CommonSense InvestSense

The abundance of investment products and investment information available today can be intimidating and confusing to many investors, both novice and professional.  Over my twenty-plus years as an attorney and investment adviser, I have tried to help others focus on some of the critical information in order to avoid unnecessary investment losses, to help level the playing field against some of the ne’er-do-well that continue to defraud the public and plague the financial services industry.

Speaking with a colleague the other day, he commented on the fact that a lot of the important information we get through trade publications such as InvestmentNews rarely seem to get mentioned in the mainstream media and press.  And when we mention such information to clients, they often comment on how useful such information would have been.

After my conversation with my colleague, I started thinking about some of the “inside” information I have shared with my clients that produced the most reaction and appreciation.  In hindsight, I think five numbers and five fats have stood out the most to me and my clients.  In this post, I will discuss the five numbers.  I will discuss the five facts in my next post.  That being said, the five numbers every investor and fiduciary should know are as follows:

1. “75” – The number “75” is actually important for two reasons.  First, a study by Schwab Institutional found that approximately 75% of investor portfolios were poorly structured and unsuitable for their investors given the investors’ financial needs and goals.  I believe that this is primarily a result of the fact that (1) stockbrokers are not required to act in a client’s best interests, and (2) investors are often mislead by portfolios that appear to be diversified because they hold a number of different types of investments, but such portfolios are often not truly, effectively diversified.

The second reason that the number “75” is important is because research and history have shown that approximately two-third, or 75%, of stocks follow the general trend of the market.  This simply supports the popular Wall Street adage, “[don’t] confuse brains with a bull market.”

2. “94” – While there are many firms and individuals in the financial services industry calling themselves wealth managers, a study by CEG Worldwide, a well-respected financial services consulting firm, concluded that 94% of those calling themselves wealth managers or claiming to provide wealth management services failed to meet the criteria used to qualify as wealth managers.  The criteria that CEG used in their study to determine true wealth management was based primarily on advisers who practiced wealth management as a process as compared to those who simply used “wealth management” as a marketing ploy to push product.  This is the same criteria that investors and fiduciaries should use in choosing a financial advisor to work with.

Secondly, one expert has suggested that this number (OK, actually 93.6, which rounded off is 94), and the study that produced it may have caused more damage to investors than any other number/study.  The number comes from the famous 1986 Brinson, Hood and Beebower (BHB) study that stated that 93.6% of the variation of a portfolio’s returns could be explained by the portfolio’s asset allocation.

The study did not say that asset allocation explained 93.6% of the portfolio’s actual returns, but rather the variation of the portfolio’s returns.  Nevertheless, dishonest brokers and advisers misrepresented, and still do misrepresent,  the BHB study’s findings to convince investors to choose an asset allocation and rigidly adhere to it, despite the proven cyclical nature of the markets.  This is the mantra of the” buy and hold” approach to investing, an approach that some have suggested is better described as the “buy, hold and regret” approach to investing.  Just ask investors how well that worked during the 2000-2002 and 2008 bear markets.

Unfortunately, given the current budget issues that exist at the time I write this post, static asset allocators may soon get yet another costly education.  Dr. William Sharpe, a Nobel laureate for his work in the area of investment management, now stresses the need to be proactive and adjust portfolio allocations when changes in the economy and/or the market dictate such moves.

3. Zero – This number represents the number of variable annuities (VA) and equity indexed annuities (EIA) an investor should own.  As a former compliance officer and a current securities attorney I have heard all the convoluted and conniving justifications for these atrocities.  I have written posts and articles warning investors about these products.  While there may be a few limited instances where they may make sense, such as wealth preservation for high net worth investors, the way they are marketed to the masses is extremely questionable.

One Wall Street Journal article reported that variable annuity salesmen were told to treat potential annuity clients as “blind twelve-year-old,” and to “put a pitchfork in their chests,” and provide questionable responses to potential client’s questions.  VA salesmen and VA advertisements often tout that by purchasing a VA the investor will never run out of money.

What is often not made clear that in order to guarantee that lifetime stream of money, you give up all rights to the money invested in the VA.  Once you annuitize your VA, the balance goes to the insurance company once you die, not to your heirs.  In most cases the insurance company offers various choices for payout, such as joint survivor and a guaranteed period, but these options generally result in lower periodic payouts and, in  some cases, additional fees.

One of the most onerous aspects of VAs is the excesssive fees that most VAs charge, especially with regard to the so-called death benefit.  VAs typically guarantee that in the event the VA owner dies with out having annuitized the VA, the owner’s heirs will receive either the accumulated value of the VA at the time of the owner’s death or the amount of the owner’s actual investment in the VA, whichever is greater.  So the VA issuer is only insuring the amount that the VA owner actually puts in the VA.

Meanwhile, the insurance company assesses the VA’s annual death benefit fee not on the basis of their actual legal obligation, which is the amount of the VA owner’s actual investment, but rather on the accumulated value of the VA.  One study estimated that the actual expense of the annual was approximately 0.10-0.12, but that the insurance companies often charged approximately 1.50%, or approximately fifteen times the estimated value, resulting in a nice windfall for the insurance company.  The additional fee also cost a VA investor by reducing this investment return.

EIAs are also problematic.  EIAs are generally sold with the pitch that investors can earn the same return that the stock market does, with the guarantee that even if the market is down, the EIA investor is guaranteed a minimum return.  What many investors are told is that the potential return is usually capped at a relatively low number, say 10%, and then  is reduced even more by a “participation rate,” usually an additional 2-3% reduction.  In short, the EIA investor is looking at annual rate of between 2-7%.  If the market is up 20% or more for the year, just who is getting the benefit of the excess over the investor’s return?

There may be other significant numbers that I have omitted.  However, investors and fiduciaries that remember these numbers and the reasons for their significance will be in a better position to protect both their financial security and/or their clients’ financial  security.

“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 under-stand 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 salesperson’s compensation, may vary by product and over time.”

The foregoing disclosure was part of a rule enacted by the Securities and Exchange Commission (“SEC”) in an effort to address an ongoing dispute about the disparity of standards for stockbrokers and investment advisers. The Financial Planning Association sued the SEC over the disparity and won, with the court striking down the rule and requiring that stockbrokers charging fees for investment advice register as an investment adviser.

The long-needed disclosure finally made the conflict of interests regarding stockbrokers very clear to investors. An SEC commissioned study by the Rand Corporation revealed that an alarmingly high percentage of investors mistakenly believed that it was stockbrokers, not investment advisers, who owed clients a fiduciary duty. A TD Ameritrade study resulted in similar findings. And yet the SEC did not require stockbrokers to continue to disclose the conflict of interests issue.

The recently passed Dodd-Franks Act included provisions which would allow the SEC to enact a universal fiduciary standard that would apply to anyone providing investment advice to the public. It is hard to see how anyone could legitimately argue against such a common sense requirement, as it furthers the express intent of the federal securities laws and the expressed purpose of the SEC, namely to protect investors. And yet Congress continues to stall and delay implementation of a universal fiduciary standard, even suggesting that yet another study should be done.

In an effort to help Congress and save taxpayers’ money, I conducted an informal survey of 210 people based on the following question – At the present time, investment advisers are required to always put a client’s interest first, but stockbrokers are allowed to put their own personal and financial interests ahead of their clients’ interests. Do you feel that anyone providing investment advice to the public should always be required to disclose any actual or potential conflicts of interest and always put their clients’ interest first? Of the 210 people polled, 100% answered in the affirmative, with many expressing surprise that this situation even existed. You are welcome Congress.

The SEC’s failure to continue to require the conflicts of interest disclosure for regular brokerage accounts highlights the need for investors to be proactive in managing their investment accounts. Not all stockbrokers are dishonest and not all investment advisers are honest. A healthy dose of skepticism never hurts. That being said, based upon my experience as a former compliance officer and a current CFP® professional, Accredited Wealth Management Professional™ and attorney, I offer the following proactive strategies.

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 and leave 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 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.

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. 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. Many 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 the NASD’s web site (www.nasdr.com).

© 2011 InvestSense, LLC. All rights reserved.

The information provided in this post 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.

One of the things that continues to amaze me are the number of cases we see where participants in a retirement plan have set up unsuitable portfolios in their retirement accounts, thereby exposing themselves to unnecessary investment risk.  When asked how they arrived at the portfolio’s allocation mix, they usually respond by saying that they followed one of the pie charts that they had been shown during an education meeting at their company or by the plan’s investment adviser.

In order to reduce their potential fiduciary liability exposure, many companies choose to adopt what is known as a 404(c) retirement plan.  Under a 404(c) plan, the individual participants in the plan generally make their own decisions on how to invest their money, choosing from among various investment options offered by the plan’s sponsor (their employer).

Most retirement plans offer the employees some form of investment education program, with such programs usually being provided by the entity offering the investments or by an independent third-party.  A common scenario is to present the employees with various computer generated asset allocation models, usually in the form of a multi-colored pie charts.  The employee is then given the task to choose the model investment allocation model that they feel most comfortable with.

In order to obtain the fiduciary protections offered by 404(c) plans, employers must meet certain requirements.  One such requirement is that they provide the plan participants with “sufficient information to make an informed decision”  Unfortunately, the Department of Labor’s concept of “sufficient information” does not include crucial information that employees need to know in order to effectively create and monitor their retirement account portfolios.

Clients and followers of this blog know that I like to refer to the study by Schwab Institutional that concluded that 75% of the portfolios they studied were unsuitable for the investors involved, based on the investor’s financial situation or financial needs.  Based on my personal experience, the percentage of unsuitable portfolios is even higher than Schwab’s findings.  When we talk to employee groups about managing their retirement plans, we suggest three keys areas for them to address

The first issue we discuss is “pseudo” diversification.  The Department of Labor only requires that employers provided risk and return information to employees for the investment options offered by the company’s retirement plan.  At the same time, the Department advocates the use of modern portfolio theory in managing investment portfolios.

Modern portfolio theory suggests that in creating an investment portfolio, an investor factor in not only risk and return numbers, but also the correlation of returns of the investments being considered.  Modern portfolio theory argues that by factoring in the correlation of returns, an investor can reduce the overall volatility of a portfolio and archieve more consistent returns.

As we discuss in our article, “Right Kind, Right Reason Investing-Positioning Your Portfolio for Success,” over the past ten years there has been a definite trend of increasing correlations of returns among equity investments.  And yet, in most cases, equity based investment options are the primary investment options offered in 401(k) and 404(c) plans.

The employer’s failure to  provide employees with correlation of returns information on a plan’s investment options and the failure to provide some method of computing the correlation of returns on such options usually results in employee retirement portfolios that are “pseudo” diversified in the sense that they have several types of investments, but the portfolios are not “effectively” diversified since the investments chosen are often highly correlated, thereby failing to provide the employee with the needed downside protection against market downturns.

The second issue employees need to address involves “closet indexing” and inflated active expense ratio fees.  Studies have consistently found that actively managed mutual funds generally fail to outperform index mutual funds.  Nevertheless, most company retirement plans are made up primarily of actively managed mutual funds.  These actively managed funds carry significantly higher fees than comparable index funds, based on the premise that the investor benefits from the active management of the fund.

However, upon closer inspection, not only do most of the actively managed mutual funds consistently under-perform their comparable index fund, in many cases the actively managed fund owes most of its performance to the performance of the relevant benchmark index.  By looking at a fund’s R-squared ratio, an investor can see how much of a fund’s performance is traceable to the applicable benchmark index and how much of the fund’s performance is actually due to active management.  Fund’s with high R-squared ratings are typically referred to as “closet indexers,” since most of their performance is due to an index, not the fund’s managers.

Even more disturbing is the impact that such “closet indexing” has on the true, effective fees charged by actively managed funds.  Ross Miller of SUNY-Albany has created a measure, known as the active expense ratio, that allows investors to assess the impact of “closet indexing” on actively managed mutual fund fees.  The concept behind the active expense ratio is that if investors can achieve equivalent index fund returns at the lower fees charged by index funds, then the effective cost of the supposed active management increases disproportionately.  Miller’s studies have shown that the effective cost of actively managed “closet indexer” mutual funds is often significantly higher than the fees stated in a fund’s prospectus, often five to six times higher.  Higher fees reduce the return to the investors.

The final issue employees need to address has to do with an employee’s overall investment approach.  In many cases employees are taught to adopt a buy-and-hold approach to investing, with occasional re-balancing back to the portfolio’s original asset allocation percentages.  This antiquated concept, based primarily on misconceptions or, in some cases deliberate misrepresentations, of the historic BHB study, needlessly cost American investors trillions of dollars during the bear markets of 200-2002 and 2008.

People have been led to believe that the BHB study found that most investment returns are based primarily upon asset allocation, not upon the specific investment chosen.  What the BHB study actually found was that asset allocation accounts for approximately 93.6% of the variability of a portfolio’s returns.  By looking at a portfolio’s allocation between stock, bonds and cash, the BHB study simply said that higher allocations to the riskier asset increased the variability of the portfolio’s overall returns.  Since stocks are historically riskier than bonds, and bonds are historically riskier than cash, the BHB’s findings are not that surprising.

However, the investment industry continually misrepresents the findings of the BHB study as evidence that buy-and-hold is the proper choice for portfolio management.  Buy-and hold ignores the cyclical nature of the stock market and exposes investors to unnecessary investment risk. Two of the pioneers of modern portfolio management, Nobel laureates Dr. Harry Markowitz and Dr. William Sharpe, have both emphasized the need for investors to make adjustments to their portfolios when the conditions in the stock market and/or the economy merit such actions.  Could the fact that stockbrokers and investment advisers often receive ongoing fees as long as their clients own an investment have anything to do with the promotion of the buy-and hold approach?

Putting the three steps together, in addition to looking for investments with favorable return and risk numbers, an employee’s goal should be to put together a retirement plan portfolio that consists of investments with low correlations of return and investments that are either low-cost index funds or funds that have a low R-squared rating.  Employees should then monitor their portfolio on a regular basis, no less than quarterly, and make adjustments to the actual investments or the allocation of the investments as needed in order to reduce their risk exposure.

The bottom line for investors in corporate retirement accounts is that they can, and should, take steps to obtain all of the information that they need to truly make an informed decision.  As the need for this additional information becomes more widely acknowledged in order for employees to be able to actually make the informed decisions contemplated under ERISA and to better protect their financial security, employers will hopefully realize the benefits of providing such information to employees and the potential liability issues for not doing so.

American investors lost trillions of dollars as a result of the bear markets of 2000-2002 and 2008.  As a result of such losses, mutual funds companies are beginning to offer so called absolute return mutual funds.  The goal of an absolute returns strategy is to achieve, positive, more consistent returns under all market conditions.  While the power of consistent returns has long been recognized, investors should be aware that the new absolute return funds often use different approaches in trying to achieve such results, some more questionable than others.

The focus on absolute returns has been long overdue.  While many investors and investment advisers focus primarily on returns, smart investors realize that the true secret to successful investing is managing investment risk.  Legendary investor Benjamin Graham first advanced this concept decades ago.  Investors would be well advised to read Charles Ellis’ classic, “Investment Policy-Winning the Loser’s Game” (the more recent edition simply goes under the title of “Winning the Loser’s Game”) for a simple explanation of the concept.  Simply put, the concept of absolute returns simply follows the Wall Street axiom of “don’t tell how much you made, tell how much you were able to keep.”

Many investors lost money in the recent bear markets because they adopted the popular static buy-and-hold approach to investing.  But the recent bear markets offered further proof that the buy-and-hold approach is fatally flawed in that it fails to recognize the cyclical nature of the stock market. What most investors do not realize is that the buy-and-hold approach is based largely on a famous study known as the BHB report and a misrepresentation of the study’s findings. 

Some financial advisors will mislead investors and tell them that that there is no reason to make adjustments in one’s portfolio since the BHB study found that asset allocation, not individual investments, accounted for 93.6% of investment returns.  What the BHB study actually found was that asset allocation accounted for 93.6% of the variability of investment returns, not the returns themselves, 

Looking at only three types of investments, stocks, bonds and cash, the BHB study concluded that the variability of a portfolio’s investment returns increased as more money was allocated to the more volatile investments.  In retrospect, this seems to simply be common sense.  The key takeaway for investors is that the BHB study, however, did not study the determinants of actual investment returns, did not claim to do so, and made no representations regarding same.

Advocates of the buy-and-hold approach to investing often offer numbers regarding the cost of missing the “best” days of the stock market.  As a trial attorney, I am always interested in the other side of the story, what is not being said.  In this case, what is not being said is that recent research indicates that the benefits of avoiding the “worst” days of the market far outweigh the cost of missing the “best” days of the market. 

A recent study by Javier Estrada of the IESE Business School found that missing the “best” 10, 20 and 100 days of the stock market (defined as the Dow Jones Industrial Average) during the period 1990-2006 reduced an investor’s returns by 38%, 56.8%% and 93.8%, respectively.  On the other hand, Estrada found that avoiding the “worst” 10, 20 and 100 days of the stock market improved an investor’s returns by 70.1%, 140.6% and 1,691%, respectively.  The study found similar results for the period 1900-2006.  The difference in the numbers is due in large part to the fact that investors have to earn more, sometimes significantly more, than they lost just to break even and the time spent in making up for such losses constitutes an opportunity cost for an investor.

So what does this mean for investors?  Does this mean that investors should engage in short-term market timing to avoid market corrections?  Not at all, as trying to time the short-term swings in the stock market would be both costly and virtually impossible.

Absolute return investing simply acknowledges the cyclical nature of the market and then takes advantage of such nature to maximize potential performance.  Those familiar with the classic book,“The Art of War,” will recognize this strategy of using the nature of things to one’s advantage as a cornerstone of General SunTzu’s strategies, but it is equally applicable to investing. 

The truth is that most investment portfolios fail to take advantage of the nature of the market, as they contain too many investments with a high correlation of returns, meaning that the investments react in like manner to market conditions and therefore fail to provide an investor with adequate protection against downside risk.  A 2007 study by Schwab Institutional reported that 75% of investor portfolios studied were inappropriate for the investor in light of the investor’s goals and/or financial situation.  This unfortunate situation is often due to the shortcomings of the commercial asset allocation/portfolio optimization software often used by financial planners and investment advisers.  These software issues and the unnecessary investment risks they create are addressed more fully in other articles on the InvestSense web site. 

Fortunately, investors wishing to implement an absolute returns strategy can do so on their own and save the costs and expenses involved with mutual funds.  There are a number of investment products currently on the market that can greatly simplify the process of constructing an absolute returns portfolio.  By heeding the advice of General Tzu and focusing on investment alternatives that have varying levels of correlation of returns and monitoring the stock market to determine when portfolio reallocations or substitutions may be appropriate, an investor can effectively manage investment risk and improve their potential for investment success.