The requirement that a financial advisor must “Know Your Client”, including his/her tolerance for taking risks, is a universal requirement amongst investment regulators around the world.

Yet a recent survey of the global landscape for best practices in risk profiling by Canadian financial planning software provider PlanPlus reveals a disturbing lack of quality risk tolerance questionnaires and support tools for financial advisors. In part, this appears to be driven by the fact that regulators articulate the principle of “know your client’s risk tolerance” but provide little guidance on how it should be done to ensure that it’s right. And to a large extent, the problem stems from the reality that neither regulators, academics, nor advisors themselves, even have agreement on exactly what key factors of a client’s “risk profile” should be evaluated in the first place.

Nonetheless, a growing base of academic research is beginning to articulate a clear risk profiling framework, from recognizing the separation of risk tolerance from risk capacity, the role of risk perception (and misperceptions) on client behavior, and how “risk composure” (the stability of a client’s perceptions of risk) itself can vary from one cline to the next. Of course, just because these factors can be identified doesn’t make them easy to measure with a questionnaire, especially when it comes to “subjective” abstract traits like risk tolerance. On the other hand, the research suggests that financial advisors just trying to interview clients about risk may not be doing a better job, either.

In the end, the optimal approach may eventually be a combination of both, where psychometrically designed risk tolerance questionnaires assess a client’s willingness to pursue risky trade-offs, and the financial advisor can then assess the client’s risk capacity, financial goals, and ability to achieve their objectives given the constraint of their tolerance. And ultimately, an effective risk tolerance questionnaire may not only make it easier to properly match investment solutions to a client’s needs, but also make it easier to manage client risk perceptions and investment expectations on an ongoing basis. Or at least identify which clients are most likely to be challenged when the next bear market comes along!

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The idea of having investments be influenced by one’s values and a desire to advance the social good (in addition to personal profits) is not new, but in recent decades there has been substantial growth in various forms of socially responsible investing (SRI) strategies. However, given the relatively limited number of SRI funds in the marketplace, investors haven’t had a lot to choose from, and the nature of buying an SRI fund or not means the investor is either all-in or all-out for the strategy (at least with that particular portion of the allocation).

Yet with the recent launch of Morningstar Sustainability Ratings, in partnership with Sustainalytics, it now becomes feasible to not just “buy an SRI fund” (or not), but to tilt any portfolio towards sustainable investing, simply by choosing the most sustainable of the available choices in any investment category. With Morningstar’s Sustainability Rating applied to upwards of 20,000 different funds (both mutual funds and ETFs), the investor (or advisor) can screen out the lowest-rated 1- and 2-globe funds, or focus exclusively on the 4- or 5-globe funds (given the 1-to-5 globe rating system).

In fact, the raw Morningstar Sustainability Scores actually reveal that some non-SRI funds are just as sustainably invested as their SRI counterparts, when drilling down to look at the underlying holdings. Despite the explicit sustainability mandate, the funds are nonetheless buying companies that align to relevant environment, social, and governance (ESG) factors anyway – ostensibly because some fund managers (directly or indirectly) find those to be good investment criteria, anyway.

Yet with more investors seeking out sustainable investing – particularly amongst the rising Millennial generation – and the potential to use Morningstar Sustainability Ratings to tilt any portfolio towards sustainable investing simply by using the number of globes as a screen, it suddenly becomes possible for sustainable investing to actually begin to influence markets in the aggregate. After all, as the growth of Morningstar style boxes and their supporting benchmarks have shown, a common “scoring system” for investors to assess outcomes can have a significant impact on fund manager behavior. In turn, if dollars shift more towards sustainable investing strategies – even by just tilting at the margin – it gives fund managers more capital to deploy to companies that score well on ESG factors, and draws capital away from the rest, which means corporate leadership may finally have the incentive it needs to truly behave in a more socially responsible manner?

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Financial advisors and investment management consultants have long recognized that different fund managers have different investment styles. Some focus on stock picking, while others rotate amongst sectors or asset classes based on macroeconomic bets. And those who don’t think active managers can do any of those things successfully simply buy index funds.

In recent years, though, Martijn Cremers and Antti Petajisto have published research suggesting that many active managers may be closer to an index fund that their investors realize. These “closet indexer” funds can be identified by their low Active Share – a measure created by Cremers and Petajisto to measure the extent to which a portfolio’s holdings deviate from its underlying benchmark, which appears to do a better job than tracking error at identifying which fund managers are really making active bets (or not).

And the Active Share research finds that closet indexers really do tend to underperform. Of course, the result that isn’t entirely surprising, as in general index funds are expected to underperform their benchmark by the amount of their fees, and an actively managed fund with a higher active management fee that really just holds the benchmark anyway would simply amount to an unusually expensive index fund.

Which means Active Share itself can be an effective way to evaluate the appropriateness of an investment manager’s fee in the first place. Funds that have low Active Share and resemble their benchmark will behave like index funds, and should charge index-fund-like fees. By contrast, funds that have higher Active Share – which are taking a larger portion of active portfolio bets – at least have the potential to outperform their higher active management fees. Though ultimately the jury is still out about whether high Active Share funds really outperform on average, or are simply an indicator of which funds might be able to outperform!

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Historically, churning – where a broker encourages excessive trading in a client’s account in order to generate a large volume of trading commissions – has been a significant regulatory concern. In fact, the rise of fee-based brokerage and wrap accounts, and the ongoing shift to advisory accounts, has been driven heavily by regulators encouraging the switch, specifically because brokers who aren’t paid based on the number and frequency of transactions don’t have any incentive to churn accounts. However, it now appears that the efforts to stamp out churning may have been “too successful” – giving rise to an emerging new problem: reverse churning.

In this week’s #OfficeHours with @MichaelKitces, my Tuesday 1PM EST broadcast via Periscope, we look at the concept of “reverse churning”, where an advisor charges an ongoing investment management fee, and how it is likely to be a growing regulatory concern in the coming years, as the DoL fiduciary rule spurs a massive shift towards various forms of fee-based brokerage and advisory accounts.

Arguably, the regulatory concern about reverse churning – where advisors charge an ongoing investment fee but fail to provide any substantive ongoing investment services – is appropriate. However, the scrutiny on reverse churning raises troubling concerns when paired with the growing popularity of using index funds, ETFs, and passive investment approaches. How is an advisor supposed to justify an ongoing advisory fee when the right thing for the client to do might really be to do nothing? And what if the bulk of the advisor’s AUM fee is actually for other non-investment (i.e., financial planning) services, paired together with an otherwise passive investment portfolio?

Ultimately, the regulators may be pressured in the coming years to more clearly delineate the difference between true reverse churning, and a prudent passive investment approach. But in the meantime, advisors that charge AUM fees – especially those who espouse a passive investment philosophy – would be well served to clearly and rigorously document exactly what they do for clients on an ongoing basis, to avoid the risk of a reverse churning allegation in the coming years!

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Judge Learned Hand once famously stated that “Any one may so arrange his affairs that his taxes shall be as low as possible” and that there’s no duty to pay any more in taxes than is absolutely necessary. And the corollary when it comes to an investment portfolio might be “Any one may so manage a portfolio to defer taxes as long as possible,” given that if the investor ever intends to use the money, eventually the tax bill must still come due, but it still pays to minimize tax drag along the way.

Yet while it’s appealing to manage investments in a tax-efficient manner – or buy “tax-managed” mutual funds to do it for you – in today’s tax environment, there actually is such thing as being too tax efficient and deferring too much in taxes for too long.

The reason is that since the beginning of 2013, investors effectively face four different capital gains tax brackets (including the 3.8% Medicare surtax on net investment income), with higher rates applying to higher levels of income and larger capital gains. Which introduces the possibility that an investor is so tax efficient, and defers their tax liability for so long, that when the taxable event finally occurs, the sheer size of the gains propel the investor into higher tax brackets, who then ends out finishing with less wealth!

Which means ultimately, while “tax drag” is bad, and strategies to minimize it – such as tax loss harvesting – are valuable, doing too much tax minimization now can just cause even more harm later. Instead, for some investors, the best approach is to recognize that in low tax rate years it’s better to harvest the gains instead of the losses. And in other situations, the best way to minimize tax drag is not to buy a tax-managed mutual fund at all, and instead leverage the asset location opportunity of sheltering growth investments that generate capital gains inside of an IRA (or ideally a Roth IRA) instead.

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The ongoing decline in interest rates since the financial crisis have been a boon for those looking to refinance a mortgage or businesses looking to borrow, but an immense challenge for investors that rely on fixed income returns, from insurance companies to individual accumulators and retirees. And as bond returns grind lower, it has brought a renewed focus on costs (that eat up an ever-larger percentage of a smaller return), including the question of whether financial advisors should charge less for managing a bond portfolio compared to a stock portfolio.

In this week’s #OfficeHours with @MichaelKitces, my Tuesday 1PM EST broadcast via Periscope, we look at the question of whether advisors really should be charging separate and different fees on the fixed income versus equity allocations in a portfolio, including and especially for those who also deliver extensive financial planning services as a part of their AUM fee as well.

Of course, given that the typical bond mutual fund is already less expensive than the average stock mutual fund, arguably the asset management industry has already spoken and suggested that the fees should not be the same. If only because today’s low bond yields, plus the more limited volatility of bonds (at least compared to stocks), means there’s just only so much opportunity to create active management value in bonds and outearn that fee in the first place.

On the other hand, the reality is that most advisors don’t manage just all-bond or all-stock portfolios as a mutual fund does. Advisors typically manage blended portfolios of stocks and bonds, sometimes tactically managing amongst all those asset classes, and an increasingly large portion of the AUM fee is being allocated to financial planning services anyway… which are based on the amount of actual financial planning work to be done, and arguably remain the same regardless of how the portfolio happens to be invested.

And in fact, with the looming Department of Labor fiduciary rule taking effect in April of 2017, charging different fees for stock versus bond allocations may become a prohibited transaction anyway, at least in an IRA where the advisor has discretion over the portfolio’s overall allocation in the first place. Which means that while advisors might charge less for conservative model portfolios compared to those that are more aggressive (and in theory have more active management opportunities), or begin to unbundle their planning and investment management fees altogether, but the question of whether to charge differently for bonds and stocks within the same portfolio may soon be a moot point anyway!

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Over the past decade, the rise of ETFs and the decline of the (actively managed) mutual fund has quickly created giant ETF behemoths like iShares, Vanguard, and State Street, while putting immense pressure on (actively managed) mutual fund companies, with US equity mutual funds in the aggregate experiencing cumulative net outflows since 2008. In turn, this has led a wide range of asset managers to try to adopt their own ETFs, seeking out ways to bring their active management process to a form of actively managed ETF (in a structure that limits their risk of being front-run on large trades).

In this week’s #OfficeHours with @MichaelKitces, my Tuesday 1PM EST broadcast via Periscope, we look at this emerging trend of actively managed ETFs, and why I am very skeptical that active ETFs will ever gain much traction amongst financial advisors.

Ultimately, the key trend to recognize is that the shift of financial advisors from being commission-based to the AUM model over the past decade has shifted the entire financial advisor value proposition. The pressure is now on advisors themselves to show the value they’re creating in the portfolio design and management process. Which means they can’t just buy active mutual funds – or actively managed ETFs – that the client could have bought themselves in their own online brokerage account.

Instead, financial advisors have been adopting their own internal portfolio design and investment management processes, aided by the growth of the AUM model itself that allows independent advisory firms to be larger than ever before and more capable of having their own investment process. Yet given the limited size of even the largest advisory firms, it’s still challenging for most advisors to manage individual stocks and bonds. ETFs became the perfect intermediate portfolio building block.

Which means in the end, the explosive growth of ETFs and their adoption by financial advisors over the past decade may be less about a shift from active to passive, and more about a form of disintermediation where financial advisors are eliminating third-party active managers and bringing the process in-house instead (or if they do outsource investment management, they go to a TAMP or SMA solution that is not available to consumers directly). Yet if this is the case – advisors are looking to bring active value that clients cannot access themselves – it suggests that the push of fund companies to offer actively managed ETFs in the hopes that they can share in the growth of the ETF marketplace may turn out to be nothing but a mirage.

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Rebalancing plays a crucial role in ongoing portfolio management, both to ensure that the overall risk of the portfolio doesn’t drift higher (as risky investments can outcompound the conservative ones in the long run), and to potentially take advantage of sell-high buy-low opportunities. The caveat: it’s not entirely clear how often a portfolio should be rebalanced, in order to achieve these goals.

The conventional wisdom is to rebalance a portfolio at least once per year, and possibly even more frequently, such as quarterly or monthly. A deeper look, however, reveals that more frequent rebalancing will on average have little impact on risk reduction, even less benefit from a return perspective, and just racks up unnecessary transaction costs along the way.

Instead, the research suggests a superior rebalancing methodology is to allow portfolio allocations to drift slightly, and trigger a rebalancing trade only if a target threshold is reached. If the investments grow in line and the relative weightings don’t change, no rebalancing trade occurs. However, if these “rebalancing tolerance bands” are breached, the investment – and only the investment – that crosses the line, is then bought or sold to bring it back within the bands.

The one caveat to the process of tolerance band rebalancing is that it requires ongoing active monitoring of the portfolio itself, to ensure that you know when a threshold has been reached. Fortunately, though, a growing number of rebalancing software tools are available to help advisors track each investment, its rebalancing thresholds, and even automatically calculate and queue up the rebalancing trades necessary to bring the portfolio in line again!

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While it’s commonplace for investors to hold multiple investments in a portfolio – often comprised of mutual funds or ETFs that in turn hold dozens or even hundreds of underlying positions – the reality is that even multi-asset-class portfolios aren’t always really diversified.

The fundamental problem is that holding many different investments that are all aligned to the same “base case” market scenario – and all go up together – may be equally at risk to decline together if an adverse event happens instead.

For instance, a “well diversified” portfolio holding US stocks, emerging markets, commodities, and corporate bonds, may be invested into multiple asset classes – but they would all be expected to go up in a growth environment, and all would likely decline severely in a recession!

Of course, the investments that don’t go down in a recession, from “defensive” stocks to government bonds, are also the investments likely to perform the worst if markets continue to rise. But in the end, that’s the whole point of diversification – to own investments that will defend in the risky events, even if it means giving up some upside in the process. Or viewed another way, being well diversified means always having to say you’re sorry about some investment that’s not moving in the same direction as the rest!

And given the complexity of today’s investment environment, and the typical multi-asset-class portfolio, a growing range of tools are becoming available to “stress test” various risky scenarios, to help determine whether a portfolio is truly diversified, or just holds a large number of investments that are all expected to go up – and down – in an undiversified manner!

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Conventional investment wisdom suggests that dollar cost averaging is a good approach to allocating investment dollars over time. By always investing a constant dollar amount, the strategy ensures that fewer shares will be bought as prices rise, while more shares are purchased if prices decline, bringing down the average cost per share in the long run. The only question is over what time horizon it’s best to average in.

Yet as it turns out, the answer is “none”. In reality, a dollar cost averaging investment strategy doesn’t actually enhance returns in volatile markets that have similar upside gains and downside losses on a percentage basis. And given that on average, markets go up more often than they go down, choosing to dollar cost average is more likely to just leave gains on the table (and the longer the time period, the greater the risk of foregone returns).

However, while dollar cost averaging may not be likely to enhance returns in the long run, it is still a risk management technique. Over the dollar cost averaging time period itself, the diversification of the “new” investment and “old” investment may actually produce superior risk-adjusted returns. And given that the pain of losses is more severe than the joy of gains, risk-averse investors may prefer to dollar cost average simply to minimize the potential regret of not doing so and seeing markets decline shortly thereafter.

Nonetheless, for investors who are comfortable with the risk of their portfolios, and aren’t specifically seeking a “regret aversion” (or at least, regret minimization) strategy, in the long run the best time horizon for dollar cost averaging is simply to invest all the money immediately – at least, presuming the investment was desirable to own in the first place!

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