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Evaluating a Financial Advisor’s Client Investment Performance

A reader writes in, asking:

“How can you measure, and verify, a financial adviser’s performance for the sake of comparing one prospective adviser to another?”

While this is a common question for people to ask, it’s not really a useful way to evaluate a financial advisor — for a few reasons.

First, an advisor doesn’t recommend the same portfolio to everybody. The investment portfolio that is appropriate for you as a client may be wholly inappropriate for another client with very different circumstances.

If an advisor or advisory firm were to calculate something like the average annualized return earned by their clients over a given period, that figure wouldn’t provide a meaningful point of comparison to another advisor’s such figure. For example, if one advisor has a clientele that is primarily middle class retirees, while another advisor’s clientele is primarily super-high-earners in their 30s or 40s, the clients of the first advisor would probably have, on average, lower returns over the last several years than clients of the second advisor — and that would simply be the result of the first advisor recommending appropriately low-risk portfolios for his/her clients.

In short, there’s no single figure that can be calculated to meaningfully measure how well the investment recommendations of a given financial advisor have performed over a given period.

Second, an advisor shouldn’t really be trying to do anything clever with respect to client portfolios. If an advisor is putting together a portfolio for you, a simple, boring portfolio of index funds/ETFs that approximately match the market’s return is your best bet. Intentionally seeking out an advisor who shows you a backtested, market-beating portfolio is setting yourself up for disappointment.

Finally, an advisor who engages in actual financial planning does a whole lot more than just make investment recommendations for clients.

A financial planner can also provide advice about tax planning or estate planning. They can help you evaluate your insurance coverage to see if there’s anything important you have missed (e.g., disability insurance). They can help with Social Security planning, and retirement planning in general. They can provide assistance with budgeting if that’s something you struggle with. They can provide advice with regard to your employee benefit options (e.g., help determine which health insurance is the best fit for your family).

And frankly, investment management is quickly becoming the least valuable part of financial planning. While there are still plenty of people whose investment performance would be improved by working with a financial advisor, the list of tools available for DIY investors to create a low-maintenance portfolio has grown dramatically over the last decade. Investors can now choose from Vanguard’s LifeStrategy funds, low-cost indexed target retirement funds at various providers, a smorgasbord of total market index funds/ETFs, or low-cost services like Betterment or Vanguard Personal Advisor Services.

Should Financial Advisors Be Fiduciaries?

A reader writes, asking:

“Do you think that a financial advisor should be a fiduciary? I’ve seen that discussed elsewhere, but never on your blog.”

Well, that depends on exactly what you mean.

If you’re in the market for a financial advisor, and you’re wondering whether you should use one who is a fiduciary (i.e., one who has a legal duty to put his/her client’s interests first) or one who is not, my answer would be, “Yes, use an advisory who has a fiduciary duty to you.”

This is a bit of an oversimplification, but in general:

  • Registered investment advisers (RIAs) and representatives thereof do owe a fiduciary duty to clients.
  • Insurance agents and stockbrokers do not owe a fiduciary duty to clients.

In the case of insurance agents and stockbrokers, they earn their pay by selling you specific products, which tends to result in biased advice. (This is not to say that RIAs are without their biases. Even fee-only RIAs have conflicts of interest, but I think they are at least somewhat less significant than the conflicts of interest faced by brokers and insurance agents.)

On the other hand, if you’re asking whether I think all financial advisors should be fiduciaries — a question which has been the subject of a great deal of debate within the industry over the last several years — I don’t have any strong opinions. I think it’s probably a good idea. (After all, why shouldn’t somebody who calls himself/herself a financial advisor be legally required to put clients’ interests first?) But, frankly, I’m not optimistic that such a change would have a large positive impact on the industry.

As it is, there are countless RIAs (who do have a fiduciary duty) who do all sorts of things that, in my opinion, clearly show they’re putting their own interests ahead of their clients’ interests. Yet, regulators don’t seem to have any problem with it.

For instance, many RIAs charge in excess of 1% per year to do nothing but passive portfolio management. At the same time, at Vanguard, you can get similar portfolio management, plus a basic financial plan, plus access to a CFP for 0.3% per year. The idea that the advisor charging more than three times as much for a lower level of service is somehow putting his/her clients’ interest first is laughable, given that there is such an obviously-better option for the investor. And yet, industry regulators have no problem with this — it is apparently not considered a breach of fiduciary duty.

And that’s not even remotely the worst of it. There are RIAs who charge high annual fees while also using expensive actively managed funds. There are RIAs who charge high annual fees while rapidly trading concentrated portfolios of individual stocks — or engaging in any number of other poorly-researched investment strategies. And, in the overwhelming majority of cases, such activities are not considered to be a breach of fiduciary duty.

In other words, if you’re going to use an advisor, yes, you should probably use one who has a fiduciary duty to you. But the sole fact that an advisor has a fiduciary duty does not ensure that he/she will always do what’s best for clients.

Do I Need a CFP, a CPA, or Both?

A reader writes in, asking:

“I’m looking for a ‘fee only’ professional who can take care of everything including tax returns, tax planning, financial planning, and handling the portfolio. I’m getting to the point where I no longer want the hassle, and my wife won’t want to handle it at all once I’m gone. Does such a person exist? Would I be better off looking among CPAs or CFPs?”

Let’s tackle the question of certifications first, since it’s relevant for anybody seeking an advisor, then we’ll move on to whether it makes sense to use a single person for all of the services desired.

Which Certification is More Relevant?

The sections of the CPA exam are:

  • Financial Accounting and Reporting (dealing with, for example, the statements that publicly traded companies must provide to shareholders),
  • Auditing and Attestation,
  • Regulation (dealing with individual taxation, business taxation, and business law), and
  • Business Environment (a catch-all category for other business topics such as economics, operations, finance, and information systems).

And the topics covered by the CFP exam are:

  • General Principles of Financial Planning,
  • Insurance Planning,
  • Investment Planning,
  • Income Tax Planning,
  • Retirement Planning,
  • Estate Planning,
  • Interpersonal Communication, and
  • Professional Conduct and Fiduciary Responsibility.

As you can see, the CFP exam is definitely tailored more precisely to personal finance than the CPA exam is.

However, there are two important caveats to note here.

First, there’s an additional, lesser-known credential that some CPAs go on to earn: Personal Financial Specialist (PFS). The PFS curriculum is very similar to the CFP curriculum, as are the topics covered on the exam.

Second, it would be rare to find any professional who is truly an expert in each of the topics covered by the exam for their certification. As you might expect, a professional’s expertise is going to depend much more on what field they work in than on what certification(s) they have. To use myself as an example, despite being a CPA, I know next to nothing about auditing, because I have never worked in that field and because my exam on the topic was approximately 4 years ago, meaning I’m well on my way to forgetting what little I once did know.

In summary, if you’re looking for a very comprehensive financial planner/professional, a CFP or somebody with the CPA and PFS certifications is likely to be your best bet. However, a person’s expertise will depend at least as much on their experience as on their certifications.

Is One Professional Really a Good Idea?

It’s easy to find a tax preparer who also does financial planning. Alternatively, it’s easy to find a portfolio manager who also does financial planning. But somebody who does tax preparation, financial planning, and portfolio management would be pretty rare. (And frankly, that makes sense. Trying to become an expert in all three professions would be exceedingly difficult.)

The most common solution would be to use two separate professionals: a tax preparer and a financial planner/portfolio manager. (In some cases, you may find it convenient to find a firm that has both types of professionals.)

Alternatively, you may not even need to pay a professional, per se, for portfolio management. Developments in the last few years — specifically, the rise of all-in-one funds and so-called “robo-advisors” — have made it clear that portfolio management is a commodity service, the cost of which is rapidly declining (and even approaching zero).

Is It Important for Your Financial Advisor to Be Local?

At the recent Bogleheads event, one investor had the following question:

“I’m planning to hire a financial advisor. I want somebody who can help me as I get older and possibly less able to make financial decisions and who can help my wife manage things after I’m gone. But the advisors I hear most about are people who live nowhere near me. How important is it that a financial advisor be in your local area?”

As you might imagine, the answer is, “it depends.”

How Do You Prefer to Communicate?

Firstly it depends on how comfortable you are with communicating remotely about very important topics/transactions.

For example, I personally prefer written communication rather than in-person communication for important topics. So I’ve never felt a need to meet face-to-face with the professionals with whom I work. My only communication with Austin Frakt — the coauthor of my most recent book — has been via email and phone. We’ve never met in person. And I’ve never even talked on the phone with any of the attorneys whose services I’ve used for my business. My communication with them has been nothing but email.

Alternatively, if you do feel the need for real-time, face-to-face discussions with your advisor, would you be comfortable talking via Skype? Or would you not be comfortable unless you were physically sitting in the same room as this person?

And don’t forget that if the goal for this advisory relationship is for the advisor to someday work with your spouse, your spouse’s communication preferences (rather than just your own) should be a high priority here. After your death or incapacitation, would your spouse be comfortable working with an advisor across the country, whom he/she has never met in person?

What Services Do You Need?

The question also depends to some extent on what type of services will be provided by the advisor.

For example, if all you’re looking for is portfolio management (i.e., picking an initial allocation, then rebalancing as necessary and tax-loss harvesting when advantageous), that’s a very impersonal service. Your portfolio is probably indistinguishable from the portfolios of many other investors, so the advisor will need little to no ongoing input from you about how to perform the required tasks.

In contrast, if you want your advisor to provide comprehensive financial planning services, there’s going to need to be quite a bit of ongoing communication between the two of you, so if you really don’t like doing that sort of thing remotely, a remote advisor probably isn’t a good idea.

In addition, if you’re looking for somebody with state-specific tax planning expertise, a local professional is certainly more likely to have that than an advisor many states away.

What’s the Big Deal with Vanguard’s Personal Advisor Service?

A reader writes in, asking:

“Why is there so much hoopla over the Vanguard advisory service? I thought that it was accepted wisdom that managing an index portfolio isn’t that hard. Are we all supposed to be using advisors now?”

The reason that Vanguard’s new Personal Advisor Service is a big deal is not that everybody should be using it. Plenty of people will continue to succeed with DIY portfolios; plenty of people (like me) will continue to be well served by a simple one-fund portfolio; and plenty of people will continue to find value in other advisors.

Rather, the reason Vanguard’s new service is a big deal is that it provides a clear benchmark against which other advisory services can be measured: 0.30% per year for portfolio management, an annual basic (investment-focused) financial plan from a CFP, and the ability to contact your CFP when you have questions.

For example, if we use Vanguard’s new advisory service as a point of comparison for a portfolio of actively managed mutual funds from an Edward Jones broker, we see that using Edward Jones means:

  • Paying roughly 0.2%-0.4% more each year (due to higher mutual fund expense ratios),
  • Paying commissions of up to 5.75% on each new investment (rather than paying no commissions at all), and
  • Having an advisor with just a brokerage license rather than a CFP credential.

Vanguard’s new service is noteworthy because it makes it more obvious than ever that the traditional “full-service brokerage” model is a poor value for investors.

Alternatively, for the many independent advisors who charge an annual fee of roughly 1% of assets under management, Vanguard’s new services makes it clear that these advisors must:

  1. Provide some very significant financial planning value over and above the basic financial plan that Vanguard provides with their service, and/or
  2. Provide some sort of investment management expertise that is likely to earn significantly better returns than a basic portfolio of Vanguard funds.

And, together, these value-added services must be worth at least 0.7% per year. That’s certainly possible — there’s a lot of room to provide value to clients via comprehensive financial planning (i.e., tax planning, insurance planning, Social Security planning, estate planning, etc.) — but the onus is now clearly on advisors to show that their services provide sufficient value to justify the additional cost.

In short, the “big deal” about Vanguard’s Personal Advisor Service is that it provides an obvious, credible point of comparison against which other advisors can be evaluated.

Testing an Advisor with Part of Your Portfolio

A reader writes in, asking:

“What do you think about testing an advisor for a few years by giving him just a piece of the overall portfolio before turning everything over?”

I think the answer depends on what type of advisor you’re considering. But first, let’s get something important (and perhaps obvious) out of the way: Intentionally withholding information from your advisor is generally unhelpful if your goal is to get the best advice possible. As a result, anybody giving you financial advice should at least know about all of your holdings.

If we’re talking about a professional who only gives as-needed advice rather than actually managing the portfolio (e.g., an hourly financial planner), you’ll be the one in control of the portfolio the entire time. There’s no real downside to showing them everything — if you don’t like the advice you get you can always choose not to implement it.

If we’re talking about an investment manager, and the idea is to give them a portion of the portfolio to test their performance over a given period, I have to say that such an approach doesn’t make sense to me. Before giving the advisor so much as a dollar, you should have both a good understanding of their investment philosophy and a high degree of confidence in that investment philosophy. It needs to be the sort of relationship where you continue to value their services even during periods of poor performance, because there will be such periods. That is, you should choose an investment manager based on the fact that they practice an investment philosophy you believe in, not based on their performance over a particular short period.

On the other hand, I think there are some cases in which a small-scale test for an investment manager can make sense. For example, if we’re talking about an online-only investment manager (e.g., Betterment or Wealthfront), and your concern is something mundane for which you can get a clear yes/no answer right away (e.g., whether you will like their website, interface, etc)., then it can be perfectly reasonable to move a very small amount of money over to them to see what you think before transferring the whole portfolio.

If we’re talking about a commission-paid advisor, it usually makes sense to stay away completely rather than giving them even a piece of your portfolio. A commission-based pay structure creates significant conflicts of interest between the client and the advisor, which typically results in subpar advice, such as recommendations of undesirably expensive investments.

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