Choosing or Evaluating Investment Advisors

Tips to help you make the best choice.

By Jason M. O’Dell, MS, CWM and Andrew Taylor, CFP
 

Over the last few years, many physicians have re-examined not only their investment assumptions, but also their relationships with their investment advisors. Volatility in the market often leaves many doctor-investors uncomfortable with the idea of simply staying the course with their current plan (if they have a plan).

In our experience, investors tend to make three common mistakes when evaluating their advisors: 1) getting too caught up in past performance; 2) failing to understand the scope of your relationship with your advisor and the fees you pay; and finally, 3) ignoring what really matters—your net return.

If you are considering changing or revisiting your investment strategy; or just value a second opinion on your current strategy, we hope this article will prove helpful. We will expand on the missteps made by many investors, and provide suggestions on how to avoid making the same errors.

1. The Dangers of Reviewing a Firm’s Past Performance

A common mistake many retail investors, including physicians, make when evaluating or selecting their investment advisor is to overrate the importance of an advisor’s recent returns. There are several reasons why this approach is flawed:

• The time frame may be too short. When looking at an investment’s track record, many clients will ask for gross returns (already a mistake) on a one-, three- and five-year basis. This is simply not enough data to make any concrete conclusions about skill versus randomness or even luck. In fact, 10 years may not be enough. An in-depth examination of this issue is well beyond the scope of this short article. However, if you are truly interested in learning more about why such measurements must be looked at over decades, and why most investment performance claims may be based in luck, we recommend you read the best-selling book Fooled by Randomness by Nassim Taleb.

• Comparisons of results are not likely not apples to apples. Even the common question, “how did your portfolio perform (last year)?” can lead to misleading answers in cases where portfolios are designed for individual clients. For example, at our firm, many of our clients have customized portfolios—based on their risk tolerance, age, time horizon, tax bracket, objectives, and a variety of other factors. Because of various factors, it is entirely possible that Client A could see returns of 3 percent and Client B could have a portfolio gain of 20 percent over the same period. Both investors could be equally satisfied (or dissatisfied) and neither of these results may give you any helpful advice about your particular situation (as Client C). Only in situations when two investors have very similar goals, circumstances, and objectives is any comparison worthwhile.

• Past performance is NO guarantee of future results. Anyone who has ever watched an investment firm’s commercial on television, listened to an advertisement on the radio, or read one in a newspaper or magazine is familiar with the phrase “past performance is no guarantee of future results.” While this can be easily discarded as legalese by consumers, it is crucial for investors to understand.

Performance chasing can be very detrimental to an investment portfolio. You cannot tell which asset class will have the highest returns, or the lowest, by simply looking at the recent historical data. This alone makes a strategy of chasing asset class-focused funds and managers based on their past results dubious at best.

2. Failure to Reassess and Objectively Evaluate the Relationship with Your Advisors

It is easy to gravitate toward advisors who are friends and family or friends of friends. It is also easy to become complacent in an advisor relationship and stay with someone longer than you should. Below we identify the most important factors in evaluating your relationship with your financial advisors.

• Two-way communication is a fundamental element of client service. When polled, most clients of any professional advisor—from attorney, to CPA, to financial advisor—name “timely and effective two-way communication” as an essential element of a fruitful working relationship. Still, many investment advisors seem to focus more on returns. Even for those advisors who value customer service, certain business models within the investment business make such communication almost impossible.

As an example, consider the entire mutual fund industry, which many physicians utilize for a substantial portion of their investment portfolios. What communication does one get from such a fund—prospectuses, monthly and annual statements, perhaps a newsletter? Is there any individual consultation with investors on the portfolio mix or the tax impact of the buying/selling within the fund or the impact sales could have on an investor’s tax liability? Generally, the answer is “no”. This is because the fund industry is built on a low-cost low-service model where two-way communication with the folks managing the fund is cost prohibitive and rarely permitted.

When choosing an investment advisor to manage your portfolio, even if this choice involves finding assistance in the management of mutual funds or ETFs within a portfolio, one should expect much more communication as a fundamental element of client service. This doesn’t simply mean that the advisor calls you when there is a hot new buy (as stockbrokers are notorious for). Rather, one should expect a defined communication process throughout the year that is independent of trade suggestions.

• A transparent and client-aligned business model is a must. Given the troublesome conflicts of interest that have come to light in the investment industry over the past few years, we feel that all investors (not just physicians) should work with financial firms that use a transparent business model and one that aligns the firm’s interests with that of their clients. There are key elements to look for in such an arrangement:

Independent Custodian: Ideally, an investment firm does not act as custodian (i.e., hold) of its clients’ investments in the firm. Rather, the firm should have arrangements with several of the largest independent custodians (such as Charles Schwab, TD Ameritrade, etc.) to hold their investments for safekeeping, while the investment firm manages the accounts. The inherent checks and balances of this type of arrangement prevents the insular secrecy that allowed Madoff, Stanford, and other criminals to operate.

Client-Aligned Fee Model: Many clients today, physicians among them, are realizing that a clear fee-based model works best for them. Under such an arrangement, advisors charge a transparent, clearly-defined fee on assets they manage. Contrast this with the traditional convoluted transaction-charge model that most brokers utilize where a client pays based on trades in the account, regardless of whether the trade added value or not. In a fee-based model, not only do clients understand exactly what the fee is, but they also understand that the firm’s interest is the same as theirs—seeing the portfolio increase in value. The annual management fee the investment firm earns is a percentage of the assets you have in your account with them. The more money you have, the more money the firm earns. Ask yourself: do you feel more comfortable paying advisors a set fee or commissions based on the number and size of the trades they make?

3. Ignoring What You Keep—Your NET Returns

Many investment clients focus primarily on management fees and expenses when evaluating advisors. While such costs are important, for most physicians, the annual fees might range from 50 basis points (0.5 percent) on the low end (very large portfolio in a fee model) to 300 basis points (or 3.0 percent) on the high end (mutual funds can be this high, as can broker transaction costs). Though this huge expense range (600 percent variability!) is one reason why we are so adamant about the AUM-based fee model above, this is not an investment client’s largest expense. Rather, taxes usually are.

The cost of federal and state income and capital gains taxes on a portfolio depends on many factors—the underlying investments, the turnover, the structure in which the investments are held, the other income of the client, the client’s state of residence, and more. For higher income investors, such as physicians, taxes will nearly always be high. To gain perspective of how much taxation reduces your returns, consider this: Over the period from 1987-2007, stock mutual fund investors lost, on average, 16-44-percent of their gains to taxes.1

The nine-year recovery of the US stock market has exacerbated this problem for investors in the top tax bracket. All-time highs in the S&P 500 mean mutual funds are no longer carrying losses to offset gains, and many funds passed on significant capital gain distributions to investors in 2017. Given that some investors are losing between one sixth and nearly half of their gains to taxes, one would think this would be a focus of value-added investment firms. Unfortunately, mutual funds themselves provide no tax advice to their investors. They provide only 1099 tax statements in January. Even stockbrokers, money managers, hedge fund managers and financial advisors at the nation’s largest or most prestigious niche firms do not offer tax suggestions—and their compliance departments are glad they don’t—because they are prohibited from doing so. Tax advice could include specific techniques for limiting tax consequences of transactions or more general tax diversification in portfolios. As a result of these limitations, most investment clients are not getting the tax suggestions they want.

But don’t investors want this tax focus from their investment firms? What is more important to you: the gross return your investment firm boasts in its marketing materials or your net after-tax return? Unless you generously want to give more to state and federal governments than you need to, the net after-tax return is the only measure that should truly matter.

With full disclosure, our firm is one that understands the focus on after-tax returns. That is one of the reasons we have a CPA on our team. As capital gains and income taxes—both at the state and federal level—may change in the near future, we would expect more investors to look for tax expertise in their investment team.

Conclusion

We advise you to remain vigilant and to constantly monitor and evaluate your plan and your advisors. We trust that if you focus on the right factors, you can make intelligent, well-informed decisions.

1. Mutual fund tracker Lipper, quoted on CNN/Money.com 4/17/07.

The authors welcome your questions. You can contact them at 877-656-4362 or through their website www.ojmgroup.com.

To receive free print copies of For Doctors Only: A Guide to Working Less and Building More and Wealth Management Made Simple, please call 877-656-4362. Visit www.ojmbookstore.com and enter promotional code PRDERM04 for a free eBook download of these books for your Kindle or iPad.

Jason M. O’Dell, MS, CWM is a financial consultant and author of more than a dozen books for physicians, including For Doctors Only: A Guide to Working Less and Building More. He is a principal of the wealth management firm OJM Group www.ojmgroup.com, where Andrew Taylor, CFP® is a wealth advisor. They can be reached at 877-656-4362 or odell@ojmgroup.com.

Disclosure:
OJM Group, LLC. (“OJM”) is an SEC registered investment adviser with its principal place of business in the State of Ohio. OJM and its representatives are in compliance with the current notice filing and registration requirements imposed upon registered investment advisers by those states in which OJM maintains clients. OJM may only transact business in those states in which it is registered, or qualifies for an exemption or exclusion from registration requirements. For information pertaining to the registration status of OJM, please contact OJM or refer to the Investment Adviser Public Disclosure web site www.adviserinfo.sec.gov.

For additional information about OJM, including fees and services, send for our disclosure brochure as set forth on Form ADV using the contact information herein. Please read the disclosure statement carefully before you invest or send money.

This article contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized legal or tax advice. There is no guarantee that the views and opinions expressed in this article will be appropriate for your particular circumstances. Tax law changes frequently, accordingly information presented herein is subject to change without notice. You should seek professional tax and legal advice before implementing any strategy discussed herein.

 

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