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Weekend Reading for Financial Planners (Mar 3-4)

Posted by Michael Kitces on Friday, March 2nd, 8:03 pm, 2012 in Weekend Reading

Enjoy the current installment of "weekend reading for financial planners" - this week's edition highlights an intriguing analysis from Morningstar's new number crunching on investor returns, finding that investors may not actually be chasing hot mutual funds nearly as much as previously believed, along with the latest contribution by Miccolis and Goodman to the Journal of Financial Planning, this time focused on the problems with measuring correlation. From there, we look at a few industry articles, from the possibility that FINRA may open up BrokerCheck data to private vendors to better get information to investors, to Mark Tibergien suggesting how to determine which parts of your firm you should or should not outsource. On the investment side, the focus turns to PIMCO's launch of an actively-managed ETF version of their flagship PIMCO Total Return fund, a primer on how the Euro breakup might go (it's not as bad as the media makes it out to be), and the latest quarterly letter from Grantham. We also look at two interesting recent articles from the New York Times, one by Robert Shiller on how high IQ investors actually invest differently, and another discussing how companies study shopper habits to market more effectively, and conclude with a quick review of the latest US News and World Report "Best Jobs in 2012" ranking which lists Financial Adviser at #23. Enjoy the reading!

Weekend reading for March 3rd/4th:

The Math That Matters: The Idea That Investors Care Mostly About Chasing Hot Funds Is Clearly False - This startling article by Don Phillips of Morningstar takes a look under the hood at the correlations between mutual fund flows, and various metrics from fund ratings to returns. The results are somewhat surprising. The Morningstar research found a 19.6% positive correlation between fund flows and total returns over the past 10-year period - in other words, funds with better long-term performance were attracting assets, not the funds with the best marketing or short-term results. Furthermore, the correlation between fund flows and investor returns - essentially, returns weighted by the amount of dollars that investors have in the fund - exhibited a whopping 49% correlation. What this means is that investors are rewarding companies who are providing good investor results, and punishing those who give bad results; investors aren't chasing hot funds, but instead are "behaving in a perfectly rational way... returning to places that have produced good investing experiences for them and moving away from firms that have tempted them to buy high."  Phillips' conclusion is that funds, advisors, and the media, would all be better served to focus on long-term returns, not short-term results, as the long-term winners in returns are ultimately the long-term winners in asset flows, too.

Be Careful With Correlation! - This article in the March Journal of Financial Planning, a continuation in the series by Jerry Miccolis and Marina Goodman of Brinton Eaton Financial Advisors, discusses the difficulties with correlation - especially the problem with using a single long-term measure of correlation. The article suggests that using a shorter-term rolling correlation - such as correlation over the trailing three years - provides a better picture, highlighting both longer term trends like the increasing correlation between domestic and international equities, and abrupt changes in relationships, like the dramatic increase in correlation between equities and commodities since late 2008. In addition, the article suggests that it may be better to look at not just the correlation number itself, but a scatterplot of the returns of asset A versus asset B, which can allow the eye to see non-linear correlations that may not be captured with the raw statistic. The bottom line: misjudging correlation can result in dramatically over- or under-estimating the true diversification of the portfolio, so it pays to dig deeper. 

Turning Inside Out - In his monthly contribution to Investment Advisor magazine, Pershing Advisor Solutions CEO Mark Tibergien discusses the outsourcing trend, and more specifically how advisors can decide what to outsource versus keeping in house. The basic principle is straightforward: "Activities that are core to your brand and offering should be managed in house while those activities that are incidental or supplemental to your vision and strategy make good choices for outsourcing." As a result, Tibergien highlights that for some firms, it makes sense to outsource investment management but retain financial planning; in other situations, it may make more sense to outsource the financial planning, if that is not a core aspect of your brand value. Beyond that, Tibergien also notes that outsourcing can make sense simply because it allows for more flexible, variable costs that scale with the business' needs, instead of hiring for a position and then creating the pressure to generate enough growth to validate the entire cost of the new staff member.

FINRA May Give Up Lock On BrokerCheck - This article from InvestmentNews discusses a recent public comment request earlier this month by FINRA on the idea of giving private vendors access to information in BrokerCheck, as a part of a wider restructuring underway for BrokerCheck after an SEC study last year recommending improvements. By releasing its proprietary grip on the data, the hope is that third party services like BrightScope could provide more effective information and disclosures to the public about brokers. The wider availability of the data could also allow for greater overall analysis of the industry and various firms; for instance, determining which broker/dealers have the highest rate of complaints against their representatives. On the other hand, some fear that open access to the data could lead to it being abused against advisors. At this point, FINRA is only requesting comments on the possibility of opening up BrokerCheck - it's possible the initiative could fail - but it's an intriguing thought that in the future, if an investor simply types an advisor's name into Google, misdeeds could actually come up as the top listing through a site like BrightScope.

Bill Gross Brings Active Management to PIMCO Total Return ETF Launch - This article discusses the launch this Thursday, March 1st, of TRXT, the ETF version of PIMCO's flagship fund the PIMCO Total Return Fund managed by Bill Gross. The PIMCO ETF appears to be the first in what will likely be a new wave of actively managed ETFs coming down the road soon - ostensibly with a goal of making the funds even more accessible, without the minimums often placed on mutual funds. Nominally, the ETF version of the fund will implement the same strategy as the mutual fund itself, but may not overlap perfectly given that the mutual fund also uses some derivatives to manage exposure (not allowed in the ETF), and bond positions in the new ETF may not perfectly match those in the existing mutual fund. Perhaps most notable, though, is the fact that this actively managed fund will be transparent, with positions disclosed on a daily basis. In a world where PIMCO's monthly disclosures of its bond fund - and the implied outlook of Bill Gross on the direction of the markets - can already move markets, will the PIMCO Total Return ETF be able to actively manage effectively without having investors use the transparency to front-run Bill Gross's portfolio shifts? Only time will tell.

A Primer on the Euro Breakup (free registration req'd but worth it!) - This article from John Mauldin's Outside the Box column by Joanthan Tepper of Variant Perception provides a walk-through for how a default, exit, and devaluation would work for a country leaving the Euro. The article highlights that in reality, many countries have left currency unions of some sort or another over the past century, and significant guidance and roadmaps now exist about how to do it properly, in a manner that is not catastrophic and allows for rapid recovery thereafter. However, Tepper also notes that the problems may be worse in Europe than in many prior examples, due to both the sheer imbalances in much of peripheral Europe, and the high amount of external debt levels that would be impacted by the process; consequently, while European countries could theoretically default without leaving the Euro, only exiting the Euro can restore competitiveness. Nonetheless, Tepper advocates that ultimately, exiting the Euro can be done in an orderly manner, and may ultimately allow growth to be restored rapidly with a flexible exchange rate.

The Longest Quarterly Letter Ever - The highlight of Jeremy Grantham's quarterly letter (yes, it's long, but no, it's not that long) is the first section, which includes his advice to investors phrased in the style of Polonius' advice to his son Laertes in Shakespeare's Hamlet. Grantham's insight is keen, especially in acknowledging the challenges that professional advisors face in the career risk of going against the crowd, even when it's the right thing to do. Grantham also shares some thoughts on capitalism and its current challenges, and some thoughts on the investment outlook over the past year and going forward from here.

What High-I.Q. Investors Do Differently - This article by Robert Shiller from the New York Times discusses a recent article published in the December issue of the Journal of Finance called "IQ and Stock Market Participation", exploring how people with varying IQs tend to invest. The results were striking; even after controlling for factors like income and education, those with high IQs tended to diversify more, own more in stocks, favor small-cap stocks, and favor stocks with favorable book/price ratios. The results don't suggest that those with high IQs are necessarily good stock-pickers; simply that they are better at following many of the basic rules of prudent investing. On the other hand, the article also notes separate research showing that people who trust more (just in general), are more likely to invest in the market and have diversified investments (perhaps because they are more likely to work with advisors). The conclusion of the article: if we can foster more trust in investment proefssionals overall, a wider spectrum of people - regardless of their IQ - might adopt a more successful investment approach.

How Companies Learn Your Secrets - This article from the New York Times discusses the intriguing intersection between our shopping behaviors, how marketers communicate to us, and habit formation. The focus of the article is on Target, which many years ago hired a statistician to try to determine, based on what shoppers were currently buying, which might be pregnant. The opportunity was not only to then send coupons to expecting mothers for baby goods, but also because new parents tend to change many of their shopping habits when the baby arrives, creating a huge opportunity for stores to pick up more of their shoppers' wallet shares. And the research worked; so well, in fact, that Target actually decided to back off how blatantly it was communicated coupon opportunities based on how much it had figured out regarding its shoppers. In between, though, the article shares interesting research into the science of habit formation, and what we know about how habits are formed, changed, and broken. One wonders how some of this habit formation and shopping science could be applied in a financial planning context as well.

Best Jobs 2012: Financial Adviser - This article from US News & World Report highlights the fact that "Financial Adviser" ranked 23rd on the top 25 best jobs for 2012. The US News research suggests that despite the recent market difficulties, financial advising is poised for significant growth in the coming decade, as the Bureau of Labor Statistics projects a 32.1% growth rate in jobs from 2010 to 2020. The article notes a median wage of $64,750, with the 75th percentile earning $111,990 and the top 10% earning more than $166,400. The article also recommends earning the CFP certification and joining the Financial Planning Association, and highlights the role of financial advisors as being "like life coaches, but for your money."

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!

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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