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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.

How Much Should You Pay a Financial Advisor?

This tax season, relative to preparing my return by hand, I would say that TurboTax saved me at least $500 worth of time and stress. And I imagine it will save me a comparable amount of time and stress next year. So, come January 2015, if Amazon is selling TurboTax for $400, would it make sense for me to buy it?

Of course not (despite the fact that it would improve my “consumer surplus”). And the reason is obvious: I can buy it elsewhere at a much lower price.

When promoting their services, many financial advisors like to state that their fee is a bargain because they can improve most investors’ portfolio performance by an amount equal to or greater than their fee. For example, an advisor charging 1% per year might argue that the fee is worth paying because, without an advisor, most investors will lose at least 1% of performance per year due to picking poor funds, misguided attempts at market timing, and other mistakes that the advisor will help them to avoid.

The problem with this analysis is that it fails to ask whether the same services can be purchased elsewhere at a lower price.

Paying for Portfolio Management

The price of portfolio management (i.e., the actual running of the portfolio — purchasing funds, rebalancing, etc.) is quickly being driven downward due to competition.

At the most basic end, a Vanguard Target Retirement or LifeStrategy fund is a version of portfolio management — maintaining a diversified selection of index funds for a cost of roughly 0.10% per year (relative to the cost of a DIY index fund portfolio).

But, for various reasons, funds of funds are a poor fit for some investors (e.g., people with lots of assets in taxable accounts or people who want an allocation not available via a fund of funds). Fortunately, the selection of low-cost portfolio management providers is growing. For example:

In addition, as recently reported on the Bogleheads Blog, for a cost of 0.30% per year, Vanguard’s new Personal Advisor Services gives you portfolio management, plus a basic annual financial plan from a CFP, plus a designated CFP to contact when you have questions.

Paying for Advice

As far as paying for actual advice, if your needs are basic, you can again get what you need for a very modest cost. For example, Vanguard offers a basic financial plan for $250 for anybody with $50,000 or more invested with Vanguard and completely free of charge for anybody with $500,000 or more invested with them. Vanguard describes the service as providing “answers to important questions, such as:

  • When can I afford to retire?
  • Will I have enough saved by retirement?
  • How much can I spend in retirement?
  • Which investments are best for me?”

Alternatively, there are numerous independent financial planners who can skillfully provide such services for a modest one-time fee. (The Garrett Planning Network would be a good place to look, for instance.)

In short, basic portfolio management and basic portfolio-related advice are both available at a very low cost these days. Paying anything more only makes sense when you need (and are going to receive) more specialized or more thorough services (e.g., a retirement plan that incorporates not only investment decisions, but also Social Security decisions, tax planning decisions, and health insurance decisions).

Portfolio Management vs. Financial Planning

I often hear from investors who are in the market for a financial advisor, but who, despite interviewing several, are struggling to find one who meets their needs. One of the most frequent causes of this difficulty is a failure to understand the difference between advisors who provide portfolio management services and advisors who provide financial planning services.

Portfolio management involves doing the actual portfolio maintenance: setting up the portfolio, rebalancing when necessary, tax loss harvesting, etc. (Just to be clear, portfolio manager is not a technical term, so these people might refer to themselves as wealth managers, money managers, investment managers, or something else entirely.)

In contrast, financial planning is about answering questions: Can you afford to retire? How much can you spend per year in retirement? Is your asset allocation appropriate? When should you claim Social Security? How can you reduce your taxes? Do you need to buy long-term care insurance? Things like that.

What confuses many people is that:

  • From a regulatory perspective, both portfolio managers and financial planners are probably registered investment advisers (RIAs) or representatives thereof, and
  • Either of them can have the Certified Financial Planner (CFP) designation (but neither is required to have it).

Some firms do financial planning. (Examples would include members of the Garrett Planning Network, or Allan Roth’s firm Wealth Logic.) Some firms do primarily — or exclusively — portfolio management. (Examples would include Rick Ferri’s firm Portfolio Solutions or Bill Schultheis’s firm Soundmark Wealth Management.) Many firms do both.

The story I hear over and over from readers is that, having been in the market for financial planning services, they contacted a local CFP and set up a meeting. But, once they arrived at the meeting, it became clear that the CFP was not really interested in providing one-time financial planning services. Rather, the CFP’s goal was to get the investor to sign up for ongoing portfolio management services — something in which the investor has no interest.

The key is to know ahead of time who you’re contacting — what type of business does this advisor usually do? If their website speaks a great deal about their wealth management services and doesn’t say anything about hourly consultations, that should be a good clue. If the advisor’s website doesn’t make it clear, you can check their Form ADV II. (When researching an RIA, checking this document is a good idea anyway.) Or, you can always call the advisor, telling them very explicitly what services you are and are not interested in, and asking if they would be a good fit.

I Am Not an Investment Advisor. (But Plenty of People Are.)

In the last few weeks I’ve received emails from several readers asking about engaging me in an investment advisory (or other financial planning) capacity.

While I’m flattered that some of you trust me enough to include me on your list of advisor candidates, I am not a registered investment adviser (or representative thereof), and I am not in the business of providing investment advice (or tax advice) in exchange for compensation.

In other words, writing books, writing these articles, and corresponding with readers is the extent of my business. (Though as I’ve mentioned before, please do not hesitate to ask me questions via email. Readers’ questions serve as the inspiration for almost every article here.)

Fortunately, there are plenty of good people out there doing good advisory work at a reasonable cost.

Where to Look for an Investment Advisor

Naturally, as a DIY investor, I’ve never personally used the services of an advisor. However, one result of writing this blog is that I get the opportunity to interact with many excellent people who do advisory work.

I’ve had positive interactions with many advisors including (but not limited to) Allan RothRick Ferri, and numerous people from NAPFA and the Garrett Planning Network.

So, perhaps those would be good places to start a search.

Finding the Right Type of Advisor

Regardless of where you look to find potential advisors, I think a useful step when considering a given advisor is to confirm that his/her investment philosophy matches your own philosophy prior to contacting him/her. (If you can’t find this information on the advisor’s website, you should be able to find it easily by looking at their Form ADV II.)

For example, if you’re looking for an advisor who uses a buy/hold/rebalance strategy with low-cost index funds or ETFs, you’re going to be wasting your time contacting (and giving your contact information to) an advisor who uses actively managed funds.

In addition, when looking for an advisor, it usually makes sense to narrow the field based upon what service(s) you’re looking for. For example:

  • Some advisors provide as-needed advice on an hourly basis (or on a fixed fee-for-service basis),
  • Some advisors provide portfolio management services (i.e., the actual running of the portfolio — buying, selling, rebalancing, etc.) on an annual-fee basis, and
  • Many advisors provide both services for a combined fee.

Naturally, if you only need one service or the other, it is generally not desirable to pay for both.

Asking the Advisors: How to Pay for Investment Advice

When looking for a financial planner and/or investment advisor, one of the most important things to decide is what type of compensation agreement will be the best fit for you. Would you rather pay an hourly fee? A fee calculated as a percentage of your portfolio? Or a flat monthly/quarterly/annual fee?

Rather than sharing my own thoughts yet again, I thought it would be more interesting to hear from three different advisors — one for each of the three business models. So I reached out to three people whose opinions I’ve come to value:

Under what circumstances would an investor be best served with an hourly fee model?

Allan Roth: When someone needs help in moving from complexity to simplicity and is willing to be a hands on manager of their own portfolio. If the client will let me design the portfolio simply enough, I can give them rebalancing rules they can follow and they may never need me again. That is the goal.

[In addition], non-investment related advice such as tax, insurance, financial independence, and estate planning coordination works better on the hourly model as need varies greatly.

Rick Ferri: That’s a two part answer:

Investor 1: Someone who wants investment advice but doesn’t want ongoing investment management. They pay hourly or by the project for a portfolio review and investment recommendations, and then it’s up to the investor to implement. Often investors who have a large amount of wealth in a company 401(k) fall into this category. The adviser doesn’t have access [to the account], so the investor has to DIY.

Investor 2: Someone who has an investment manager but who also needs other financial services. Perhaps they need a full financial plan, or estate planning help, or insurance review, or tax planning. In my opinion, these services should be paid for hourly or by the project even if they’re provided by the same adviser who does the investment management. I believe it’s unethical to lump these other services under a higher AUM (assets under management) fee because that links tax planning to the value of an investment portfolio, which makes no sense. In addition, often the investor only needs occasional extra advice, so why should they pay for it continuously with AUM?

Dylan Ross: An investor seeking specialized help when facing a complex decision with significant consequences may be best served with an adviser that charges by the hour. Some examples might be deciding when to begin Social Security, getting a second opinion before a major purchase, or general guidance on how to best structure their investment portfolio.

While hourly advice is frequently touted as great for one-time or the occasional as-needed help, it doesn’t have to stop there. It can also work well for ongoing, pay-as-you-go services. However, for general, less complex advice, it may be more expensive than paying flat periodic fee. For someone considering purchasing any kind of an annuity with their life savings, hiring a fee-only hourly advisor to look everything over would be a very, very wise choice.

Under what circumstances would an investor be best served with a fee based on assets under management?

Rick Ferri: There are two types of AUM fee advisors — wealth managers and investment managers. The first wraps all financial services under an AUM fee and the second charges a lower AUM fee for investment managing services. [Mike’s note: This second type of service is what Rick’s firm does.]

Many individuals and small institutions do not desire to manage their investment portfolio directly or cannot manage them for legal reasons. They delegate this duty to a legal fiduciary, such as Portfolio Solutions. We work with these clients to come up with a sensible long-term plan for their needs or the needs of beneficiaries, implement their plan with discretionary authority, maintain the plan day-to-day including cash flows, and report on performance versus appropriate benchmarks periodically.

I believe the difference between the DIY investor and adviser investor return is discipline. DIY is the best option from a fee perspective because there is no extra adviser fee. That being said, very often DIY investors don’t stay disciplined. Procrastination and inconsistency in management are common and this lowers long-term returns. An adviser is paid to be disciplined. This keeps a portfolio strategy on course and often leads to higher returns.

If you decide to hire an advisory firm, make sure they have the same strategy ideas that you do. This way your thinking is aligned and there is no confusion on what the adviser is trying to accomplish. Also, fees matter. The more an investor pays an adviser, the lower their returns.

Dylan Ross: I have formed the opinion that charging a fee based on assets under management is only really appropriate for asset management services like portfolio management or mutual funds. So it would be most appropriate for an investor seeking only to have their investment portfolio managed in accordance with a particular investment strategy or philosophy, not for household financial management or financial planning.

Tying the fee to the value of an account almost seems as if the account, not the person, is the client. If you don’t want to manage your own investments or haven’t been capable of doing so, paying a fraction of a percent of your assets to a low-fee advisor like Portfolio Solutions for disciplined investment management would be money well spent.

Allan Roth: [An AUM-based fee is best] when someone does not want to be a hands-on manager of their own money and wants someone else to handle the portfolio. Fees matter, so a great manager for a low price like Rick is right for those clients. I nearly always recommend Rick for those who want someone to do the investing for them.

Under what circumstances would an investor be best served by a flat annual/quarterly/monthly fee?

Dylan Ross: Flat periodic fees are best for folks who want/need general ongoing advice or regular access to advice at a predictable, fixed cost. It’s similar to a level-pay plan from your utility company, or health club membership. It can be a less conflicted solution for those seeking an advisor to manage assets and provide planning advice. For those seeking ongoing help with general personal finances such as cash management, debt liquidation, credit, saving and investing, low-fee access to a financial planner or an automated online service may be the best fit.

Allan Roth: I don’t see a big difference between this model and the AUM model. In reality, most fees I’ve seen in this matter are based on asset size. It does give more flexibility, like the hourly model, to advise on assets such as employer 401(k), pensions, etc.

Rick Ferri: I believe all investors who have smaller accounts and wish to have account managed under a discretionary relationship should pay a flat fee in lieu of an AUM fee. This is fair to the adviser and fair to the client. The flat fee will vary from adviser to adviser as does the adviser’s account minimums. Investors should choose an adviser that meets their needs.

Finally, Dylan Ross provided this summary, which I mostly agree with: “In a nutshell, I think that that folks are best served to pay a financial planner that is a generalist (not a Jack-of-all-trades, but a true generalist like a family doctor is a generalist) a low, periodic fee. Pay financial planners that are specialists by the hour, as-needed for specialty advice. And for specific services like investment account management, pay a portfolio manager or mutual fund company based on assets under management.”

Checking out an Investment Adviser: Form ADV Part II

Editorial note: We discussed this topic a couple years back, but a few reader emails have made me realize it’s time to cover it again.

When researching a registered investment adviser (RIA), in my opinion the single best first step you can take is to read the RIA’s Form ADV Part 2.

Form ADV is a form that investment advisers have to file with the SEC. Part 2 of the form contains most of the important information that you’d want to know about an investment adviser. For example, you can see:

  • How the adviser charges for his/her services (hourly, fee-for-service, percentage of assets under management, etc.),
  • How much the adviser charges for his/her services (e.g., if it’s hourly, what is the hourly rate?),
  • What services the adviser offers (e.g., if you’re paying 1% per year, are you getting comprehensive financial planning? Or is it just portfolio management, and you would have to pay extra for other financial planning services?), and
  • The adviser’s investment philosophy (i.e., how they pick investments and how they allocate between those investments).

What’s nice about this form is that it’s a way to get the relevant information quickly, without having to filter through a bunch of sales talk (as you would often have to do if you visited the adviser’s website), and without having to give the adviser your contact information.

How to Find an RIA’s Form ADV Part 2

Downloading an RIA’s Form ADV Part 2 is easy:

  1. Go to the SEC’s Investment Adviser Search website.
  2. Look up the adviser by firm name.
  3. Click “get details” then “Part 2 Brochures.”
  4. If necessary, click the link for the most recent brochure filed.

How About an Example?

Let’s say you recently read Allan Roth’s book How a Second Grader Beats Wall Street, you liked it, and you’ve decided to include Allan’s firm Wealth Logic as one of several firms you’re considering. But first you want to find out a bit more about his practice, how much he charges, and so on. So you look up Wealth Logic on the SEC site and download the ADV Part 2 brochure.

With regard to how Allan’s firm charges clients, you find the following plain-English statement:

“All fees are hourly or fixed dollar to minimize any conflicts of interest. No additional profits can be made as a result of the advice rendered. The hourly rate is currently $350. This rate is both negotiable and can be capped for a period of time. All fees are due within 30 days of the billing date and a retainer amount may be requested.”

It’s clear and to the point. And if, for example, Wealth Logic instead charged a fee based on the amount of assets under management, there would be a table showing exactly how that fee is calculated.

With regard to what types of investments Allan’s firm recommends to clients, you’ll find the following statement:

“Minimizing expenses and emotion, and maximizing diversification, are core methods Wealth Logic applies in designing portfolios. Broad index funds of mutual fund and ETF categories are those most often used in the practice, as well as Bank and Credit Union CDs going directly to those institutions insured by the FDIC or NCUA.”

Again, it gets right to the point with very little fluff.

Looking up a registered investment adviser’s Form ADV Part 2 should certainly not be the only research you do on an adviser. But it’s an excellent first step to quickly check for things that would eliminate the adviser from consideration (e.g., an important conflict of interests, fees that you think are too high, a minimum asset level that you don’t meet, or an investment philosophy that’s markedly different from your own).

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