Excerpts From The Professional Financial Advisor IV

One area where people feel some degree of basic satisfaction is regarding scientific progress. Of course, in order for things to get better, we need to actually implement the things we learn. It’s all well and good to come up with a better mousetrap, but if no one knows about it, it won’t do anyone much good.

A few questions: What if that better mousetrap were a threat to the status quo? What if a multi-billion-dollar industry had developed surrounding the production and sale of inferior mousetraps? Furthermore, what if there were an army of sales representatives that earned commissions selling these inferior mousetraps?

Some commentators have suggested that a primary role for advisors is to assist their clients in avoiding big mistakes. Nonetheless, the advisors that bought into this rationale effectively sold a value proposition that had a questionable basis. Of course, it’s tough to position yourself as an expert if you have to admit that your presumptive “value-added service” is tenuous. Note that the same holds true for advisors using individual securities as it does for those using mutual funds. This should be easy enough to follow. If a mutual fund manager can’t reliably pick stocks, what makes you think an advisor can do it?

Since the vast majority of mutual funds lag their benchmarks in the long run, the industry has chosen to score itself against itself. While published performance tables measure mutual funds against their benchmarks, mutual funds are rated according to their performance relative to other mutual funds rather than in relation to their benchmarks. For instance, you might get a false impression when looking at rankings because the rankings only deal with funds that are still around. There would be 25% of all remaining funds in each performance quartile, yet some funds in the second quartile today would have lagged their benchmark. Remember, benchmarks have no associated costs, but all investment products do. Over a period of two or more decades, fewer than 25% of all (remaining) funds beat their benchmark. One could literally go to a ranking book to find a fund with a ten-year track record that is ranked in the first quartile (top 25% of all funds around for that long). People could buy it thinking they’re making a shrewd decision even though the fund may have lagged its benchmark!

Why do so many advisors portray themselves as being good fund pickers? Fund picking and stock picking are statistically improbable value propositions in the financial services industry today, but the majority of consumers fail to see it that way.

By comparing one product to another, the financial services industry creates the impression of a balanced, apples-to-apples comparison. This comparison is fair in a relative sense (i.e., we can see which funds have been better than the others in the past), but that’s as far as it goes. In fact, current comparisons might actually prevent you from making a truly informed decision.

The real challenge is in outperforming an appropriate benchmark or lagging that benchmark by the smallest possible amount. That test would be far more meaningful to consumers. It is impossible to buy a benchmark. If you wanted to buy the TSX, you’d be unable to do so. The best anyone can do is buy a product that seeks to track the benchmark in question. All products cost money, so it should stand to reason that a product that tries to match a benchmark is likely to lag by something close to the cost of the product. The most common products used to track a benchmark are index funds and exchange-traded funds (ETFs).

By now, most people have heard of ETFs. They are a sort of hybrid between stocks (because they trade on exchanges) and mutual funds (because they are highly diversified). Not surprisingly, ETFs come in many shapes and sizes and feature many strategies and alternatives.

For now, let’s concern ourselves with the most basic type of ETF: the type that aims to track a benchmark. We’ll discuss other types elsewhere. The oldest and best-known ETFs are concerned only with generating a performance that does not deviate much from a benchmark (known in the business as “minimizing tracking error”). Stated a little differently, if you define risk as “the extent to which my investments deviate from the market as a whole,” then traditional benchmark-tracking ETFs are for you. This is just one definition of risk. Many people would define risk as “the potential of losing money,” but both approaches have their place.

It might be added that likely the greatest risk of all, market risk (i.e., having your investments drop in value), warrants copious disclosure by the advisor irrespective of the products or strategies chosen. More often than not, an investor will lose money in a falling market and make money in a rising market, and the product decision will make little difference. When choosing between individual securities, mutual funds, ETFs, and other options, an advisor should ideally be able to explain the pros and cons of each and to recommend products and strategies that suit their clients’ circumstances.

Similarly, investors should consider their own views regarding risk, reward, and the probability of outperformance when making decisions and advisors should aim to offer dispassionate advice and guidance to assist them. True professionals offer the most important details of all material facts. The approach should involve professional input based on credible research. Deliberately remaining silent on those same material facts is, to my mind, a form of manipulation.

John J. De Goey, CFP, CIM, FELLOW OF FPSC, is a Portfolio Manager with Industrial Alliance Securities Inc. (IAS). The views expressed may not be shared by IAS. His book, The Professional Financial Advisor IV, is scheduled to be in bookstores across the country before Christmas.