Investment Advisors - The next big investment scam

• There has been an explosion in the number of ordinary investors using professional investment advisors and money managers. These managers generally get a fixed percentage of the value of your account, (frequently 1 ½ to 2 ½ %) every year.  For this fee they are expected to do all of the homework, and make all of the decisions about what to buy, sell or hold in your account.
• The large national brokerage firms have steered millions of customers, and trillions of dollars, to these “professional” managers.   The manager frequently shares a portion of the annual fee with the brokerage firm, and with the individual broker who sells the idea to the customer. 
• This is called a “wrap account”.  It can be problematic for a number of reasons. 
• First, wrap accounts are frequently expensive.   Depending on how much money you place with a manager your annual fees may be several thousand dollars a year, or more.   Depending on what are your needs, this may be much more than you need to spend for investment advice.
• Second, the relationship between the stockbrokerage firm and the advisor is much more important to the firm than its relationship with any one individual customer.  There is no guarantee that the brokerage firm will act in the customer’s interests if things go wrong with an advisor.
• Many customers have been told to stay with advisors who are losing money because the brokerage firm doesn’t want a change, and for no other reason.  It is hard for the brokerage firm to be loyal to its customers when its relationship with the advisor may be much more  lucrative.
• There has also been an explosion in the number of investment advisors in the last ten years.   Many stockbrokers, financial planners, CPA’s and others have followed the relatively easy path to becoming a “registered investment advisor”.  
• Being “registered” (with the Securities and Exchange Commission) as an investment advisor, does not qualify a person to be a “good” investment advisor, any more than getting a license qualifies someone as a good driver.   Therein lies the biggest problem for consumers.
• Like any thing else, being a good investment advisor requires some amount of intelligence, skill, training, and experience.  A lot of people who hold themselves out to be professional investment advisors don’t measure up in one or more of these categories.  

Firms like Charles Schwab have set up programs to enable a stockbroker from almost any other firm, to become registered and to set up shop as an investment advisor.  There is no requirement that the person becoming an investment advisor actually know how to analyze investments or set up portfolios appropriate for any investor.

In addition, Schwab, and other firms, have established “advisor networks” or similar programs where consumers who want to consider an investment advisor, can obtain an appropriate referral.   Unfortunately, Schwab doesn’t always know if the advisor is actually appropriate for anyone.

Investment advisors are universally judged by how well they perform, and just as frequently, judged not by how much money they actually made for their clients, but how well they did versus a pre-established index, such as the S&P 500.   This should tell you a number of things.

In the first place, if the advisor is going to “beat the market average”, the advisor is going to need to take more risk than the market average. And given the fact that the advisor needs to beat the market by at least 2% to cover their own fee, it stands to reason that whatever portfolio the advisor selects for you, there is going to be a greater than average risk associated with it.

Secondly, nobody “beats the market” year in and year out, over the long term.   Anyone who claims to do so is suspect.   Over the long term, you are going to have periods of time when you do not do well, and even lose money.  It’s the nature of the stock market.  Nonetheless, how an investment advisor actually performs, over the long term, good markets and bad, is the key information that any consumer will want to consider.

It is surprising then, that the brokerage firms that are quick to recommend an advisor to you, frequently claim not to monitor the performance of the advisors whom they are recommending.  Be careful, referrals to investment advisors that are unsupported by meaningful performance information and comparisons, have little or no value.

Within the financial community, investment advisors were generally considered to be the crème de la crème of financial professionals.  Because they take over complete control of an investor’s portfolio and make all the decisions about what to buy and sell,  investment advisors have always been held to the highest fiduciary standard of care.  

Investment advisors are expected consider the interests of their customers first.  They are expected to follow all of the appropriate rules and make all the appropriate disclosures.   They are always expected to protect the funds entrusted to them.  More and more, these things just don’t happen.

The SEC is the primary regulator for investment advisors.  And the problems that the SEC routinely sees are appalling.

The SEC acknowledges that some of registered investment advisors have what they call: “deficiencies in portfolio management.”

This is government-speak for the advisors inability to ensure that investments for its clients are consistent with the client’s instructions, risk tolerance and goals, and to ensure that required records are kept.  In short, some advisors aren’t making investments in a manner that is consistent with the clients' goals and instructions.

The SEC also notes “deficiencies in performance calculations”.  Problems in this area include overstated performance results, comparing results to inappropriate indices, failing to disclose material information about how the performance results were calculated, using prohibited testimonials, and advertising past results in a misleading manner.  An advisor is expected to calculate and set forth its past performance in an honest way, and must provide information that is not misleading. 

Finally, there is the problem that the SEC calls “inadequate disclosure”.  Full fair and accurate disclosure by all stock market professionals and participants is at the very heart of the SEC’s regulatory scheme.  Yet the Commission acknowledges that advisors frequently make inaccurate disclosures about their performance, their fees and their methodology.

All this from people who want you to trust them with your entire portfolio.   It has to make every investor nervous. 

So how do you pick an investment advisor?  Carefully.  We recommend that you interview several potential advisors, and read all of their printed materials.  Ask for both parts of the Form ADV that they file with the SEC. Ask about their track record, in both good and bad markets.  By all means, get references, and check them out.

A good advisor will want to know a lot about you and your specific goals for this portfolio. If the advisor buys the same portfolio for every customer regardless of who they are or what they want, go elsewhere.  If the advisor knows what they are going to buy for you, before they know you, be very suspicious.

Ask how they select the investments that they will buy for you. Ask who makes the selections.  Investment advisors can be qualified as Certified Financial Analysts (CFA).  Ask about an exit strategy.

Have a frank discussion about how much, if anything, you are prepared to lose over a year or two.  If the advisor goes past that amount, or reaches it in a much shorter time, be prepared to terminate the relationship.

Here are some common warning signs that advisors are not as professional as they could be:

          1)  they invest all your money at once.  The day after your deposit check arrived at the investment advisor’s office can not be the best day to invest all of your funds into the market. Good advisors may take several weeks to ease a customer into the market as they purchase the stocks they follow when the price is right.  

          2) you can’t understand the statements they send you. This is self explanatory.  It’s your money. The advisor should be able to tell you what is being done with it, simply and clearly. 

          3) you don’t see an exit strategy being followed.  If the broad market takes a significant dip, you should expect that many of your positions will have been sold.      Professional advisors don’t hold onto stocks too long.  And they don’t get emotional about selling, and taking a loss, if it happens. 

          4) the advisor manages a hedge fund.   If you are a sophisticated investor, nothing that we have said to this point in this article will be either new or shocking to you.  Hedge funds are for sophisticated investors only.  If the reason you sought out an investment advisor in the first place was because you are not a sophisticated investor, and your advisor suggests that you might want to get the ‘better return” that his hedge fund offers, fire the advisor.   They are not acting in your best interest.   

          Contrary to what you may hear from your broker, and elsewhere, investment advisors are not for every one.   If you really need or want a professional to manage a portfolio for you, and you are not afraid to accept some losses, it will still take some diligence on your part to find the investment advisor who is right for you.