 2012, Vol. 68, No. 3:4-6
6. http://www.spindices.com/resource-center/thought-leadership/spiva/
7. Robert Arnott, Andrew Berkin and Jia Ye, “How Well Have Taxable Investors Been Served in the 1980s and 1990s?” Journal of Portfolio Management, Summer 2000, Vol 26, No.4.
8. Arnott, Berkin and Ye.
9. John Bogle, The Little Book of Common Sense Investing:The Only Way to Guarantee Your Fair Share of Stock Market Returns,” New York:John Wiley and Sons (2007), 103
10. Bogle, “Common Sense Investing,” 51
11. Charles D. Ellis, Winning the Loser’s Game: Timeless Strategies for Successful Investing, 5th ed., New York:McGraw Hill (2010), xii

Posted in Investment Portfolios, Portfolio Construction, portfolio planning, Retirement Distribution Planning, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged Active Management Value Ratio, financial planning, investing, investment portfolios, investments, investor protection, InvestSense, portfolio construction, retirement distribution planning, wealth management, wealth preservation | Leave a comment

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