With summer in full swing, I've been reflecting on what I learned from one of my experiences from a summer past - being hired to serve as a financial expert witness in a case against another "financial advisor". This was a new and somewhat revelatory experience for me.
Being an expert witness was different than I had imagined. Having watched far too many "Law and Order" episodes, I imagined myself heroically defending my written testimony under the withering cross-examination of the opposition counsel. This case ended rather anticlimactically in comparison.
But what I really took away from this experience was:
1. a reinforced opinion that, too often, consumers continue to misplace their trust in "financial advisors" who are either ill-equipped to provide sound investment advice, or who give in to financial incentives to do otherwise:
For the most part, the investing public turn to one of three groups for investment advice: brokers, insurance salespeople, or investment advisors. To make matters confusing and to impress prospective clients, these groups can and do refer to themselves by any number of titles (wealth managers, financial advisors, investment consultants, etc.). At the end of the day, however, you the consumer of investment advisory services are either dealing with someone licensed to sell securities, licensed to sell insurance products, licensed to be an investment advisor, or possibly some combination of the above.
You the consumer could be forgiven, then, for assuming that your financial professional, with all of this licensing and regulation, and perhaps working for a firm with name recognition, and perhaps possessing impressive-sounding designations, must be an investment expert. It turns out that this assumption could be dangerous to your financial future. But don't take my word for it:
"Among wealth managers who advised clients with $500,000 to $20 million, only 7 percent said they felt strongly that they had received adequate training to complete their job to the highest standard, and some 36 percent said they believed they were not fully qualified to do their job."
--- a PriceWaterhouseCoopers survey
"The biggest challenge the industry faces today is asset allocation. Advisers need to be qualified to do this. There might only be 10% of advisers that are qualified to do it today. That's not where it needs to be ... we have a long way to go to get the average adviser qualified."
--- Paul Hatch, vice chairman of Morgan Stanley
"The vast majority of life insurance companies have no formal education requirements for becoming an agent."
"...financial advisers are brandishing a baffling array of new credentials - some of which can be earned with minimal or no study and a few hundred dollars. Increasingly, say regulators, financial advisers are using these dubious designations as marketing tools to win the trust of older, wealthier clients, in hopes of selling high-fee investments that aren't appropriate for them."
--- a Wall St. Journal article
2. a renewed appreciation for the benefits of having our investments priced by, and traded in, transparent and liquid public financial markets:
The stock market has been a stomach-churning roller coaster ride for much of the past couple of decades. Yields on everything from savings accounts to junk bonds are paltry. And in this age of global capital markets, it has become more and more difficult to find true diversification.
So it's not surprising that the investing public have become more desperate for alternatives to the traditional asset classes - stocks, bonds and cash. It's even less surprising that the financial industry has responded to this demand, whether well-founded or not, by promoting a host of "alternative investments", i.e. hedge funds, commodity and managed futures exposure, life settlements, equity-indexed annuities, structured notes and CD's, private REITs, promissory notes, venture capital, private equity, and so on.
The CFA Institute defines "alternative investments" as commonly exhibiting the following features:
1) relative illiquidity, which tends to be associated with a return premium as compensation,
2) diversifying potential relative to a portfolio of stocks and bonds,
3) high due diligence costs, and
4) performance appraisal that is unusually difficult, due in part to the complexity of establishing valid benchmarks.
Now, I'm all for diversification as a means of reducing portfolio volatility, but not without regard to the risks and expenses associated with the investment vehicle being considered. The danger with many of these "alternative investments" lies in items 1), 3), and 4) above. With these characteristics, it's not hard to imagine a recipe for a serious setback, if not a financial disaster, to a retirement portfolio.
Take an investment, on which it is very difficult to perform sufficient due diligence, contained in an asset class with which we have had relatively little historical experience. Combine with financial advisors who for the most part are ill-equipped to perform that due diligence and whose objectivity is corrupted by outsized commissions. Stir in clients begging to be told that there's a little extra yield to be had, or that the proposed investment offers the upside of stocks without the potential downside. And for a little kick, add a dash of illiquidity to make it costly or impossible to get out of the investment once it becomes clear it's not performing as expected.
Let's be clear - I have nothing against adding illiquid, privately-held, non-correlating investments to a traditional portfolio of stocks and bonds. In fact, clients are often surprised when I second their motions to add various forms of "alternative investments" to their overall portfolios. But I'm much more comfortable when the real estate, say, is in a neighborhood with which they are familiar, or when the private debt or equity is in the industry in which they are involved on a daily basis. And even then, these "alternative investments" should be viewed as the seasonings in, rather than as the main ingredients of, a well-balanced and healthy portfolio, precisely because they tend to be unproven and opaque in nature.
For my own purposes, I prefer to add "alternative investment" exposure to client portfolios using liquid, exchange-traded, cost- and tax-efficient vehicles. That way, my own initial due diligence is checked and counter-checked every day as market participants' combined opinions are weighed and reflected in the daily price performance of that investment. And if circumstances change, there's a way out.
About the Author
Paul Winter, MBA, CFA, CFP® is a Fee-Only financial advisor and fiduciary in Salt Lake City, UT. His independent wealth management firm, Five Seasons Financial Planning, provides professional portfolio management and objective financial planning services to individuals and families, and to their related entities including trusts, estates, charitable organizations, and small businesses.