I’ve seen many positive changes in the advisory business over the past three decades. Fees have gone down and diversification has gone up. Advisors are a large part of the reason flows are moving from expensive active to low-cost passive funds. This has been good for our clients. Still, we have further to go, and having advisors address these 10 failures in their practices will help us get there.
All of these suggested changes are in the best interests of our clients, which ultimately benefits our business:
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Taking too much equity risk. The bull market is now well over eight years old. The total return of the U.S. stock is 363.3% as of October 6, 2017, as measured by the Vanguard Total Stock ETF (VTI), since it bottomed out on March 9, 2009. It turns out that advisors timed the market poorly during the real estate bubble and plunge. Advisors took on a ton of risk at the 2007 market high on October 9, with only 26% bonds and cash but upped the amount to 51% on March 9, 2009, just in time to miss out on the recovery.
Today, many advisors and investors have a high tolerance for risk and I’m seeing portfolios even more aggressive than in 2007. Risk-profile questionnaires are inherently unreliable as clients tend to be risk-takers in good times only to run to cash when stocks tank. Further, they don’t measure the client’s need to take risk.
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Buying risky bonds or bond funds. Much like in 2007, I’m seeing managed portfolios with bonds and bond funds either barely investment grade or junk. This is a dumb strategy and shows how short our memories are. In 2008, just when we needed our bonds to act as a shock absorber when stocks tanked, Morningstar reports the average bond fund lost 8% while the average high-yield (junk) bond fund lost 26.4%.
By contrast, a high-quality bond fund like the iShares Core US Aggregate Bond ETF (AGG) gained 7.9% and served the role of bonds as a shock absorber. But unlike 2007, it’s even harder for advisors to put clients in high-quality bond funds because rates are so low. As of October 9, 2017, AGG is yielding 2.27% which makes it hard for the AUM-based advisor to justify taking nearly half of that return in fees. So advisors fall for the argument that bond indexing has failed, ignoring the fact that many funds take on far too much default risk.
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Doing what our clients want. I often hear an advisor say their clients want high equity exposure or higher paying bonds. In fact, I heard many advisors tell me they turned to cash after the 2008 stock plunge because their clients demanded it. But working with our clients’ best interests in mind doesn’t mean always agreeing with them. Though it’s important to listen to our clients and understand their concerns, it’s critical that we push back when we disagree. We need to be prepared to be fired or even to fire a client.
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Confusing knowledge with unique knowledge. Going into 2017, I wish I had a dime for everyone who told me interest rates were sure to rise and intermediate and long-term bonds were sure to be in a world of hurt. After all, the Federal Reserve told us they were targeting three rate increases in 2017. Yet despite the Federal Reserve following through on two of the increases, and saying it’s on target for a third this year, intermediate-term and long-term bond rates fell and those bonds performed quite well.
We shouldn’t be surprised that the Fed raised rates and bond rates fell. That the Fed made the announcement it would raise the overnight rate was already priced into the market, which controls those longer term bonds. There was a 50% chance that bond rates would fall. I wasn’t issued a crystal ball when I passed the CFP exam. Thinking we can predict what markets will do is hazardous to our clients’ wealth.
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Building complexity into portfolios. I’ve seen very few portfolios perform better than the three-fund portfolio known as the Second Grader Portfolio. In fact, it’s the top performer of the eight Dow Jones MarketWatch lazy portfolios. Named after my son, this simple portfolio consists only of a total U.S. stock, total international stock and total bond index fund.
Yet we advisors can’t resist the need to complicate. There may be some very good reasons for doing so, such as tax consequences, but typically there are many bad reasons – none worse than the client might question why they are paying so much for such a simple portfolio.
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Failing to build a tax-efficient portfolio. As mentioned above, taxes are one justification for complexity. Stock index funds are very tax-efficient since they generate little in the way of capital gains and dividends are currently taxed at lower rates. These funds are best held in taxable accounts. If we put them in tax-deferred accounts, we are merely having clients pay higher ordinary income when they withdraw. Bonds and REITs are taxed at higher rates and are best held in tax-deferred accounts. Roth accounts get more complicated and are dependent upon many factors. But once the client has set an overall asset allocation, tax location is critical and a big value added we can do for our clients.
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Building portfolios concentrating on income rather than total return. It’s a like a bad movie that plays over and over again. Companies like GM and Eastman Kodak will always be safe. Master limited partnerships are ultra-low risk toll taking entities as oil passes through them that produce safe income. Safe dividend stocks are now a better alternative to bonds.
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Not telling clients to pay down the mortgage. When I point out that a mortgage is just the inverse of a bond and we should tell clients to pay down or pay off the mortgage, that advice is not always received well by my fellow advisors. The argument is simple – it doesn’t make financial sense to borrow money at 4% only to lend it out at the 2.27% that AGG was paying. The client doesn’t make it up with volume. I’ve heard all the arguments, such as the tax-deductibility of the mortgage (without mentioning the taxing of the bond) and the inappropriate comparison of stocks to mortgages when the client holds bonds. Liquidity is the only reason to avoid paying off a mortgage. Of course, advising clients to pay down their mortgage typically lowers our income as we have fewer assets upon which to base our fee. But, as fiduciaries, it’s just another opportunity to put our clients’ interests ahead of our own.
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Showing income that isn’t. This is legal (but shouldn’t be) and happens in different ways. With individual muni bonds, for example, I see statements showing handsome income of 3.5-4% tax-free, or twice what a muni bond fund is showing. The trick works like this: The bond is purchased at $110 with a $4 coupon and will mature or likely be called in four years at $100. The income shown on the statement is the full $4 with a 3.64% yield ($4/110). But the bond is depreciating about $2.50 per year ($10/4 years), so most of that is return of principal.
Other income exaggeration could be a single-premium immediate annuity (SPIA) paying 5% income. The client could, for example, build a $5,000 income stream by buying a $100,000 SPIA. But it ain’t income if the client needs to live 20 years just to get their principal back.
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Chasing past performance. I don’t believe for a minute that investors time investments as bad as DALBAR states. But clients chase performance and we advisors are human. Money was pouring into smart-beta funds a few years ago when performance was hot and now more money is going into plain old cap-weighted funds after smart-beta lagged. The saying that “past performance is not indicative of future performance” happens to be true. New funds are launched all the time with back-tested success and many advisors jump at the promise of great returns with lower volatility (“low-vol funds”). Then we are surprised and flee when performance lags.
As a matter of fact, I’m a believer in chasing bad performance. I call it rebalancing which, for example, meant buying equities after the 2008 plunge and selling equities at today’s market highs. However, that’s hard to explain to a client.
Though change is never easy, addressing these 10 problems is needed if we truly want to be viewed as the professional fiduciaries. The word “fiduciary” is much easier to say than to practice. But these practices are good for our clients and putting our clients first is ultimately good for us advisors.
Allan Roth is the founder of Wealth Logic, LLC, a Colorado-based fee-only registered investment advisor. He has been working in the investment world with 25 years of corporate finance. Allan has served as corporate finance officer of two multi-billion dollar companies, and consulted with many others while at McKinsey & Company.
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