Articles About Investments

As financial advisors increasingly adopt ETFs, the wholesale shift from actively managed mutual funds to passive investment vehicles is driving more inflows to ETF providers like Vanguard and Blackrock and State Street and than all other mutual fund families combined… and leading mutual fund companies into a mad scramble to figure out what they have to do to once again appeal to financial advisors.

Yet the reality is that, with the rise of the internet, the fundamental role of the financial advisor themselves is changing. In a world where consumers can purchase virtually any publicly traded investment online themselves, financial advisors are compelled to add value above and beyond “just” bringing third-party mutual fund managers to the table. In fact, an increasing number of financial advisors appear to be “coping” by eliminating third-party managers, and instead becoming the investment portfolio managers themselves.

In this context, the rise of ETFs is not so much about a shift from active to passive, but simply a recognition that when financial advisors build investment portfolios, we prefer to do it using ETFs as our “building blocks”, rather than individual stocks and bonds. Although in point of fact, a recent FPA Trends in Investing Survey revealed that advisors are increasingly building portfolios with ETFs, and stocks, and bonds, and even private equity funds – anything except third-party mutual funds. Which just helps to show how the shift from active to passive is really just a mirage; what’s really occurring is a process where financial advisors are remaining active, but disintermediating mutual fund managers and going hands-on to actively build the portfolio themselves, whether as an independent RIA, or under a Rep-As-PM arrangement in a broker-dealer.

Of course, the caveat is that just as many mutual fund managers have struggled in an increasingly competitive market for alpha to outperform their benchmarks, there’s no indication that individual financial advisors are any better at the process. Which means ultimately, the financial-advisor-as-investment-manager shift itself may be short-lived, as advisors further shift to providing financial planning value outside of the portfolio altogether. But until financial advisors get to the point that the majority of us truly view our value-add as going beyond the investment portfolio – where a bona fide shift to passive investing may gain further traction – the ongoing rise of ETFs will remain less about a shift to passive itself, and more about how financial advisors are defending their own fees by squeezing out the costs of the investment products they use for client portfolios!

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This week is the first that financial advisors must operate under the Department of Labor’s fiduciary rule, subject to Impartial Conduct Standards which require that they must give best interests advice, for reasonable compensation, and make no misleading statements. While much has been said about the impact this will have for advisors and their clients, there’s also a not-well-discussed secondary shift that will be triggered by the DoL fiduciary rule, which will impact actively managed mutual funds and their performance in the coming years – in a “surprisingly” positive way.

In this week’s #OfficeHours with @MichaelKitces, my Tuesday 1PM EST broadcast via Periscope, we discuss how the DoL fiduciary rule will likely end out causing an improvement in the return performance of actively managed mutual funds, thanks to the rise of clean shares and a shift in how brokers are compensated for recommending such funds!

Most predictions about the likely impact of the Department of Labor’s fiduciary rule is that it will lead to a (continued) decline in the use of actively managed mutual funds, and support the ongoing rise of passive ETFs, thanks to the fiduciary rule’s focus on low cost. But the truth is, that there actually is no requirement in the DoL fiduciary rule that financial advisors eschew actively managed funds and switch to lower cost passive funds. The only real requirement is that if an advisor is going to use an actively managed fund, that there needs to be a clear reason and justification for paying that active manager’s fee. And if you can make the case for the active manager, there’s nothing wrong with using the actively managed fund.

There is, however, a requirement to use the lowest cost share class if multiple share classes of the same fund are available. This is why we’ve seen the launch of T shares and clean shares – which either pay a uniform 2.5% upfront commission and 0.25% trails, or eliminate commissions entirely with the broker-dealer then wrapping a levelized commission around the whole fund or account. And this matters, because mutual funds currently have to report their performance net of commissions and broker compensation. But as broker-dealers shift to being compensated by levelized commissions outside of the funds (even if the consumer still pays a 1% fee via the broker-dealer equivalent to the 1% trail in a C share), the mutual fund itself will no longer have to count the broker’s compensation against their own performance!

And this is important because a lot of mutual fund managers have not been underperforming by the amount of the manager’s fee, but instead, they’ve been underperforming because of the drag of the broker’s commission compensation. Which means, “suddenly”, we’re going to start seeing the average actively managed mutual fund begin to improve on its performance… starting this week, with the rollout of the DoL fiduciary rule (and the rapidly rising adoption of clean shares in particular). Not because mutual fund managers are necessarily managing any differently or better, but simply because they’re no longer paying broker compensation out of their own performance track records! Ironically, this may even handicap RIA performance reporting relative to brokers, given that brokers typically point to mutual fund performance (which will not include the broker-dealer’s level commission payout) instead of account performance, whereas advisors in an RIA that want to market GIPS-compliant performance track records will still have to follow specific rules requiring a full accounting for fees.

In the end, this shift may still result in a roughly-similar total cost to consumers – whether it’s a 1% AUM fee, a 1% commission, or a 1% broker-dealer payout wrapped around clean shares – but the net result nonetheless is that with a shift to clean shares, reported performance for actively managed mutual funds is going to start looking better. Which means in a few years, we may suddenly be talking about how much better actively managed mutual funds are doing again. But it won’t be because “the pendulum swinging from passive to active”… or because that’s when the Fed started accelerating their rate increases… or whatever else happens economically from here. It will be because DoL fiduciary reconfigured how brokers get paid, reducing the need for 12b-1 fees, reducing the expense ratio of actively managed mutual funds, and improving the reported performance of the mutual fund itself!

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Historically, different financial advisors operated different business models depending on their industry channel – RIAs managed investment portfolios, while wirehouses sold proprietary products and securities from their inventory, and independent broker-dealers sold third-party investment products. Accordingly, asset managers and product manufacturers aligned their investment wholesalers to those channels, with one for wirehouses, another for independent broker-dealers, and a third for the independent RIA community. The challenge, though, is that as the advisor value proposition evolves, along with industry business models, and the regulatory environment, the “traditional” industry channels are breaking down as a way to segment financial advisors!

In this week’s #OfficeHours with @MichaelKitces, my Tuesday 1PM EST broadcast via Periscope, we discuss, from the investment wholesaler perspective, the four different types of financial advisors that have emerged, how they differ based on client approach and value proposition, and how wholesalers can best add value to these different types of advisors!

The key issue is to recognize that financial advisors tend to have fundamentally different ways in which we frame our own value proposition, and approach client situations, that are no longer necessarily defined by industry channel. And this matters, because when companies with their own wholesalers are trying to reach advisors, the ways in which an advisor approaches their clients and define their own value proposition heavily impacts what that advisor will and will not see as valuable from their wholesalers!

For instance, some advisors taking a very financial planning-centric approach to clients, while others are more investment-centric. And when it comes to delivering value to clients, some are more advice-centric, and others are more product-centric. Thee various combinations result in four categories of financial advisors: (1) fee-for-service financial planners; (2) investment managers; (3) needs-based sellers; and, (4) asset gatherers.

From the perspective of the wholesaler, it is crucial to recognize that each of these segments receives different value from a wholesaler, and demands different types of products and services. Because if an advisor is an asset gatherer, they are going to want to see a product that can easily help them gather assets… but if they are needs-based sellers, they will want planning strategies and sales ideas… and if they are an investment manager, they will want products that they can manage to demonstrate their own expertise (without outsourcing to other active managers!)… and if an advisor is a fee-for-service financial planner, they will want solutions that help them simplify investment management to free up time to service clients and focus on planning. Thus, investment managers (which might be an RIA or a Rep-As-PM at a broker-dealer) tend to use stocks, bonds, and ETFs, but asset gatherers (which might be RIA or at a broker-dealer) are more likely to use multiple TAMPs and SMA, and fee-for-service financial planners (usually RIAs) will typically just use one TAMP for all of their assets and be uninterested in individual investment products at all!

The bottom line, though, is simply to recognize that the whole advisory industry is in the midst of reorienting itself, and trying to segment financial advisors by wirehouse, broker-dealer, and RIA industry channel no longer works. Advisors are reinventing their value propositions and where they focus, while DoL fiduciary further forces firms to re-draw their lines and tech innovation accelerates these trends. Which means, if wholesalers want to reach financial advisors and add value to them, wholesalers need to pay attention to the four different types of financial advisors!

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In today’s increasingly competitive landscape for advisory firms, financial advisors are looking for any way they can to differentiate. Whether it’s their experience and credentials, specialization or depth of services, or simply the sheer size of the firm, based on its assets under management. After all, the reality is that – justified or not – a sizable reported AUM does imply a certain level of credibility and represents a form of social proof (the firm “must” be good, or it wouldn’t have gotten so much AUM, right!?).

As a result of this trend, though, advisory firms are increasingly pushing the line in counting – or potentially, over-counting – their stated assets under management. Which is important, because not only is overstating AUM a potential form of fraudulent advertising, but the SEC has very explicit rules to determine what should be counted as AUM (or not) for regulatory purposes.

Specifically, the SEC states in its directions for Form ADV Part 1 that regulatory AUM should only include securities portfolios for which the advisor provides continuous and regular supervisory or management services. And while most financial advisors today are regularly working with clients regarding their investment securities, not all advisors are necessarily providing “continuous and regular” services on their client accounts. In fact, if the advisor doesn’t have direct authority to implement client trades (either with discretion or after the client accepts the advisor’s recommendation), it’s virtually impossible to include the account as part of regulatory AUM.

The greater challenge, though, is that the increasingly common offering of comprehensive financial planning services – where advisors provide holistic financial planning advice on all of a client’s net worth – does not mean the advisor can claim all of those assets as regulatory AUM. In fact, most of the time the advisor should not include outside 401(k) plans and other non-managed assets that were advised upon as part of the financial plan, nor the value of brokerage accounts holding mutual funds and various types of annuities (unless the advisor truly provide ongoing management services), nor TAMP or SMA assets (unless the advisor retains the discretionary right to hire/fire the manager and reallocate to another one). In fact, even having discretion over an account doesn’t automatically ensure it being counted as regulatory AUM, particularly if it’s a passive buy-and-hold account, unless the advisor can actually substantiate that monitoring and due diligence is occurring outside of any ad-hoc or periodic client review meetings!

Fortunately, for advisors who want to report some number representing the total scope of their advice – including the amount of assets that don’t count as regulatory AUM – it is permissible to report on Assets Under Advisement (AUA) in the advisor’s marketing and in Part 2 of Form ADV, as long as the advisor can document and substantiate the calculation process. But the fact that it’s permissible to report both AUM and also a (typically large) AUA amount doesn’t change the fact that, when reporting regulatory AUM itself, it’s crucial to report the right number!

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In November of 2016, a joint 18-month study from the State Street Center for Applied Research and the CFA Institute, which combined 200 in-depth interviews with global industry leaders and a survey of 3,300 “investment professionals”, was released, and claimed to have discovered “the hidden variable of [organizational] performance”. Dubbed “Phi”, the research suggested that a combination of the motivational forces of Purpose, Habits, and Incentives was associated with superior organizational outcomes; specifically, the results showed that a one-point increase in Phi was associated with 28% greater odds of excellent organizational performance, 55% greater odds of excellent client satisfaction, and 57% greater odds of excellent employee engagement.

In this guest post, Derek Tharp – our new Research Associate at Kitces.com, and a Ph.D. candidate in the financial planning program at Kansas State University – analyzes the Phi study and delves deeper into exactly what it is, how it is measured, and what conclusions should (and shouldn’t) be drawn from this study.

Because while the researchers did find a statistically significant relationship between Phi (as measured by self-reported purpose, habits, and incentives), and organizational outcomes, client satisfaction, and employee engagement, it’s not entirely clear what the results actually prove.

The challenge, in part, is that the study itself didn’t actually evaluate organizational performance, client satisfaction, or employee engagement! Instead, the researchers evaluated self-reported assessments of organizational performance, client satisfaction, and employee engagement, and compared them to self-reported statistics on Phi (for the entire organization). And this distinction is meaningful, because it isn’t exactly clear that employees make valid or reliable assessments of company-wide motivational forces, nor the entire company’s organizational performance, client satisfaction, or employee engagement — and especially when these employees may not actually even know if clients’ goals are being met (how “organizational performance” was defined), whether clients or satisfied, or whether other employees within a large multinational financial services firm are actually even engaged!

In addition, there’s the fundamental challenge that a correlation between two data points doesn’t necessarily prove causation either. In other words, the fact that high-performing organizations also report higher Phi doesn’t mean the higher Phi caused the better results. Perhaps organizations that are already outperforming simply attract more motivated employees (which means the causality goes the other direction).

In the end, the Phi study did ask some interesting questions and set out with some lofty ambitions to evaluate the impact of motivational forces – a question that is admittedly not easy to study. But until further research can tie Phi to actual outcomes or provide evidence that the self-reported measures are assessing something meaningful in a valid and reliable way, then the conclusions we can actually draw from the Phi research are limited.

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The research on the optimal strategy to generate retirement income from a portfolio has been evolving for decades.

In the 1950s and 1960s, with the initial rise of a portfolio-based retirement, the leading strategy was simply to buy bonds and spend the interest (by literally “clipping the coupons” from the bearer bonds of the time). Until the inflation of the 1970s ravaged the purchasing power of bond interest.

The harsh consequences of inflation on bond portfolios led to a dramatic shift by the 1980s, as retirees increasingly purchased high-quality dividend-paying stocks instead, counting on the ability of businesses to raise prices and keep pace with inflation… which also helps their dividends to rise and keep pace with inflation as well.

The dividend strategy was popular until eventually retirees realized that owning stocks and focusing on the dividends, while ignoring the capital gains, just leads to large retirement account balances that could have been spent along the way. As a result, by the 1990s, retirement portfolio strategies shifted again, to consider a more holistic “total return” approach that incorporates interest, dividends, and capital gains as well.

Unfortunately, though, capital gains may be one of the largest drivers of total return in the long run, but it’s also one of the least stable, forcing the retiree to periodically rely on the portfolio principal as well. Of course, in the end, retirement principal that is unspent is arguably a wasted spending opportunity – where the “optimal” retirement portfolio is for the last check to the undertaker to bounce. On the other hand, given the uncertainty of a retiree’s time horizon – not knowing when you’re going to die – means in practice, the principal can and should be used more dynamically, spending from it in some years but leaving it untouched in others.

Which means ultimately, the modern retirement portfolio will really rely on four pillars for retirement income – interest, dividends, capital gains, and principal. Or stated more accurately, the four pillars of retirement cash flows – since the treatment of the pillars as “income” for tax purposes can vary depending on both the pillar itself (interest is taxable and principal liquidations are not), and the varying types of retirement accounts (from pre-tax IRAs to tax-free Roth accounts).

Nonetheless, the fundamental point is simply to recognize that a retirement portfolio has multiple ways to generate the desired cash flows for retirement. And in fact, in a low yield environment, it can be especially important to diversify across all four pillars – or retirees take on additional risks in stretching for yield, from interest rate and default risk (from longer-term or lower-quality bonds), to the concentration risks of buying just a subset of the highest dividend-paying sectors (which, as the financial crisis showed, can expose the portfolio to severe risk along the way!).

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From its start in 1980, the 12b-1 fee was controversial – a distribution charge assessed against current mutual fund investors, that the fund company can use to market the fund to new investors. In other words, the mutual fund got to use investor dollars (rather than its own money) to grow the fund’s assets under management (AUM).

In theory, this use of the mutual fund investor’s own money to market the fund company’s products was supposed to be good for the investor, because it would help grow and scale the fund and bring down its operating expense ratio. However, several decades later, subsequent analysis is finding that while mutual funds that charge 12b-1 fees are successful at incentivizing salespeople to bring in more assets under management, the 12b-1 fee isn’t living up to its promise of helping to scale up and bringing down the expense ratio as the mutual fund grows.

At the same time, the reality is that investor behaviors are shifting as well. A growing number of consumers are purchasing their investments directly, avoiding the 12b-1 fee altogether by eliminating the mutual fund salesperson middleman. And as more and more financial advisors become affiliated with an RIA firm and get paid an AUM fee on an advisory account, the 12b-1 fee is less and less of a driver to incentivize financial advisors anyway.

In fact, the entire shift of financial advisors from being mutual fund salespeople (compensated by upfront commissions and ongoing 12b-1 fees) to operating as actual financial advisors instead (compensated by fees directly from their clients) raises the question of whether the 12b-1 fee is still relevant at all. Especially given the 12b-1 fee’s controversial roots, and the misalignment it creates between who pays the marketing and distribution costs, and who actually benefits from it.

Of course, the reality is that financial advisors, custodians, broker-dealers, and product providers still need to get paid for what they do, which means eliminating the 12b-1 fee still won’t necessarily bring down costs for the end client. Instead, it would likely just shift where and how financial advisors and their platforms get paid. Nonetheless, given the 12b-1 fee’s implicit conflicts, and their declining relevance, arguably it’s time to create a more appropriate pricing structure for the realities of today’s investment marketplace!

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Even for financial advisors, the proliferation in recent years of different variable annuity and mutual fund share classes can be overwhelming. Some companies may have as many as 15+ share classes for a single investment strategy, all with unique advisor compensation, surrender charges, and fees. Yet by definition, not all of these share classes can possibly be the best for any particular investor. And in too many cases, it’s simply a matter of the advisor choosing how they wish to get paid.

In this week’s #OfficeHours with @MichaelKitces, my Tuesday 1PM EST broadcast via Periscope, we discuss why there are only a few share classes necessary under a fiduciary rule, and why that means there’s an impending fiduciary armageddon for (most) mutual fund and variable annuity share classes coming soon!

Because the reality is that the differences amongst most share classes ultimately boils down to the different ways that mutual fund companies pay distribution costs – i.e., commissions – across various sales channels. Those who preferred upfront commissions would sell A or B shares, while those who preferred levelized commissions would sell C shares, and those who got paid an advisory fee would charge their 1% AUM fee separately and use institutional or advisory share classes instead. Retirement plans and 529 plans cut their own deals as well, for their own share class alternatives. And the client got whichever share class happened to be sold by the broker or plan they were working with, and paid the associated cost, including embedded commissions, 12b-1 fees, and sub-TA fees, that may or may not apply.

But in a fiduciary world, the advisor is always expected to use the lowest cost share class for the client. Notably, the fiduciary rule doesn’t actually require that advisors use the lowest cost fund, period; it’s a myth that the fiduciary rule requires index funds to the exclusion of actively managed funds. However, if the advisor is going to recommend an actively managed fund… it better be the cheapest version of the fund available, because using anything different would represent a conflict of interest for the advisor enriching themselves at the expense of the client with an unecessarily-more-expensive product.

Yet taken to its logical conclusion, this means that most variable annuity and mutual fund share classes will be rendered entirely irrelevant under DoL fiduciary! At best, there may only be 2 share classes available – the uniform-commission T share for those who are paid some moderate upfront commission, and an institutional or advisory share class for everyone else (who separately charge their own advisory fee on top). And the other dozen or more share classes just vanish!

Of course, the transition may not happen immediately. Not only is there the potential that DoL fiduciary will at least be delayed, but given that it only applies to retirement investors, other share classes may still get used in non-retirement accounts for a while longer. But the key point is that under a fiduciary rule, there is only a legitimate need for one or two share classes at most. As a result, whether it’s the Department of Labor fiduciary rule, or one that the SEC follows with in a few years, what we’ll soon see is an armageddon that destroys most mutual fund and variable annuity share classes, as we complete the shift from being brokers who sell whatever products we can get paid to sell, into advisors who actually sell advice and implement the best solutions we can at the lowest cost they’re available for!

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The process of assessing an investor’s risk tolerance is all about determining his/her willingness to take investment risk, and financial capacity to bear risk, and blending it together to match to an appropriate investment portfolio. Most commonly, this is done with a risk tolerance questionnaire that posits a series of questions about time horizon and need for income, and attitudes about risk and market volatility, to calculate a “risk score” and determine the portfolio that goes with it.

The caveat to this one-dimensional approach, however, is that by averaging together risk tolerance and risk capacity scores, the advisor can unwittingly end up in situations where clients with extremely low risk tolerance (or risk capacity) end up with portfolios that are far too risky for their situation. In other words, the low risk tolerance (or capacity) should have acted as a constraint to the investment policy statement, but didn’t.

So what’s the alternative? Simply put – risk tolerance and risk capacity should be measured separately, and then scored on a two-dimensional scale that considers the contributing role (and limiting nature) of each (rather than a single continuum that merely averages the two together).

Fortunately, there are numerous risk tolerance software solutions specifically designed to assess “pure” risk tolerance on a standalone basis, including FinaMetrica and Riskalyze. And for comprehensive financial planners, the reality is that the financial plan itself is a measure of risk capacity, as reflected in the Monte Carlo probabilities of success and failure.

For those who don’t do full retirement planning projections for every client, a recent alternative software solution is Tolerisk, which is designed to perform a two-dimensional risk tolerance assessment by separately gathering information about the client’s risk attitudes and their basic financial goals.

The bottom line, though, is simply to recognize that risk tolerance and risk capacity are two different dimensions of the client’s overall risk profile, and must be assessed and ‘scored’ separately to properly recognize the constraining role that each can have on the appropriate investment policy statement!

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The “Paradox of Skill” is the recognition that as the average skill level of a group increases, it actually becomes harder and harder for superstars to occur; as the skill level rises, the variability around the group average declines. This phenomenon helps to explain why despite the improvement in baseball players, no one has hit over .400 since Ted Williams did it 75 years ago, and also provides insight on why it’s getting harder and harder to find “good” active investment managers. Because the whole field has gotten so much better, it’s actually become incredibly difficult to stand out from the (already excellent) pack.

As a result, a growing base of data suggests that the amount of available alpha is shrinking, a combination of both the paradox of skill itself, and the mere fact that more and more investment research is revealing previously unknown investment factors that, once known, can no longer be exploited the way they were in the past.

Yet despite this trend, a number of known investment opportunities have continued to persist, even though they’re widely known. For instance, it’s long since been documented that small cap outperforms large cap, that value generates a long term premium over growth, and that stocks exhibit momentum effects. But for all the research showing these outperformance opportunities to be available, investors fail to invest sufficiently to fully take advantage of them.

The gap, however, may be at least partially explained by the growing field of behavioral finance, and research that shows all the ways that we fail to invest “rationally” despite having all the available information (or without bothering to get it in the first place). And in point of fact, many of the most popular – and persistent – alpha opportunities, from small caps to value to momentum, are actually well-explained by common behavioral biases (including the availability, familiarity, and recency biases) that are hard-wired into our brains. Which helps to explain why they’re persistent – because their very nature is the tendency to impact our investment decisions, even when we “should” know better.

Of course, the caveat is that “sustainable alpha” opportunities created by persistent behavioral biases may be the hardest to exploit, precisely because those behavioral biases impact us as well – both in the investment decisions we make, and as advisors, the investment decisions we must justify to clients (who themselves have the same biases). Or viewed another way, it may be the persistent challenge and “risk” of trying to buck the behavioral trends that generates the risk premium associated with sustainable alpha in the first place!

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