July 3, 2005

My take on industry's hot button issues
Fees, the value of advice, and other issues

I have, over the years, expressed my views on a variety of hotly debated and sensitive issues in the investment industry. But such things are scattered over many articles. Also, as my business grows more toward consulting with and providing research to financial advisors, I thought it relevant to rehash my stance on some key issues.

Fees

A couple of financial advisors remarked to me recently that they thought I was too tough on fees or that they thought I hated fees. I am critical of high and excessive fees. For instance, I don't have a great deal of tolerance for funds that charge 3% or more. And it's true that costs are one of the key quantitative factors I use when constructing my recommended list of funds for advisors.

All else being equal, lower costs are better. Also, the more conservative the portfolio, the more direct - and inverse - the relationship between costs and performance. So, as we move along the risk spectrum from conservative to aggressive, fees and other costs matter less. But they always have some level of importance.

I also think it's most meaningful to compare costs at the portfolio level - and in a cost/benefit context. In other words, it's usually impossible to judge whether somebody is paying a fair price until it is known what services and other benefits are being delivered in return by the advisor.

just don't like them

Related to the issue of fees is my general dislike for bond and balanced funds. My reasoning goes like this. The gross yield on the Scotia Capital Universe Bond Index sits south of 4% at the time of writing. The median management expense ratio (MER) of Canadian bond mutual funds is 1.63% per annum. That means something like 40% of the gross return is eaten up in fees. But since this gives no credit for bond managers' ability to add value, I decided to take a closer look at some numbers.

I recently calculated the gross performance (before MER but after trading costs) of all Canadian bond mutual funds (i.e. excluding segregated funds, mortgage funds, and high yield). Only 40% of them beat the broad Canadian bond market - before management fees. This leads into the 'balanced fund' issue.

The same reasoning applies here - i.e. that fees eat up a big portion of the gross bond yield. But for balanced funds, the issue is worse because fees are higher - and generally equal to that of equity funds. With a median MER of 2.24% per annum, and an often conservative approach to bond management and asset mix, most balanced funds don't offer good value in my opinion - compared to simply separate bond and equity funds. However, I recognize that the more compact packaging of balanced funds can be useful for servicing small clients and that it helps to battle the tendency of investors to fall prey to 'mental accounting' - a well documented investor behaviour that can chip away at an investor's discipline.

Advice and compensation

Those that think I'm too tough on fees also have the impression that I don't like advisors to get paid. And that's just not true. My start in this industry was as an advisor, licensed to sell investments. Even when I jumped to the research side of the industry, I did so in support of financial advisors to help enhance the advice they give to their clients.

Plus, I always had a few clients to whom I provided personalized advice. I continue to offer research to the advisory industry to support their efforts. And I continue to deal with a small list of individual clients through my firm's Investment Counsel license in Ontario.

So, clearly I believe in the value of professional financial advice because I think most people are ill-suited to handle their own financial affairs. It's not that they're incapable or not smart enough. It's that few are able to be very competent at their 'day jobs', maintain some life balance (i.e. spending time with love ones), and know enough to make smart decisions on investments (insurance, taxes, estate issues, etc.). Some can do it - and I know some that have. But they're a tiny minority.

Canadians need good financial advice. And even though our industry - like any - has its share of bad apples, I believe that most advisors add value to their clients in both tangible and intangible ways.

Advisor motivations

Outgoing OSC chief David Brown recently implied that advisors referred clients to embattled hedge fund firm Portus because of its lucrative 'referral fees'. In a recent article, I took exception to this. It's a big assumption to make. While Portus paid lucrative fees to advisors, I strongly disagree with Brown's inference.

Critics of the industry often point to the fact that more than 90% of Canadian advisors are paid by commissions; and that this system creates conflicts of interest. I won't disagree with that. I think the industry needs to change. If nothing else, making advisor compensation more transparent will be a positive for all clients and for most advisors.

In my experience, telling clients exactly what they're paying for their investment portfolio fees - in dollar and percentage terms - is both enlightening for clients and smart for advisors. First, advisors that put all of their cards on the table not only run a better chance of winning their client's trust; but they also demonstrate a certain level of confidence in the value of their advice. Second, it's a savvy marketing move.

Understand that I'm not a good marketer. So, why should you listen to me and show your clients - in writing - how much they pay in dollars and percentage terms? Because if you do, I'd bet money that you'd be the first to ever show them such details. And they'll appreciate it.

I do think that the current system of embedded compensation can skew advice at times. But it doesn't mean that advisors are evil or that they don't deserve to be paid. Nor does it mean that every advisor seeking a more professional practice is bound for a fee only model. But it does mean that transparency is a necessity - and perhaps somewhat inevitable.