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Written by Glenn szlagowski - Financial Adviser

Category: Newsletters

Published: 26 April 2013

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The value of advice

“Investors diligently seek investments that they hope will produce the best returns but lose much of that benefit when they yield to psychological factors” --- DALBAR 2011 Quantitative Analysis of Investor Behavior

With stock markets making recent all-time record highs, many investors realize they may have made a mistake by selling, reducing or switching their investment portfolios in the past four years.

In 2008, the U.S. residential housing system teetered on the edge of collapse, bringing down banks, brokerage firms and insurance companies. As these giant U.S. institutions toppled, the Great Panic of 2008 - 2009 started. One of its first victims was the stock market.

Despite their financial adviser's counsel to increase holdings in down markets, many investors took to the fire exits, bailed out, jumped ship and kept on selling their stocks. For investors who didn't have advisers, they likely sold at the lows. Many of these people are never coming back or will be back only when the market gets high enough. See story below by clicking on this link:

 http://www.marketwatch.com/story/mom-and-pop-the-worlds-worst-investors-2013-04-04

For the remaining investors terrorized by the media's headlines of the time, even the staunchest investors were starting to eye the exit signs.

As scary as 2008 was, by early 2009 things got worse and stock markets continued to plummet with no bottom in sight. The U.S. benchmark stock market index - the S&P 500 dropped almost 60% from its highs in 2007.

And then on March 9, 2009 something magical happened and financial historians still don't know why, the stock markets reversed course, went up and kept going.

Currently, the stock market [S&P 500 Index] is about 130% higher than it was on March 9, 2009. Happily, the investors with advisers stuck it out, weathered the storm and today, are happily reaping the benefits of patience, determination and sticking with the plan.

This year, Canadians were still reducing equity positions and investing in bonds (bond funds and balanced funds). American investors however, seem to have shifted their attention to stocks a few months earlier than Canadians.

[Editor’s note: balanced funds are mutual funds that contain both stocks and bonds.]

Although the "Great Rotation"[1] back into stocks hasn't started yet, some money managers believe that some accumulated cash from previous years of non-investing is starting to be invested now.

So what have we learned from this lesson of history? Although I could write chapters about behavioral science, in reality the modern investor has learned nothing more other than to illustrate that people given the same circumstances, will likely react the same way as previous generations have always done. Human nature is indeed immutable. The internet, modern communications, smart phones, tablets and cloud computing has done absolutely nothing to change that cycle - other than perhaps to make bad investment decisions a bit faster than ever before.

One of the most important roles of a good adviser is to modify or prevent certain bad aspects of investor behavior that unmitigated (or left to the press) utterly destroys investor returns. The Great Panic of 2008 – 2009 certainly proved that investors should have a good adviser not only in good times but even more so – in bad times.

[1] “Great Rotation” – Investors massively piled into bonds during the last four and a half years. The “Great Rotation” refers to the possibility that this huge amount of money in bonds will be “rotated out” and switched to stocks. 

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Written by Glenn Szlagowski - WealthAdviser

Category: Newsletters

Published: 18 April 2013

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The Great Rotation - nice theory eh? 

Greetings to our international readers from the GWN (Great White North). https://en.wikipedia.org/wiki/List_of_Bob_%26_Doug_McKenzie_appearances_on_SCTV 

Despite recent volatility, American stocks are de-rigueur these days and the S&P 500 stock index managed to hit a recent of high of +135% from its low of just four years ago.

Where is this money coming from? 

Although financial advisers and equity money managers blissfully dream of trillions of dollars of bonds stampeding back into stocks driving stock markets to new record highs, the word is that the so-called Great Rotation is just not happening.

The data crunchers are scratching their heads. The money is not coming out of bonds at all. As a matter of fact, there is still a lot of money going into bonds rather than out of bonds. 

Maybe the money is coming out of savings products like certificates of deposit? The stats say no, but the rush of investors putting in new savings in the banks [at zero interest rates] has slowed markedly. Does that mean that Ben Bernanke's financial repression is working? https://en.wikipedia.org/wiki/Financial_repression

[Editor's note: search engine results for "financial repression" turns up a whole list of complicated explanations. Here is my take on the term: The U.S. has artificially lowered interest rates in order to make savings painful.] 

It looks like new money rather than savings or bonds has pushed the U.S. stock market to recent highs. 

As far as when the Great Rotation from bonds to stocks will ever start, perhaps the best explanation comes from portfolio manager Michael White who manages the CAD $775 million AGF Canadian Asset Allocation Fund. He tells me: "The Great Rotation will start when investors receive their bond statements with a whole bunch of negatives on it." 

Source:  In search of the 'Great Rotation' - Mark Hulbert, Wall Street Journal's MarketWatch April 9, 2013.

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Written by Glenn Szlagowski - Wealth Adviser

Category: Newsletters

Published: 03 April 2013

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Adviser fees - devolution or evolution

 My last article on Fees and Commissions elicited a surge in readership and due to some strange quirk of search engine optimization (SEO) , the article was very briefly (thanks to Google), the most popular article in the world with respect to individual financial adviser compensation. 

Perhaps because of these high search engine rankings, I was contacted by famed investor advocate - Ken Kivenko and I mentioned to him that I would likely author a follow-up article on fee-based adviser compensation with more detail. 

But first a recap. 

Financial Advisers - like stock brokers and mutual fund brokers, traditionally have used a transactional or commission based model. If you buy a stock or mutual fund, you pay some sort of commission. If you sold a stock, you likely paid some sort of commission to sell as well. 

In recent years, mutual funds are bought and sold quite differently than they used to be. Some decades ago, mutual fund commissions were fixed and non-negotiable. In the mutual fund world there can be a commission to buy or sell but unlike stock transactions you do not pay both. 

[Editor's note: please refer to my Fees and Commissions article for the differences between front-end and back-end loads.]  

A solution looking for a problem 

The Canadian Securities Administration torched off a storm of controversy with its recent discussion paper on mutual fund fees and commissions - ostensibly to identify potential investor protection issues arising from the current structure of mutual fund fees. 

Our national business papers has further fueled the controversy by opining that the transactional ( commission based)  model was rife with conflict of interest issues and generally, commissions of any sort were/are evil incarnate and must be banished permanently. 

I do not agree with this view. 

I should firstly point out that the introduction of service fees (trailing commissions) in the 1980's had pretty much eliminated the threat of account churning of mutual funds and eliminating many of the conflict of interest scenarios. 

[Churning - the frequent purchasing and selling of securities for the purpose of earning additional commissions.] 

Secondly, most advisers have voluntarily eliminated front-end loads on mutual funds, likely in response to the Canadian banks domination in the fund industry and their introduction of "no-load" funds. 

A majority of advisers in the last decade or so have decided that earning a total service fee/commission of about 1% a year is likely to be a fair and equitable compensation for managing large amounts of money. Advisers have gradually eliminated their front-end loads and nowadays typically charge a 0% commission for the purchase of a mutual fund. Due to the nature of a front-end mutual fund purchase there is never any commissions to sell a front-end mutual fund. Therefore, a client buys the mutual fund for 0% commission and can decide to sell this fund at any time without incurring a commission - zero in, zero out. 

The trend towards 0% commissions has had some interesting and unanticipated effects. The back-end option of buying a mutual fund was introduced in the 1980's to help clients avoid paying front-end commissions. In a back-end load option you could avoid paying a commission to buy and a fee to sell. There was one condition though. In order to avoid all of these commissions or exit fees you had to promise to leave your money at the fund company for a full seven years. If you sell within that time you may have to pay a significant exit fee.

Despite the possibility of an early exit fee, this was a good deal for the client as the back-end option could now easily avoid the lofty front-end commissions of the time. 

A reader by now may have gathered the crux of the problem for advisers. Advisers have eliminated the front-end load on mutual fund purchases so that clients do not have to pay commissions to buy or sell a mutual fund.  If this is the case, why buy a back-end mutual fund? 

A no-brainer. You want the mutual fund with a front-end set at 0% commission - the one without conditions attached to it. To no one’s surprise, back-end load fund purchases are declining in popularity.

Commissions are disappearing or have disappeared which means it is far cheaper to buy a mutual fund today than it was 25 years ago. However, an interesting question arises. Why have commission based advisers cut their own commissions? 

The answer is straightforward. Advisers are quite happy to receive just the 1% annual trailing commission paid to them from the fund company. 

The 1% commission (sometimes referred to as a service fee or trailing commission) is a type of asset based fee. The interest of the adviser and the client is now aligned. If the value of the client's account goes up, then the adviser receives higher compensation. If the client’s account value goes down – the adviser also feels the pain. Since there are no buy or sell commissions to worry about¹, the problem of account churning has essentially, been eliminated because the adviser is receiving a regular stream of asset based compensation and no longer is tempted to churn the account in order to generate  commissions.

¹Front-end load mutual fund purchase set by the adviser to be 0% commission. The mutual fund prospectus allows up to about a maximum 4% front-end load to be charged, but in this case, the adviser sets it at 0%. The 1% trailing commission/service fees are in reference to the “trailer” received from equity mutual funds (stock-based mutual funds). 

You might come to the conclusion - hey that's a great deal! I don’t have to pay commissions anymore because my adviser has waived them and my adviser is still being paid an open, transparent and disclosed fee to manage my investments. What's wrong with that?

Indeed, what is wrong with that. But alas, in the world of securities regulations, life is not so simple. 

The regulator has pointed out that the asset based trailing commission of 1% could represent a potential conflict of interest. 

Well, how about those possible conflict of interest scenarios? Would the 1% trailing commission be considered as an inducement to buy that fund company's products? 

Let's think about that for a nanosecond. Nope. All adviser based mutual fund companies pay about the same trailing commissions of 1% so if they all pay the same then how could it possibly be seen as an inducement? 

So yes, we advisers are having a rough time of it. We have voluntarily reduced or eliminated commissions for mutual fund purchases and now it appears that the 1% asset based trailing commission that many advisers derive most of their income - is now under the intense scrutiny of the regulators and the popular press (gleefully sharpening their knives - intent on eliminating all commissions of any description). 

Oddly, the solution is obvious but in my view, unnecessary. 

We could end the controversy merely by eliminating the word "trailing commission" and call it something else - perhaps a AUM fee (asset under management fee). The word "commission" is now eliminated -problem solved! Everyone declares victory and goes home. The economy gets a boost as legions of lawyers get to rewrite the securities regulations. Certainly, a win-win situation for everyone. 

Heaven help us, there is another but. The press points out that the new proposed AUM fee of 1% is being paid by the fund company. You can't have the fund company pay the adviser because that is a conflict of interest. 

What to do now? 

How are we going to make the perennially unhappy popular press happy? 

Some years back I suggested that the AUM model would become more prevalent. It looks like it might happen sooner than expected. 

Here is the solution. The fund company could strip out the adviser compensation in the mutual fund and then we can force the adviser to charge it to the client! We'll call this new adviser compensation model a fee-based model. 

If the client pays the adviser directly there will be no conflict of interest because the client is handed a bill and has to pay it. Bills are open, transparent and being what they are, bills are generally disclosed to the clients too. Brilliant! 

What is the net economic benefit to the client of the two adviser compensation models? 

Here they are again: 

1. adviser compensation of 1% asset based commission paid by the mutual fund company , zero commissions to client. 

or 

2. adviser compensation of 1% asset based fee paid by the client, zero commissions to the client. 

From an adviser viewpoint, which one is better? 

This is a tough one. In Option 1, I get 1%. In Option 2 I get 1%. Help, my brain hurts! It seems to me that both are the same. Is this a trick question? 

From a client’s viewpoint which one is better? Option 1 or Option 2? 

Let’s ask a client. 

Wait a second! You mean that in Option 2, I have to pay a bill? 

Yessir..that is correct! 

But I am not paying a bill right now. 

You are not paying the bill right now because the price of advice is built into the product. We reduce the price of the product and hand you a bill for the difference in product prices. Isn't that great! 

But I kinda like the old all-in-one pricing. I already know that my adviser is earning a commission for the services he provides... 

Shush! Sorry, we are not allowed to use the "C" word any more. Commissions are out...fees are in. Option 2 means you have to pay a fee out of your pocket but the fees might under certain circumstances be tax deductible. I am not supposed to tell you that by the way. I am not a tax professional. Who knows…in the future…with the budget cut backs, the fees may not be tax deductible after all.

 I am confused. It sounds like I will be paying 1% one way or another. Why bother changing anything? 

Exactly! And I am more confused than you. However keep this quiet. We're changing words and calling commissions something else. We are now calling them fees. It will make the press deliriously happy. Regulators can claim they are looking after consumers interests. Lawyers will make billions! 

-- 

My apologies for my light hearted Walter Mitty moment…just couldn’t resist. 

Back to the serious stuff. 

The raging controversy rages on internally in our industry but for almost all Canadians the differences between a transactional versus a fee based account is hardly worth discussing at the next cocktail party. 

My view is that a zero commission based front-end mutual fund purchase is very close to a fee-based account without all of the complications. 

Although the press delights in skewering the traditional commission based model, the asset based model is nowhere near a panacea it is painted to be. The U.S. industry has used fee-based adviser compensation for a much longer time than in Canada and there has been a number of problems, issues and yes, even lawsuits from clients suing their advisers regarding fee-based accounts. 

Here are some cons about the new proposed fee-based accounts to think about: 

1. Adviser fees may be higher than the old commission structure. For instance, fixed income funds (bond funds) have generally lower compensation than equity (stock -based) mutual funds. Advisers will be forced to charge 1% fee where previously the commission was only a half percent (0.5%). I have to ask the following question to the press about their anti-commission campaign; why is a high fee always better than a low commission? 

2. Why put clients in stock mutual funds that can drop up to 60% in value (Does anyone remember the S&P dropping almost 60% in 2009? An adviser could put all of the client's money into a money market fund and collect his 1% per year and not have to worry about the stock market. The adviser makes the same amount of money, say 1% whether the account is ultraconservative or not. So why take chances? Fee-based accounts as a result, may be dumbed down to help preserve the adviser's steady stream of fee-based income. Hmm..sounds like a conflict of interest to me. Weren't fee based accounts supposed to eliminate conflicts of interest? 

3. Since fee-based accounts are based on assets under management, would an adviser encourage a client to make a very substantial charitable donation, or make a large real-estate purchase? Advisers will be continually worried about losing assets from fee based accounts and make recommendations that may not be to the client’s benefit. 

4. In a fee-based account, the adviser's firm generally puts limits on the number of transactions (in order to save costs) that can be done in this type of account. That can be good or bad however there are some lawsuits in the U.S. concerning the charging of fees with no activity in the account. Will advisers be sued if they recommend doing nothing if nothing is the best thing to do? How about his scenario? The adviser just doesn't bother to do any work on the existing accounts and his or her business model is to collect new clients and new assets only. That 1% per year is coming in every year whether the adviser works for it or not. 

5. High Net Worth clients (HNW). Rich people are funny. Thankfully, I am not one of them. Their concept of percent of assets is often different than the ordinary joe.  HNW clients tend to think of gross dollars spent rather than in percentage terms. Will a HNW client pay a 1% annual fee on a sizeable account? Perhaps not. They may be willing to pay perhaps as little as 1/10th of that. Brokerage firms and Dealers may face increasing price pressures vying for the same HNW client. 

6. If fee-based revenues become increasingly tight, firms will have to compensate and charge fees on products where there are none currently - like GICs or high yield savings accounts. Undoubtedly, there could be pressures to charge management fees on all assets or perhaps even charge fees for holding cash when the stock market takes an occasional scary dive. 

7. The little guy. How are you going to charge asset based fees on a $100 a month investment plan? The small or new investor will not be able to afford it because fee-based account minimums are quite high, usually starting at $100,000 or so. If we make mutual funds unaffordable, these clients will go elsewhere for cheaper alternatives. 

So where do we go from here? Despite the question marks I’ve raised, it looks like the fee-based compensation model will be given the nod. Commissions will be eliminated and be replaced with fees. The fee-based account does appear to have an economic benefit for high net worth investors who have the bargaining power to reduce their fees. For the rest of us, I think the current system is fine. We have mutual fund compensation structures for small and large investors alike and fee-based accounts are nothing new as we already have had this option for several years. 

Hopefully, this article has shown some of the cons of fee-based accounts but I am of the view that more choice is better. I am all for reform but eliminating all of the traditional commission structures may not be of benefit to everyone.

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Written by Glenn Szlagowski - Financial Adviser

Category: Newsletters

Published: 28 March 2013

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Media hurting investor returns?

"As a percentage of total mutual fund assets, [low MER] index funds have nearly doubled their market share over the last decade, exposing many more investors to an investment style the record shows woefully underperformed its competition." .... Christopher Carosa CTFA 

For those investors that drank the media Kool-Aid of "lower cost is always better", Carosa brings up a good point. The "lost decade", a phrase coined by the media themselves, spawned an endless stream of articles about how poorly investments did during the decade of 2000 to 2010 (the lost decade). As the following article points out, the media's focus on low cost investing during that time frame turned out to be bad advice.  

Source: http://fiduciarynews.com/2010/01/does-the-%E2%80%9Clost-decade%E2%80%9D-signal-the-end-of-passive-investing/?utm_source=FiduciaryNews&utm_medium=401kPlanSponsorsandtheMutualFundExpenseRatioWildGooseChase&utm_campaign=070312y 

I can add a further point to the author's thesis by asking a simple question: How many investors actually managed to hold their index investments for the full 10 years? Very few, if history is any guide and the actual rates of return for the index mentioned in Carosa's article is likely to be much lower than stated. 

Quantitative research is widely available for mutual funds - likely due to their sheer popularity but research is largely absent for the holders of index or other ETFs. The prima donna of financial research firms is DALBAR and their 20 + years of study indicate that due to certain behavioral patterns, the average investor severely underperforms their own investments by likely buying high or worse - selling low. DALBAR goes on to say the one of the significant factors in investor underperformance is "inappropriate response to media". Unsurprisingly, the media's propensity to urge their readers to buy at market peaks or sell at market bottoms is all too well known. DALBAR's well-respected research tells us that the average investor loses up to several percent per year by engaging in inappropriate investing behaviors. 

"The Media's job is to sell advertising, not provide you with intelligent advice.".... Barry Ritholtz ( The Big Picture ) 

The media's position is that they are informing and educating readers but all too often, it can be easily undone when the headlines are screaming buy or sell. So if the average investor is buying at market peaks – remember the tech wreck? or selling at market lows ( U.S. Financial Crisis of 2008 – 2009)? - who should we be blaming for ill timed, emotion based investing that decimates investor's returns. Yes, it is likely the media and they are guilty as charged. 

Recently, the media has printed a number of articles suggesting that low cost investing without an adviser is a sure-fire way to riches. 

Is that good investment advice?  Is it good reporting? Should a reporter be neutral and unbiased in writing financial articles? 

Personally, I think they should be held to the higher journalistic standards of yesteryear, but lately I am seeing editorials or rants disguised as articles in some of Canada's finest business newspapers. 

And no, I do not agree with the media's view that investing is easy if you just pick the cheapest investments and dump your adviser. That is just wrong.  

Overall, is the media helping or hurting investor returns? Based on a number of recent articles I am seeing, I think the latter possibility is the most likely.