Paying the Chef to Chew Your Food?

When a client hands their savings to a financial planner, the money can pass through three or four sets of hands before it’s actually invested. I spent years inside that arrangement as a representative at two advisory firms, while also holding my own portfolio of stocks. The gap between what I saw working in my own account and what I could offer clients is a big part of why I opened my own practice.

Here I’ll be sharing an insider perspective on the asset management services offered to retail investors – with a take that most other financial professionals either can’t, or won’t, write about in public.

MISE EN PLACE

Financial planners offer two complementary services. The first is planning: “save this much, in those types of accounts, at that expected rate of return, and you’ll hit your goal.” The second service is implementing the plan: asset management, selecting the investments expected to accomplish the targeted rate of return.

The difficulty is that planning and asset selection are both specialized disciplines with only marginal overlap, so the first instinct of many planners is to delegate. Unfortunately, this can end in unappetizing results.

I found this quote from a planner writing on an industry blog, posted a few years ago. My emphasis added:

Clients deserve a team of analysts (not financial planners) managing their money, and as a start-up not operating in a big city, hiring and paying for a team of analysts wasn’t feasible. But I could still provide great value by finding one of the best third-party managers in the U.S. for my clients, and manage that relationship for them. I chose [VeryGood Asset Management].

I’m being intentionally vague about both the source of my quote and the asset management firm named, because the point isn’t to put them on blast but rather to examine a general industry phenomenon.

I’m sure this planner does provide value for his clients, and the real VeryGood Asset Management may indeed be good, posting fine risk-adjusted returns relative to their competitors (as a group known as “turnkey asset management platforms”, or TAMPs).

However, what is it exactly that a hypothetical VGAM is doing, and what does it mean for an advisor to “manage that relationship” for a client?

Third-party asset managers construct portfolios of mutual funds or ETFs. They research the massive pool of fund managers out there and pick those they believe are outstanding. Then they curate models, each of which usually holds 8-25 funds, with each fund containing between several dozen to many hundreds of individual stocks, and then balances those models to represent different risk/reward profiles – “Aggressive”, “Moderate”, “Conservative”, etc.

The planner’s role in “managing the relationship” is to select the appropriate VGAM risk profile based on what they know of the client’s goals, and then stay in close contact with a representative of VGAM to keep the client informed as to what’s being done with their money.

Speaking from within the industry, this sort of arrangement is normal-to-unremarkable. But as I type, it’s obvious how someone could find this convoluted and hard to understand – because it is.

PLATING THE PROBLEM

Let’s zoom out a few hundred years and think about the evolution of retail investing over that time.

Problem #1: Owning an operating business is one of the finest ways to accomplish financial independence, but we don’t all have the time and temperament to be business owners (and even a talented entrepreneur might not want to put all their eggs in one basket).

Solution: the public capital markets allow us to purchase minority ownership in companies which are regulated to disclose their financial results to investors, so we can make an informed decision to share in their fortunes.

…leads to Problem #2: most of us also don’t have the time and temperament to be good at reading financial statements and picking stocks.

Solution: we create investment trusts, or mutual funds, to pool together money and hire some (hopefully) very smart and disciplined people to do the stock picking for us in return for a reasonable fee.

…leads to Problem #3: there are now tens of thousands of mutual funds vying for our business and attention, all touting their returns – some of which excel because of a superior process, and others that are merely lucky.

Solution: investment advisory firms parse through all the mutual funds and create pre-made portfolios out of (hopefully) the best of them – so the investor can save time by getting a package of funds all at once.

…leads to Problem #4: those investment advisory firms are too busy and too big to answer questions from small investors. And, there are many different advisory firms out there who use different strategies, and some of them are more skilled (or more lucky) than others.

Solution: the investor works with their personal advisor, who “manages the relationship” with the investment advisory firm (or several of them), who then pick the mutual funds, who pick the stocks, whose companies sell hamburgers or semiconductors or what-have-you. Profits then go back to the individual investor who kindly put up the capital to get this whole process started… After fees to all parties have been deducted, of course.

PROPER MASTICATION

The ultimate problem is that there are too many fingers in the pie, and as the investment landscape gets ever more complex, that number keeps increasing!

What started off as an accessible way for everyday people to invest in great businesses has become a bloated industry with the retail investor two, three, or more layers from the firm making money by selling hamburgers.

Truism: in the long haul, we can’t expect returns from our investments to be greater than the underlying profitability of the businesses we own shares in, minus all the costs in between.

Some fees ARE worth paying; I do believe that people can benefit greatly from personalized financial advice. Evidence suggests that just a little hand-holding dramatically improves investor outcomes; helping stick to a plan, owning stocks for the long-run. But hand-holding can go too far, and there’s no reason that it needs to involve hands, holding hands, holding hands… all of which are dipping out a share of the fees.

One solution is to use only passive index funds and give up on the idea of active management or stock selection entirely (instead of seeking the needle in the haystack, buy the whole haystack). By emphasizing passive buy-and-hold, this strategy also helps avoid some of the worst self-inflicted investment errors.

However, indexing is not foolproof – there are now more indexes and ETFs that exist than there are underlying stocks to hold in them – so we’re circling back to a “Problem #3” situation. Saying “just buy the index” is not very helpful advice when there are thousands of different indices. Which index do I buy, or how much of each of them?

Further, operating on the intuition that “if it seems too good to be true, it probably is”, I have reservations about whether the fully-passive strategy will persist in beating active stock selection forever. “Buy index funds, forget about them, and you’ll beat the experts” does strain credibility, even if that statement has been largely true for the past several years. It looks like a free lunch, but how long will it last?

Surely there’s a better way, where an individual can get personalized advice without the convoluted, fee-laden experience of a “managed relationship” with many layers of separation from the underlying stocks?

Surely, it should be possible to get planning advice and also a transparent and understandable investment process?

Yes.

THE NOURISHING CONCLUSION

Compare retail investing to growing food. Some very few people grow their own, harvest and eat it (private entrepreneurs and business owners). Many others buy raw ingredients and are home cooks, although they occasionally must tolerate an inedible mess (stock pickers). Lots of us like something pre-prepared to save time (ETFs or mutual funds) and may even want a restaurant experience with a 5-course meal (investment advisory portfolios).

But personal service stops somewhere: nobody asks for their chef or waiter to chew up the food for them. Unfortunately, that’s where a lot of financial planning clients end up with the asset management solutions they’re given – over-processed and by extension, under-performed. And possibly a bit nauseated.

Jumping back to the quote from the well-meaning financial planner at the top, I’d agree that planners are not stock analysts (although whether you get a superior result by hiring a big roomful of analysts and keeping only the ones who did best last quarter is also up for debate). Turnkey asset management platforms are convenient, but they also may be non-transparent and laden with fees. We can do better.

One solution for investors is to separate planning from asset management entirely: paying hourly for financial planning while self-managing the portfolio. The risk is implementation failure – it takes only seconds to wake up in the morning in a bad mood, or with a strong (but wrong) conviction, go online and click “sell all” – and those few seconds can undo years of sober progress.

Part of the advantage of working with an advisor should be that you talk to someone objective before making a life-changing financial decision with your investments, but that implies the advisor must have a hand in doing the asset management.

Getting good advice should not require you to compromise on the quality of investments used to implement your plan.

Important Information

This article was first published on October 16, 2021 and reflects the author’s opinions as of that date. Statements about the industry, such as the number of mutual funds and indexes and the recent record of index funds against active managers, describe conditions at the time of writing and may have changed since.

Firms and products: “VeryGood Asset Management” and “VGAM” are placeholder names. Descriptions of turnkey asset management platforms, mutual funds and index funds are general characterizations; individual providers and products differ widely in cost, transparency and results.

Conflict of interest: This article argues for a service model in which the same adviser prepares the financial plan and selects individual securities to implement it. That is the model Bormann Wealth Management offers, and the firm is paid by clients who choose its services, so it has an incentive to favor this approach. Third-party managed portfolios, index funds, or hourly planning combined with self-management may suit some investors better. A portfolio of individual stocks can be more concentrated, and therefore riskier, than a portfolio of diversified funds.

Investment risk: All investing involves risk, including the possible loss of principal. Index funds follow their markets down as well as up. Past performance does not predict future results.

Scope: This article is general information, not advice for your circumstances. No advisory relationship is formed until a written agreement is signed by both parties. Bormann Wealth Management, LLC is a registered investment adviser in the State of Washington; registration does not imply a certain level of skill or training. See Disclosures and Form ADV Part 2A.