Tuesday, May 24, 2011

Financial Advisors vs. Money Managers

By: Bert Whitehead, M.B.A., J.D. Copyright 2011

Recently an ACA member’s client emailed me to comment that we were being paid to manage assets – stocks, bonds, real estate, etc. - and that I should be suggesting some opportunities to help increase his portfolio during these exciting times. This is a widespread attitude among clients, and I think it is a fair comment and merits addressing.

There is a significant difference between ‘Money Managers’ (or ‘Investment Advisors’) and ‘Financial Advisors’ (or ‘Financial Planners’). Money Managers generally charge based on the size of a client’s portfolio, i.e. assets under management (AUM). They claim to add value by finding ‘opportunities’ for clients and timing the market. Some claim they also advise clients on insurance, estate planning, taxes, etc., but they generally are not adequately trained in these areas. Moreover, people generally do what they are paid to do, and if they are paid based on AUM, they focus on gathering assets and new, exciting investments.

Financial Advisors take a much more comprehensive approach. We are trained and credentialed to coordinate all of the financial aspects of a client’s life, with a focus on meeting their life goals. Certainly investments are an important part of this, and our job is to recommend and monitor suitable Money Managers for clients. To do this we use the principles of “Functional Asset Allocation” (FAA) and eschew the ‘carnival barker’s’ approach of touting the ‘next hot stock’, or the next investment “frontier”, or other market timing approaches.

Many new advisors start out with the belief that they can add value by selecting investments. I’ve been at this for 39 years, and when I started out I tried to convince clients that I could add value by my superior investment knowledge. I managed portfolios of covered options, came up with strategies using fundamental principles for building portfolios, used technical analyses to determine when clients should switch asset classes, etc.

In my early career, I did beat the market a couple of years in a row…and then I got whipsawed and was grateful to be able to get my clients’ funds out while they were still ahead. Given that there are thousands of professional investors in the market, the theory of large numbers will always produce some who consistently beat the market year after year.

Indeed, Peter Lynch managed Fidelity Magellan for 13 years and reportedly beat the S&P for 11 of those for an average 29% annual return. The smartest thing he ever did was to quit while he was ahead. His successors used his same formulae and strategies and have underperformed the market ever since.

(It’s also worthwhile to note that during those years the S&P index was the highest performing general index for only one year. For four of the 11 years the small cap index dominated, international stocks won in 5 of those years, and bonds won out the other 3 times.)

Interestingly, most ‘financial advisors’ are really ‘investment managers.’ Their proposition is basically: “Give me your money and I’ll make you rich!” When I look up and down the street, from small financial firms to large wire-houses, they all make the exact same claim: “We’re smarter! We know how to beat the market!” As a matter of fact, most newer advisors, as well as day-traders, stockbrokers and insurance sales people, ultimately pin their success on their ability to convince themselves and their clients that they can produce superior results.

At some point we have to realize that we don’t live in Lake Woebegone, where all the children are above average. Every investment guru in the phone book can’t be beating the market at the same time unless they have a Madoff scheme.

I happened to visit Wall Street during Lynch’s era and saw the office buildings filled with people and computers. They spent most of their working lives trying to figure out the best investments. How would I ever be able to outsmart them? When I researched this more closely, I was struck by the fact that the S&P index outperforms 85% of large cap money managers!

When I delved into managers who claimed to beat the market and carefully analyzed their performance, I noticed that their success was based on fudging the indexes or benchmarks they used. Many managers today are ‘closet indexers’ who invest most of their clients’ money in line with an established index but with small modifications that, they hope, will help outperform the index.

I finally realized that most investment managers were charging extremely high fees because they could convince their clients – and their clients wanted to believe – that they produced higher returns. John Bogle’s new book (“Enough: True Measures of Money, Business and Life”) is a classic expose of how the financial industry has overcharged consumers by creating the myth that there really are gurus out there who can improve investment performance because of their advanced understanding of markets.

Take note that, of the thousands of studies done in academia, and by pension funds and investment houses, there has never been a single study that has shown that any market-timing scheme worked consistently. All the credible studies have shown that the keys to investment success are consistent investment, reinvesting profits, and basic diversification. Investors who jump from one investment to another, or even one asset class to another, consistently show lower returns than the market. Much of these inferior results are due to excess transaction costs, taxes, and not being invested during up-markets because of wrong decisions based on fear and greed.

This is when I developed FAA. I found I didn’t have to decide what the next hot stock was, or if interest rates were going up or down, or if small cap stocks were going to beat large cap stocks. All I had to do was balance my clients' portfolios to include a range of large cap, small cap, and international diversified no-load mutual funds or index funds. This portfolio features a rock solid bond-ladder as a foundation to keep clients from jumping in and out of the market every time they listen to Jim Cramer tout the stock du jour on his nightly investment circus.

The real value added by FAA is due to the comprehensive approach used to grow client portfolios. Real estate is regarded as a key asset, clients are coached to not do stupid things, inflation is dealt with intelligently, a bond ladder is used as a hedge and to assure consistent cash flow, wealth is preserved by cutting losses, behavioral obstacles are addressed, and tax strategies are employed to improve overall investment return.

The key advantage for my clients is that, no matter what new investment frontier is touted as “hot”, our clients are already invested in it because they stay balanced. When I look back at the thousands of successful investors I have known, none of them did it by ‘smart investing.’ Most wealthy people attain wealth by investing ‘sensibly’ and avoiding stupid mistakes. The worst stupid mistake is to start believing in carnival barkers.

The unique perspective of ACA members comes from being able to advise a client from a comprehensive view of their situation, which requires a higher level of credentials than is available in a field dominated by sales people. We can include tax advice along with investment strategies, sensible insurance approaches to enhance estate planning, etc.

The major problem in financial advice is not the lack of ideas about new opportunities. The fact remains that the majority of financial advisors are not true fiduciaries and are incentivized to give advice that is better for their own pocketbooks rather than their clients’.


Note: This review has been helpful in that it made me realize that many of the strategies we do use are unique and don’t require market timing (e.g. Cambridge Index, the no-lose Roth conversion, etc.) I will elaborate more on those in the future.



I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.

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