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Weekend Reading for Financial Planners (Apr 28-29)

Posted by Michael Kitces on Friday, April 27th, 5:00 pm, 2012 in Weekend Reading

Enjoy the current installment of "weekend reading for financial planners" - this week's edition highlights the big industry news: legislation proposing that all investment advisors be regulated by an SRO, with an implication the SRO would be FINRA, although another new SRO (perhaps SROIIA?) could fill the void instead. Continuing the theme, we also look at an article by Don Trone exploring how we might measure just how much of a fiduciary an advisor really is. From there, we have a brief look at the other 'big' news this week - the release of Google Drive - and why advisors should steer clear, at least with their client and business files, along with a review of the last article from this month's Journal of Financial Planning, building on the idea that the best withdrawal strategies should not just defer pre-tax accounts as long as possible but instead should whittle them down bit by bit over time. Next, we look at three practice management articles: one about how firms are increasingly developing talent in-house because the young advisor shortage is putting upward wage pressure on hiring from the outside; how it's crucial to have compensation conversations upfront to avoid resentment and problems later; and how hiring friends and encourage friendships in the workplace can actually be a good thing, despite the common taboo. We wrap up with three interesting investment articles: the first from Morningstar Advisor about why absolute return funds are failing to deliver; the second about how to change the Sharpe ratio to better account for real world market risk and volatility; and the third by Jeremy Grantham of GMO, highlighting that as money managers try to manage their career risk and avoid getting fired, they create some incredible market volatility and inefficiencies along the way. Enjoy the reading!

Weekend reading for April 28th/29th:

Bachus, McCarthy Introduce SRO Redraft - This AdvisorOne article highlights the biggest industry news of the week - the introduction by House Financial Services Committee Chairman Spencer Bachus of "the Investment Adviser Oversight Act of 2012" that would shift oversight of investment advisers away from the SEC, to one or more new SROs that would be called "National Investment Adviser Associations" and would report to the SEC, acting on the results of the regulatory study issued by the SEC last year as required by Dodd-Frank. Although the legislation doesn't mandate that FINRA get the job as SRO, the Bachus statement that accompanied the legislation lauded FINRA's record, noting "Customers may not understand the different titles that investment professionals use, but they do believe that ‘someone' is looking out for them and their investments. For broker-dealers, that is true, but for investment advisers, it is all too often not true — and that must change." However, early indications suggest the legislation isn't likely to make it through the Senate this year, and Bachus will not continue as committee chair next year, leaving the ultimate fate of the legislation in doubt. Nonetheless, in response to the proposed legislation, the Financial Services Institute issued a press release supporting the legislationthe Financial Planning Coalition issued a statement against it noting the cost implications of the recent Boston Consulting Group study, and FINRA issued its own estimates of cost to oversee advisors to dispute the Coalition's BCG study. 

Defining Fiduciary In Three Dimensions - This article in Financial Advisor magazine discusses recent efforts by Don Trone of 3ethos to craft a measure of just how fiduciary a fiduciary really is, concluding that ultimately three aspects must be measured: the advisor's adherence to laws and regulations; the advisor's process (you may say you're a fiduciary, but do you have a process to ensure it?); and the advisor's principles and attitudes (do you have the attitude of a fiduciary, regardless of whether you're required to or not?). Ultimately, it appears that Trone hopes to measure how fiduciary advisors are on these three dimensions, and then look at advisor-client outcomes, to try to understand the client impact of being a fiduciary. This article represents an early glimpse of what might be coming on fiduciary research in the future, but more generally it makes some interesting points about the fact that being a 'true' fiduciary is much more than just following the associated rules and regulations.

Google Drive, Financial Advisers Should Drive Right On By - This article by Davis Janowski of Investment News covers the brand new release of Google Drive, which is Google's cloud-based storage and file sharing offering to challenge the likes of Dropbox and similar competitors. Janowski suggests that advisors should steer clear of Google Drive at this point, at least with respect to their business use with client data, due to questions about Google's privacy policy and what it can or cannot do with the data - an issue technology consultant Bill Winterberg also raised on his blog this week. On the other hand, Janowski notes that the offering is free, Google is generally very innovative and collaborative, and consequently suggests that Google Drive may still be a fine option to consider for personal use. Just steer clear of it with client data, at least until some compliance experts weigh in on whether Google's privacy policy would be considered a confidentiality risk or breach by any of our industry regulators.

Tax-Efficient Retirement Withdrawal Planning Using a Comprehensive Tax Model - This article in the Journal of Financial Planning explores the impact of various tax-sensitive withdrawal strategies for producing retirement income, using as accurate of a tax model as possible based on current tax laws. The article finds that the standard common rule - use taxable assets first and tax-deferred assets last to maximize tax-deferred growth - actually does not always produce the greatest value over time. The article finds an optimal strategy of taking pre-tax account withdrawals sufficient to absorb available deductions (although taking enough to fill the 10% bracket is a close second), then to tap taxable assets, then tax-free assets, drawing upon the remaining pre-tax investments last. The effectiveness of the strategy relies upon stability of taxable income to maintain relatively low tax rates throughout retirement, which is why tax-free assets are liquidated before pre-tax accounts are fully spent (but always after taxable accounts). For those who want to see the gory details of the comparison across 15 different strategies, the article includes extensive charts and supporting discussions; those who just basic to focus on the conclusions and applications, just read the Executive Summary, Research Design (to understand the abbreviations the authors use), and the Conclusion section at the end.

Building A Talent Hothouse - This article from Investment Advisor magazine by Dan Inveen and Eliza Depardo of FA Insight discusses the latest results from their research, showing how it is increasingly difficult for firms to attract high-quality experienced staff - and as a result, firms are increasingly focusing on growing and developing their own, in-house. The underlying problem driving the environment is demographics - with two associate advisors coming into the industry to replace every three lead advisors exiting/retiring, the squeeze is on, as low supply of young talent pushes up prices (wages) required to attract and retain them. The best firms operate with three levels of professional staff (support, associate, and lead advisors), have a clear career track about how individuals can progress through those levels, and spend resources on personal development for those staff members (with an individualized development plan), to cultivate their homegrown talent.

The Dangling Conversation - This article by Mark Tibergien from Investment Advisor magazine discusses the ramifications of the all-too-common dangling compensation conversation - where failure to confront compensation problems head-on usually results in worse problems down the road. The communication generally breaks down as the employee becomes convinced he/she is critical to the success of the firm, while the manager/owner tries to balance the needs of the employee with the needs and profitability of the firm. Ultimately, the miscommunication often boils down to the fact that employees tend to view what they're paid as a statement about their value, while the manager tends to set pay in light of the firm's financial situation. The article provides an excellent example of a classic employee-employer conflict, with an example of how a challenged firm owner ultimately navigated the situation.

A Friendly Face - Continuing the discussion of hiring practices, this article by practice management consulting Angie Herbers explores how hiring friends, often considered a business taboo, can actually be a very effective strategy. While Herbers acknowledges many of the classic challenges of such situations - such as perceived favoritism from other employees - can be problematic, it still pales in comparison to the difficulties that arise from non-friend employees who don't get along with the boss or co-workers. The key is that for the most part, according to Herbers, is that happy employees are great employees, and employees who are friends and/or develop friendships in the workplace are happier, so workplace friendships should be encouraged - and it's even easier to cultivate such situations by hiring those we have a relationship with already. On the other hand, limits should still apply to friendship, even in a healthy business context. Herbers lays out suggestions and pitfalls for each of four friendship situations - friendships between employees, hiring friends of employees, friendships between the employee and employer, and hiring friends of the owner.

Why Absolute-Return Funds Fail to Deliver - This article from MorningstarAdvisor explores how many absolute-return funds may be so flawed in their design that they are virtually doomed to fail from the start, and the ongoing failure of the majority of absolute return funds to deliver on their promise suggests the prophecy is already fulfilling. The article notes that broadly, absolute return strategies fall into three buckets - equity strategies that can go long or short the markets, debt and currency trading strategies, and open-ended "Go-Anywhere" strategies that simply try to buy whatever is going up and avoid (or possibly, short) whatever is going down. The problem, as the article notes, is that few of these strategies are actually implemented in a market-neutral, zero-beta approach, and consequently they are very prone to strong directional market movements. Unfortunately, though, very neutral strategies - in the midst of a low return environment - can be difficult to implement for absolute returns due to ongoing costs and fees (which can be a large percentage of return given low yields). Strictly speaking, this doesn't mean that absolute returns funds couldn't be designed in the future; Morningstar's primary point simply seems to be that, especially when leaving exposure to beta, calling it an absolute return strategy doesn't make it so.

Building A Better Sharpe Ratio - This article by James Picerno in Financial Advisor magazine takes a hard look at the Sharpe Ratio, a measure of reward-to-variability that Picerno suggests not only falls well short of capturing the full spectrum of risks, but deserves a higher level of scrutiny given its near celebrity status as a performance measure in the industry. Picerno suggests looking at two recent extensions of the Sharpe ratio: "modified" Sharpe (which incorporates non-normality measures of skewness and kurtosis) and "conditional" Sharpe (which further incorporates how severe extreme events could be and how far out the 'fat' tail they might extend). The article concludes by pointing out that there's risk in the process itself of trying to estimate risk, as emphasized by some of the complexity of these measures. Nonetheless, the article provides a good look with some "moderately heavy" math about more advanced ways to look at risk and try to assess returns relative to risk.

My Sister's Pension Assets And Agency Problems - In his quarterly letter, Jeremy Grantham of GMO provides an intriguing discussion of the role that career risk plays in the business of managing money. As Grantham notes, in the end money managers - as any human being - want to keep their job, and the best way to do this is to ensure that you are never, ever wrong on your own. Accordingly, money managers tend to herd together and "go with the flow" to avoid the risk of being wrong alone and getting fired - and in the process, create momentum effects, bubbles, and drive investment prices far above or below fair value, resulting in volatility that is 19 times greater than what would be expected by economic changes alone. Grantham also notes that clients will tend to be more patient of these trends if they start during good years than bad years, and that the primary value of client relationship management is extending the number of years that clients will be patient in the face of abnormal market momentum. Grantham goes on to discuss how investment constraints have played out when comparing investing a family member (his sister's pension) versus institutional funds on behalf of his firm, and wraps up with a good conversation about Sharpe ratios and his investment outlook.

I hope you enjoy the reading! Let me know what you think, and if there are any articles you think I should highlight in a future column! And click here to sign up for a delivery of all blog posts from Nerd's Eye View - including Weekend Reading - directly to your email!

  • Tim Kober

    It is important to note that the draft SRO proposal “recognizes the authority given to the states over small investment advisors in Title IV of the Dodd-Frank Act by preserving state authority over investment advisors with fewer than $100 million in assets under management, so long as the state conducts periodic on-site examinations.” This raises the possibility that the SRO (assumed to be FINRA) would adopt *rules-based* regulation while the states and NASAA continue to use *principles-based* regulation.

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Michael E. Kitces

I write about financial planning strategies and practice management ideas, and have created several businesses to help people implement them.

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