My Investment Advisor Is Doing a Great Job…Are You Sure?

Transcript

I think we would all agree that trust is the most important aspect of any relationship. And when it comes to financial advice, this couldn’t be more true. If you have someone in your financial life—this could be a paid professional, friend, family member, or anyone who can provide you with unbiased advice specific to your situation that gives you peace of mind—as far as I’m concerned, they are worth their weight in gold. 

Unfortunately, during my time as an advisor, I saw some pretty bad actors that lived up to the common financial advisor stereotype many of you probably hold of the profession. This episode will cover not just one, but two, stories that still get me heated to this very day.

Welcome to the first season of Invested Poorly: Sad Tales of FInancial Fails, a short-form podcast designed to help everyday investors make wiser investment decisions by learning what NOT to do with their money. Host Jeff Harrell shares timeless stories from his former life as a financial advisor, about the poor—and irrational—choices he witnessed investors make that disrupted their journey to financial independence, or FI. Your ability to recognize, and avoid, similar mistakes could make all the difference for you along your path to reach FI.

Check out the “Introduction” episode for more background on Jeff, why he created this podcast, and how it can guide you to becoming the hero of your own investing story. Now, on with show.

When you hire a financial professional, you obviously want them to act in your best interest at all times. This includes not only giving you good advice, but, if they are also managing your money, it is extremely important they provide you with reports that illustrate how your accounts are doing and compare the performance to relative benchmarks. If you haven’t done so already, be sure to check out episode 6 on past performance and episode 9 on market experts. These two episodes highlight how, and why, passive index investing is very hard to outperform over the long-term.

If you are using an investment professional to manage your money, it is more than fair to ask them to provide you with reports that illustrate the returns they have achieved while managing your accounts and compare your returns to relative benchmarks. Most investment firms actually do a pretty good job of providing this information in various forms. For the most part, these reports are helpful and informative, although many can be confusing. This is especially true when it comes to the performance reporting section; and that is where my first story comes into play.

A client of mine once sent me a performance report from an account being managed by another advisor, to get my take. Although the other advisor was using actively managed funds and had a high allocation to asset classes that I personally didn’t like, on the surface there was nothing wrong with the account, if you were comfortable with the strategy.

However, what stood out to me was not what he was invested in, but the performance report being sent to the client. The account had a track record that was over five years. The report illustrated the performance of the account over 1, 3, and 5-year time periods and compared them to something called a “target risk moderate index.” His account was outperforming all three time periods, creating the perception his account was doing pretty good. However, that benchmark meant nothing to me, so I asked my client about it. Not surprisingly, he had no idea what it represented, so I told him I would investigate.

The first thing I did was look at his report closer to see if there was a disclosure or something that provided more information. To my surprise, there wasn’t. This was a little shocking because on the performance reports we sent to clients, we always listed the components of a benchmark in the disclosure section. So for this one, I would have to dig a little bit deeper. I first went to the advisor’s website to try and figure out what this “target risk moderate index” represented. Despite the fact that I’m an investment professional and knew exactly what I was looking for, it took me a while to figure out what he was using, which I eventually determined were S&P composite indexes.

Okay great, but I still didn’t know what a “target risk moderate index” was. Digging further into this, I found out that S&P has multiple “target risk indexes” that can be used for comparison purposes. This sounds great because it simplifies the process for investors, and advisors, by creating a diversified benchmark that can be used for comparison purposes, which is exactly what the advisor was doing. However, the final step of my investigation was where things took a turn for the worse.

When I looked back at my client’s account, I noticed he had roughly 85-90% of his portfolio in stocks and the rest in bonds. When I looked at the composition of the “target risk moderate index” it only had 40% in stocks. I also noticed S&P had a “target risk aggressive index” that had 80% in stocks. Now I realize I’m a professional, but I pose the question to you: why do you think the advisor would show a benchmark with 40% stocks versus the option with 80% stocks, when the 80% stock benchmark is clearly more representative of how the account is being managed?

You guessed it, performance. The 1-, 3-, and 5-year returns of the “target risk aggressive index” were all much higher than my client’s account, so that wouldn’t have looked nearly as good on the report. Do I need to go any further? You be the judge of why you think the advisor chose the benchmark that he did. And if this was your advisor, how would you react?

Another troubling example of misleading performance reporting came from a client of mine who also sent me his performance report from another advisor. He had been using this advisor for over ten years, so he had a very long track record. The performance report looked pretty straightforward. It showed the return of my client’s account and compared it to many indexes, like the S&P 500, the Dow Jones Industrial Average, the NASDAQ, etc. My client’s account was outperforming some of these indexes and underperforming others, which is exactly what one would expect with a diversified portfolio. At first glance, there was nothing alarming, or so I thought.

I remember being almost done with my review when I glanced at the performance segment one final time, and something just didn’t look right. I noticed in one of the calendar year returns, the S&P 500 listed a negative return on his report, which made me think back to that year because my memory suggested there had been a late surge in December that turned the index positive during the last couple of trading days. So I started questioning my memory, thinking maybe I was mistaken and maybe the market actually did go down that year.

Well, as they say in baseball, “upon further review, the call is overturned.” Because I figured out why his report was showing a negative number for the S&P 500 that year. The advisor was using index returns based on the change in price of the index, which does not include dividends. I’m not going to lie, I was irate when I saw this because it’s this type of deceptive activity that justifiably gives financial professionals a bad name.

Okay, I realize most of you listening may still be confused as to what was going on, so let me try and make this perfectly clear. The advisor was comparing the total return of the portfolio he was managing with all income and dividends included, to the S&P 500 without the dividends included. This guarantees the performance listed every year on the performance reports understates the total return of the S&P 500 by the dividend yield. Now, there are only two possible explanations for how this happened.

Option one, is the advisor was incompetent and didn’t understand the difference between a price return index and a total return index. Not very reassuring, if you ask me.

Option two, is the advisor fully understood the difference and used a comparison that understated how the indexes were really doing by the amount of the dividend every year in order to make the account he was managing appear to be performing better than it truly was.

You decide for yourself if the advisor was more likely incompetent or intentionally misleading. Either way, this is not an advisor I’d put in the trust category. Keep in mind, I’m an investment professional and I almost missed it, so what are the odds an everyday investor would pick up on it? Slim to none, if you ask me.

I sure hope you enjoyed this episode of Invested Poorly and will be able to take something from it to improve your decision making as you navigate the twists and turns of your personal investing adventure. Be sure to check out my website at AreYouFI.com (that’s A R E Y O U F I dot com) where you can find resources and show notes with the charts and graphs I mention during the episodes. These are like little treasure maps that can help you choose more wisely along your quest to reach FI, or financial independence.

Never forget, in the short-term the stock market is unpredictable, and as my mischievous little nephew likes to say, “things just happen”! So focus on the long-term, by controlling your emotions, simplify your investments, and always… ignore the noise.

I’m your host, Jeff Harrell.  Thanks for listening.

Invested Poorly: Sad Tales of FInancial Fails was created for informational purposes only and should not be relied on for specific tax, legal, or investment advice. You should consider consulting a qualified professional to review your situation before engaging in any transactions. Investing involves risk, including loss of principal and past performance is no guarantee of future results. 

This podcast was produced by Ted Cragg. Learn more about creating podcast mini-series like this by visiting QuickEditPodcasts.com.