Dirty Little Secrets

Dirty Little Secrets: Protecting Investors and Fiduciaries
Against “Black Box” Investment Fraud

James W. Watkins, III, J.D., CFP®, AWMA®

CEO/Managing Member
InvestSense, LLC

Providing investment advice is big business.  A Wall Street Journal article reported that from mid-2000 to mid-2002, an estimated 9.5 million families obtained a financial plan, with another 6.6 million people receiving a retirement plan.1  Those figures take on even more significance when you consider that costs for plans typically run from a couple of hundred dollars to thousands of dollars.

In most cases, these plans are generated primarily by relying on computer-based asset allocation/portfolio optimization software programs (“computer program(s)”).  Like any other computer program, the value of the computer output is dependent on both the value of the data input and any inherent limitations of the computer program itself.   

In the context of financial planning and wealth management, the concerns with the data input and inherent program limitations variables have led to questions regarding the overall quality of advice being provided by computer-based, or “black box,” investment advice.  One noted industry expert has expressed his concern that the emphasis on mathematics in the wealth management process has resulted in the process becoming nothing more than a “sexy but simpleminded pseudosophisticated analysis,”2 with the fear being that the  

“black box” 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

These concerns are neither new nor unknown within the financial services industry.  A 2007 study by Schwab Institutional estimated that approximately 75 percent of investor accounts they studied were unsuitable as being inconsistent with either an investor’s financial goals or financial needs.  While one might expect widespread denial of the study’s findings, an  Investment News article reported one professional’s response – “we’ve always known it.”4  

Portfolio optimization is based on the theory that an investor can achieve a better overall, more consistent, return by investing in various types of investments that perform differently from each other under various market and economic conditions. According to the theory, known as modern portfolio theory (MPT), the combination of such investments will hopefully result in more consistent returns, as the poor performance of some investments will be offset by the performance of other investments in the portfolio.  

MPT-based portfolio optimization requires calculations that are confusing and complex. Consequently, it can be difficult for investors and fiduciaries to determine whether the recommendations are suitable and properly calculated. While the calculations involved with MPT-based portfolio optimization may be beyond the average investor, an awareness of the weaknesses cited by critics, of both the theory and its application, may alert investors and fiduciaries to questionable investment advice and help prevent unnecessary financial loss.

1. MPT-Based portfolio optimization recommendations are based on assumptions and “guesstimates.” In the small print at the bottom of many investment advertisements there is a disclaimer that “past performance does not guarantee future performance.” The inability to predict the future is generally acknowledged. Yet past performance is exactly what MPT-based portfolio optimization software programs, commonly referred to as optimizers, typically use in producing portfolio optimization projections and asset allocation recommendations.  

Optimizers generally use data based on the historical returns and volatility of general asset categories and/or market indices. In some cases, the optimizer may allow a financial advisor to substitute their own risk/return assumptions for the historical data. Either way, the uncertainty and instability produced by the reliance on past performance or the financial advisor’s “guesstimates” increases the potential for error and financial loss, so much so that at least one financial scholar has described portfolio optimization programs as “estimation-error maximizers.”5

Supporters of MPT-based portfolio optimization argue that any perceived weakness in using past performance is offset by basing the past performance data on performance over long periods of time, in some cases as far back as the 1920’s. Such an argument overlooks the fact that such historical averages may actually be a disadvantage, as they may not accurately reflect current or future market returns and conditions. The validity of such concerns can be seen in the increased volatility of today’s markets, with daily swings of one hundred points or more in the Dow Jones Industrial Average becoming a relatively common occurrence.

Optimizers that allow a financial advisor to substitute their own “guesstimates” for historical risk/return data present even greater issues. An optimizer’s recommendations are based on the relationship, or correlation, between each investment’s returns and volatility, both absolute and relative to other investments and/or investment options. The nature of the calculations results in a bias toward investments with high returns, low volatility and low correlation with other investments. This bias often results in asset allocation recommendations that are unsuitable for an investor given their financial needs, investment objectives, risk tolerance level or other personal investment parameters.  

2. The calculations and recommendations produced by optimizers are highly unstable and easily manipulated.  Optimizers often paint optimistic pictures of how an investor can improve investment returns and reduce investment risks by making certain changes in their portfolios. Going behind the numbers and recommendations often results in a less optimistic, more realistic picture.

Given MPT’s bias toward high return, low risk investments, an optimizer’s projections and calculations can be easily manipulated by simply overstating an investment’s return and/or understating an investment’s risk factor. Because of the complexity of optimizer calculations, slight changes in any of the inputs can result in significant changes in an optimizer’s projections and recommendations. An optimizer can also be manipulated by setting the optimizer’s investment options or minimum/maximum allocation settings at unsuitable levels to insure that certain changes in the investor’s portfolio will be recommended, resulting in sales or purchases of investment products and commissions for the financial advisor.  

3. An optimizer’s “optimal” portfolio may not be in the investor’s best interests at all. Optimizers generally take an investor’s answers to some sort of investor profile or risk tolerance questionnaire, assign the investor a risk profile based on such answers, and then produce asset allocation recommendations and risk/return projections for the proposed portfolio. Investors are led to believe that the new recommendations represent the best, or optimal, portfolio for them.  

While an optimizer’s recommendations may be theoretically optimal, reality often shows that the recommendations are not in the investor’s best interests at all. This gap between theory and reality can result for various reasons, including the nature and weighting of the questions on the risk questionnaire, the inability of the optimizer to factor in an investor’s personal financial parameters, and the failure of the optimizer to factor in the costs that would be incurred in implementing the recommendations, including costs such as commissions, fees and taxes.

Most risk tolerance questionnaires are totally worthless due to the nature of the questions themselves and/or the weighting given to the investor’s answers to such questions. Asking an investor how they would feel if their portfolio lost half its value seems rather foolish.  

Other questions, while reasonable, offer little real insight and increase the potential for misinterpretation. Asking an investor how many years of investment experience they have does not properly differentiate between the seventy year old widow, who has twenty years of investment experience with certificates of deposit and treasuries, and the sixty year old former executive who has twenty years of investment experience with various investment products. The optimizer may only see twenty years of investment experience and may incorrectly designate the widow as a sophisticated investor, incorrectly assuming experience equals knowledge and sophistication.

The weighting of such questions is equally troublesome. The unethical financial advisor can simply weight the questions in such a way to ensure that certain recommendations result to increase the likelihood of product sales/purchases and commissions.  Equally weighting the questions may seem to be the most obvious way of preventing such abuse; however some answers and personal factors outweigh others in choosing a legally suitable and effective investment portfolio.  

For example, an investor may indicate that they are not comfortable with market/ investment risk and they simply want to produce income while preserving their capital. While this position may leave the investor exposed to other risks, such as loss of purchasing power due to inflation, this position does not violate any securities rules or regulations and should be respected by a financial advisor.  In such situations, the investor’s position alone determines what is suitable or unsuitable, regardless of the remaining answers on any risk tolerance questionnaire. For such an investor, any equity product would be realistically inappropriate, regardless of any theoretical recommendations.  

Likewise, an optimizer may completely overlook the fact that an investor’s statement that their income is sufficient is based on the fact that their current portfolio produces the needed income. An optimizer could, and often does, misinterpret the investor’s answer, resulting in unsuitable recommendations that significantly reduce or eliminate the needed portfolio income. 

Optimizers do not factor in the costs that would be incurred by an investor in following the optimizer’s recommendations. When costs such as commissions, fees and taxes are factored in, investors often discover that the recommendations are not in their best interests at all.

One tactic used by unethical financial advisors is to tout that a recommended move would be tax-free without mentioning that the move would result in new commissions for the financial advisor. This is a tactic often used in connection with annuities and tax-deferred accounts such as 401(k) accounts and IRAs. These costs are significant, as they can reduce the performance of an investor’s account.

4. There are legitimate questions regarding the value of MPT and portfolio optimizers. Few would dispute the value of diversification or the rationale of combining investments with low correlation to reduce investment risk exposure. The issue, however, is how to do so to protect an investor’s best interests. Historical trends suggest that effective diversification could be as simple as investing equal amounts in a stock market index, such as the S & P 500, and bonds.

Various financial scholars have become increasingly critical of the basic concept of MPT and its current application, including optimizers.6 Critics have generally cited the inherent biases and overall instability of the calculations and recommendations produced by MPT and optimizers. The overall value of MPT and optimizers has also come under increased scrutiny in light of recent studies that have shown that the correlation of some investments actually increases during times of market volatility, thereby failing to provide the risk reduction benefit touted by MPT.7 

5. Many financial advisors and money managers do not rely on MPT or portfolio optimization.  Many financial advisors recognize the weaknesses and problems associated with MPT and optimizers. Consequently, the human element, their knowledge and experience, is the primary planning tool of most financial advisors. The use of the human element is the only way to ensure that the investor’s personal investment parameters are properly considered in creating suitable investment recommendations.

The willingness and ability to perform the needed human element functions is what separates the true financial planning and investment professional from the “black box” planners and advisors who simply accept whatever projections and recommendations an optimizer produces. These “faux” planners and advisors often have little or no interest in the quality of the advice being provided, as they simply see optimizers and asset allocation as marketing tools to sell insurance and investment products. 

6. Proper implementation is just as important as portfolio optimization. Commercial portfolio optimizers are usually limited to only making recommendations in terms of broad, general asset categories (e.g., large cap growth, small cap value). Assuming that the recommendations are suitable for the investor, the financial advisor must then choose specific products that are consistent with the assumptions that were used in producing the optimizer’s risk/return projections and asset allocation recommendations in order to properly implement the recommendations. Unfortunately, far too often this is an area that financial advisors overlook, exposing investors and fiduciaries to unnecessary financial loss due to unsuitable investments.

There are various reasons for inconsistencies between an optimizer’s recommendations and a financial advisor’s implementation recommendations. Commercial optimizers do not generally offer a financial advisor the option of going back and analyzing an investor’s portfolio based upon the advisor’s recommendations. The amount of data that would be required on all the various investment options makes such an option impractical for commercial optimizers.

Such inconsistencies can also result from an advisor’s lack of experience, an advisor’s lack of due diligence in researching the investments recommended, or the lure of higher commissions. Financial advisors who are affiliated with an insurance company or broker-dealer may be required to recommend certain proprietary investments whose qualities are inconsistent with the assumptions used by the optimizer and unsuitable for the investor.

Some financial services professionals attempt to brush away such recommendation- implementation inconsistencies, or “gaps,” by claiming that the variances are insignificant in the long run, as time reduces any problems.  That simply is not true.  With regard to fees and expenses, the Department of Labor has estimated that each additional one percent of fees and expense reduces an investor’s end return by approximately 17 percent over a twenty year period.8 The concept of time diversification is similarly flawed, as it ignores the impact of such “gaps” on an investor’s end, or total, return, as explained in John Norstad’s excellent article, “Risk and Time.”9

Investors who work with financial planners, investment advisors, financial consultants, or other financial advisors will probably receive various colorful charts and risk/return projections that have been generated by MPT-based portfolio optimizers or similar investment calculators, such as Monte Carlo simulators. Monte Carlo simulations are somewhat different from optimizers in that they usually present an investor with various risk/return scenarios instead of asset allocation recommendations. 

Unfortunately, Monte Carlo simulations suffer from the same limitations and weaknesses as MPT-based optimizers, as will any computer-based investment advisory program.  Computers are helpful in the financial advisory process, but providing suitable financial and investment advice requires the human element to ensure that an investor’s financial needs, investment objectives, risk tolerance level and other personal investment parameters are properly considered.  

Further proof of this need for the human element can be seen in the various asset management and separate account programs offered by many investment advisors. These programs are often touted as providing investors with personalized investment advice and services as compared to the impersonal investment services provided by mutual funds. Investors are usually asked to choose among several categorized and standardized portfolios. The investment advisor then affiliates with a third party investment advisor who produces periodic MPT-based portfolio optimization recommendations for each of the standardized portfolios 

As evidence of their realization of the need for the human element, the third party investment advisors usually include a provision in their contracts with investment advisors that provides that it is the responsibility of the investor’s investment advisor, not the third party investment advisor, to determine the suitability of the standardized portfolios and any recommendations. Many investment advisors fail to recognize the significance and consequences of such a provision, namely that the third party advisor realizes that MPT has serious weaknesses, that MPT is not the standard by which legal suitability is determined, and that trying to fit every client into one of several mass produced, standardized portfolios increases an advisor’s potential liability exposure.

By adding such a provision, the third party investment advisor effectively transfers both the suitability determination and the corresponding liability exposure to the investor’s investment advisor. From an investor’s or a fiduciary’s perspective, this calls for an investor to exercise even greater care before choosing their financial advisor or deciding to participate in such an investment program. Investors and fiduciaries who fail to do so may find themselves with cookie-cutter portfolios that are unsuitable for them or their beneficiaries, exposing them to unnecessary financial losses.

Bad Medicine

My mother just suffered a heart attack.  Upon her return from the hospital, I noticed that she was spending two-thirds of her day sleeping.  Upon examining her five prescriptions, I noticed that all five indicated that the use of the drugs could result in drowsiness.  When I contacted her primary physician, he immediately discontinued two of the drugs and reduced the dosage of one of the other drugs.

In the financial services industry, investors and fiduciaries are often the victim of another case of “bad medicine,” a combination of practices that can have disastrous results.  MPT advocates often advise investors to adopt a “buy-and-hold” approach to investing, arguing that studies have shown that approximately 96 percent of an investor’s returns are based on asset allocation alone.  MPT advocates then argue that by using MPT to produce the optimal portfolio allocation for an investor, there is little to gain by changing the original portfolio allocation. 

The study most often pointed to by the proponents of the MPT+buy-and-hold strategy is a 1986 study commonly known as the Brinson, Hood and Beebower (BHB) study.10  The study examined 91 pension plans and the impact of the plans’ asset allocation  among three types of investments –equities, bonds and cash.     

The BHB study concluded that asset allocation accounted for approximately 96 percent of the variability of a plan’s returns.  The BHB study examined the variability of returns, not the factors behind the returns themselves.  The BHB study’s findings with regard to variability of returns should come as no surprise since the study only looked at three asset categories.  Historically, equities have been riskier than bonds and bonds have been riskier than cash.  The BHB study simply found that the variability of the pension plans’ returns increased as greater allocations were made to riskier assets.

The financial services industry has deliberately misled the public and pension plans by misstating the BHB study’s findings in order to promote their own financial interests.  Worse, they have used these misrepresentations to convince investors and fiduciaries to adopt a buy-and-hold approach to investing and to leave their funds invested in their investment products, in many cases leaving investors and fiduciaries exposed to unnecessary investment risk.

As a securities attorney, there are two aspects of the MPT+BHB argument that I often utilize in resolving cases.  First, Dr. Harry Markowitz, who introduced the concept of MPT, was quick to point out that the “optimized” portfolio was not always the proper portfolio for every investor.  Markowitz made it clear that suitability issues, such as an investor’s willingness and ability to bear market risk, trump optimization in the wealth management equation.11

Second, those who deliberately misrepresent the BHB study’s 96 percent figure have to explain why they recommend and sell actively managed investment products if active management contributes less than 4 percent to investment returns, when the 96 percent figure would suggest that passively managed, less expensive investment products such as index mutual funds and exchange traded funds would be more in the client’s best interests.      

One wonders how those suffering losses in the 2000-2002 and 2008 bear markets feel about a buy-and-hold approach now.  Gradually, more and more investors are recognizing the wisdom of Charles Ellis’ admonition that the secret of successful investing is in properly managing market risk, not in trying to manage market returns.12

Preventing “Black Box” Financial Planning/Investment Fraud

“Black box” investment fraud threatens individuals and investment related fiduciaries, such as pension plans and trusts.  While the public and investment related fiduciaries may not be aware of the threat posed by “black box” investment fraud, the industry is well aware of the problem. The situation is so bad that Dr. William Sharpe, a Nobel Laureate for his work in the area of investment management, has described the situation as “financial planning in fantasyland.13 

The good news is that there are strategies that investors and fiduciaries can use to protect themselves from such fraud.  The key to preventing such fraud is to understand how such fraud is committed and recognizing certain “keys” discussed herein that may alert investors and fiduciaries to questionable activity. 

Most asset allocation/portfolio optimization plans have various figures and charts that often leave an investor or fiduciary totally befuddled.  As we have discussed, even investors and fiduciaries with some understanding of the numbers may not understand the significant impact that even slight errors can have on the quality of the advice provided. 

Investors and fiduciaries need to always ask for the assumptions that were used in preparing a plan, especially the correlation of returns data in order to ensure that the portfolio has been “effectively” diversified as opposed to “pseudo” diversification, where a portfolio gives the false impression of being diversified solely by virtue of the number and types of investments in the portfolio. 

The investor or fiduciary should ask the financial advisor to rerun the portfolio projections using the actual investments in the portfolio or being recommended by the financial advisor.  It can be done relatively easy, albeit not by most of the commercial asset allocation/portfolio optimization programs currently in use. The investment portfolio should also be analyzed from the standpoint of volatility, the consistency of performance and correlation or returns over various rolling periods of time, and the impact of any investment and/or advisory fees and expenses upon an investor’s projected end return. 

Finally, the investment portfolio should be stress tested to determine how effective the suggested portfolio would have been in providing both upside potential and downside potential to an investor.  While past performance is admittedly not a guarantee of future results, it can be useful as part of the overall quality of advice analysis process.   


The concept of the optimal investment portfolio is somewhat like the search for the Holy Grail, enticing but difficult to attain. The theories and premises upon which most portfolio optimization is based present a number of issues due to the inherent biases and relative instability of the projections and recommendations produced.

Given the significance of the issues involved, one’s financial security and potential liability issues for investment related fiduciaries, a proactive approach to wealth management should be adopted by both investors and fiduciaries. A proactive wealth management program should include asking why such recommendations are needed and having the adviser provide written documentation of such reasons, and seeking more than one opinion by having an objective, independent third party review asset allocation recommendations prior to actually investing their money or making any changes in their investment portfolio. A properly designed proactive approach to wealth management can save investors and fiduciaries a significant amount of time, stress and money.  

© 2012 InvestSense, LLC. All rights reserved.

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.


1. R. Simon, “Financial Planning: Selling for In-House Gains,” available online at online.wsj.com/article/SB107628100612423901.html
2. H. Evensky, “Heading for Disaster,” Financial Advisor, April, 2001, available online at financialadvisormagazine.com/component/content/article/315.html?issue=7&magazine ID=1&Itemid=27
3. H. Evensky, S. Horan, T. Robinson and R. Ibbotson, “The New Wealth Management: The Financial Advisors Guide to Managing and Investing Client Assets,” (Hoboken, NJ/Wiley Desktop Editions, 2010), 187
4. Brooke Southall, “Wirehouse accounts don’t match client goals,” InvestmentNews, March 12, 2007, 12. 
5. R. Michaud, “The Markowitz Optimization Enigma: Is “Optimized” Optimal,” Financial Analysts Journal, January/February 1989, 33.
6. See, e.g., R. Michaud, Efficient Asset Management (Boston, MA, Harvard Business School Press, 1998), W. Sharpe, “Financial Planning in Fantasyland,” available online at http://www.stanford.edu/~wfsharpe/art/fantasy/fantasy.htm; S. Lummer, M. Riepe and L. Siegel, “Taming Your Optimizer: A Guide Through the Pitfalls of Mean-Variance Optimization,” Global Asset Allocation Techniques for Optimizing Portfolio Management, J. Ledderman and R. Klein, eds. (New York: John Wiley & Sons, 1994) and available online at http://www.ibbotson.com/download/research/Taming_Optimizer.pdf.
7. R. Campbell, K. Koedijk and P. Kofman, “Increased Correlation in Bear Markets,” Financial Analysts Journal, January/February 2002; E. Jacquier and A. Marcus, “Asset Allocation Models and Market Volatility,” Financial Analysts Journal, March/April 2001. 8. “Private Pensions: Changes Needed to Provide 401(k) Plan Participants and the Department of Labor Better Information on Fees.”  Available online at http://www.gao.gov/ new.item/d0721.pdf, 7.
9. J. Norstad, “Time and Risk,” available online at http://www.norstad.org/finance/risk-and-time#fallacy.
10. G. Brinson, L. Hood and G. Beebower, “Determinants of Portfolio Performance,” Financial Analysts Journal 42 (July/August 1986), 39-48
11. Harry M. Markowitz, “Portfolio Selection,” Journal of Investing, March 1952, 89.
12. C. Ellis, “Winning the Loser’s Game: Timeless Strategies for Successful Investing,” 5th Ed. (New York, NY: McGraw/Hill, 2010), 45, 139.
13. W. Sharpe, “Financial Planning in Fantasyland,” available on the Internet at http://www.stanford.edu/~wfsharpe/art/fantasy/fantasy.htm