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Archive for December 2010

Money Manager Due Diligence – It’s About Process

Jim Lorenzen, CFP®

Jim Lorenzen, CFP®

Selecting the right money managers for your serious assets isn’t something to take lightly.  Unfortunately, too many people take far too many shortcuts, going straight to ‘star ratings’ and other `easy answer’ vehicles, and sidestepping altogether the data collection, situation needs-analysis, risk assessment, and Investment Policy Statement (IPS) steps so necessary to the manager screening process.  Let’s face it:  While every manager might be right for somebody, no manager is right for everybody.

But, once those steps are completed and you have your Investment Policy Statement, what are the steps required to conduct a true due-diligence process?

Here’s a brief thumbnail overview to get you started on the right foot – or maybe to help you assess whether your advisor has adopted a prudent investment process.

  1. Performance numbers:  While most of us are aware that past performance is of limited value in determining future performance, it does help narrow the list of potential candidates.    I’ve provided some insight into this in a previous post, Understanding Management’s Value.  You’ll want to consider time-weighted composites of actual results, quarterly returns, and both gross and net of fees.  One thing to look for, of course, is consistency over different time frames.  I personally like to see five years from an equity manager and three years from a bond manager.
  2. Performance relative to assumed risk:  There are several measures you can use here, such as the Sharpe ratio, alpha, beta, and standard deviation.  If you’re not familiar with these, you can learn about them or ask your financial advisor for help
  3. Performance among peers: Here it’s important to have third-party objective evaluations.  Briefly, you don’t want to compare a domestic large-cap value manager with an international mid-cap growth manager.  You’d be surprised how often people compare apples and oranges, utterly convinced their comparisons are valid.
  4. Manager’s Adherence to Stated Investment Style:  Let’s face it, if you’ve selected a manager because of their investment process and proven ability as a value investor, you don’t want that manager to begin making earnings-based investment decisions.  This ‘style drift’ into growth investing destroys your allocation strategy.  Part of the due diligence process is constantly confirming that the manager consistently follows a process and doesn’t chase fads or ‘hot’ sectors.  ‘Chasing returns’ is for amateurs, not professionals.
  5. Performance in both `up’ and ‘down’ markets:  Bull markets can make bad managers look good.  Everyone’s a sailor when the seas are calm and the wind is at your back.  It’s when the wind is against you and the seas are choppy – when you have to put down your champagne glass and work with the sails – that we find out who the true sailors are.  Most pros would gladly accept a manager that experiences only 80% of the upside if the downside experience is only 70%.  It’s important to note, too, that even in a bull market you might expect better than a 1 in 4 chance that a portfolio will go down before it begins to go up.  Individual investors typically want all the upside with none of the downside; so, for many, the concept of relative performance over time is an education process.
  6. Performance of key decision makers and their organizations:  Even those firms that use a ‘black box’ – quantitative models – to arrive at their decisions, still need people to interpret and implement the output.  Some of the areas of interest are ownership (vested interest), size of the firm (focus), assets under management (concentration), change in personnel, trading capability (costs), research (in-house vs. purchased, soft-dollars (using transaction costs to cover manager expenses), conflicts of interest (broker-dealer affiliates, banks, insurance companies, or investment companies (mutual funds) need to affirm that their money management operations are completely independent of other corporate activities – ethical walls may exist in theory but can be hard to carry out in practice).

This is overly brief, to be sure; but it might provide a little insight on how extensive a prudent manager selection process is and why there are seldom any quick or easy answers. 

It’s also important to reiterate that the process should always be conducted in light of the Investment Policy Statement (IPS) that was created upon the completion of a well-constructed investment plan… and that is, as you might expect, only as good as its input on the data collection, risk assessment, and goal-setting components.

Jim

Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER™ and in his 20th year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California.   IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description.  Nothing contained herein should be regarded as tax or legal advice and the reader is urged to seek competent counsel to address those issues.   The above represents the author’s opinion and should not be regarded as investment advice which is provided only to IFG clients upon completion of a formal financial and investment plan.   For questions or comments, you can reach Jim at 805.265.5416 or through the IFG website, http://www.indfin.com.

Is Rebalancing Your Portfolio Always Smart?

Jim Lorenzen, CFP®

Jim Lorenzen, CFP®

That’s what we’re taught!  Financial advisors, including yours truly, have been promoting the idea for years!  But, does is it always the best thing to do?

Those of us in the investment world are constantly telling people that past performance is not necessarily an indicator of the future… and you can’t assume historical patterns will continue.  This is because of the arbitrage principle:  If investment prices did follow a predictable pattern, smart investors will arbitrage that pattern away.

But, in the case of rebalancing, does maintaining your portfolio allocations actually help or hurt?

It depends.

For example, what if your measure of risk is experiencing inadequate cash flows in ten or twenty years?  And, what if you control that risk by holding part of your portfolio in 30-year Treasury bonds to provide a safety net?

If you do your periodic rebalancing, you will likely not maintain your risk hedge; in fact, you’ll likely destroy it.   Let’s say you start out with 50% in stocks for long term growth and 50% in Treasury bonds to provide your income safety net.  Suppose the market drops 20%.  Rebalancing would mean you’d be selling some of your Treasury bonds, your income safety net.   Here, rebalancing could be viewed as short-sighted.

For most investors, risk is a long-term, not a short-term, concern.  Short-term volatility is a component of risk, to be sure; but, too much emphasis on it can result in taking your eye off the ball from a long-term risk control strategy such as, for example, one which focuses on protecting income or hedging inflation.

Maybe `one size fits all’ advice isn’t the best, after all.  Before you can implement a prudent strategy, you have to have a plan.  And, the best plans always begin with an analysis of who you are financially – and where you want to go.

Jim

Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER™ and in his 20th year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California.   IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description.  Nothing contained herein should be regarded as tax or legal advice and the reader is urged to seek competent counsel to address those issues.   The above represents the author’s opinion and should not be regarded as investment advice which is provided only to IFG clients upon completion of a formal financial and investment plan.   For questions or comments, you can reach Jim at 805.265.5416 or through the IFG website, http://www.indfin.com.

How Bad Advisors Spot Easy ‘Marks’

Jim Lorenzen, CFP®

Jim Lorenzen, CFP®

… and how good advisors spot unsophisticated clients.

A little over a week ago I saw a short special program – it might have been on one of the PBS stations – conducted by the industry’s regulator authority, FINRA and a representative from AARP.  It was about the ‘red flags’ people should look for in avoiding investment scams.

Almost all the red flags had to do with things to listen for, etc.; but, they all had one thing in common:  Client greed.  The ‘scammer’ can’t appeal to someone who isn’t greedy.

One of the points the program rightfully made was that most victims aren’t `little old ladies’ or widows, etc.  Quite often, they’re what most people would consider sophisticated investors.  In fact, they consider themselves sophisticated investors.

They weren’t.  Not one of them.

They didn’t reveal the credentials of the stockbroker victim they featured.  Chances are he was little more than a securities salesman.  And, just because someone studied tax preparation/strategy or medicine doesn’t make them a sophisticated investor, either, any more than it would qualify them to work on guidance systems for the Space Shuttle.

Often, people who consider themselves to be sophisticated investors reveal their lack of sophistication quite quickly.   Usually they’ll ask an advisor they meet, whether in a business situation or socially, a common question.  It’s a question that tells the `bad’ advisor how to make a sale – and it tells the high-end advisor that the investor has never had a true financial plan and really knows little, if anything, about the investment process.

Here’s the question you should NEVER ask an advisor:

“What kind of return do you get for your clients?”

The `bad’ advisor is thinking:  This idiot is simply chasing return.  S/he buys based on greed.  All I need is the right charts – along with a few other bells & whistles like short time, limited supply, etc., and I’ll have a buyer!

The high-end advisor is thinking:  This is a small-timer who has no experience working with high-end asset management.  If he did, he’d know I have 45-year-olds and 80-year-olds as clients and they’re not trying to achieve the same objectives.  The question shows s/he’s never experienced the financial planning process and since s/he thinks they know what they’re doing when they don’t, this is going to require a lot of education.   Be wary.  People who continually `chase returns’  – which this person does or else I wouldn’t be hearing this question – are always searching for the silver bullet and never seem to stick with anything.

Result:  The `bad’ advisor will begin engaging the prospective client in a ‘returns’ discussion.  The high-end advisor may engage in polite conversation designed to `qualify’ the prospective client quickly.  The usual outcome is disqualification.   This person will likely end-up with someone selling investments – and will likely buy the best story.

That’s my two-cents.

Jim

 

Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER™ and in his 20th year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California.   IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description.  Nothing contained herein should be regarded as tax or legal advice and the reader is urged to seek competent counsel to address those issues.   The above represents the author’s opinion and should not be regarded as investment advice which is provided only to IFG clients upon completion of a formal financial and investment plan.   For questions or comments, you can reach Jim at 805.265.5416 or through the IFG website, www.indfin.com.

Warren Buffett Likes Bank of New York Mellon?

Jim Lorenzen, CFP®

Jim Lorenzen, CFP®

It might seem that way!  According to a November 23rd articles in Advisor Perspectives, Warren Buffett purchased 1,992,759 shares of Bank of New York Mellon during this past July through September quarter with an average share price of about $26.13, which came to around $52 million+.  

Let’s start with a note of caution:  Don’t run out and start buying the bank’s stock simply because of this post.  The purpose of this is to, hopefully, provide some food for thought about investment philosophy.  This is neither an analysis of BNY’s stock nor a suggestion you should buy it.  On the contrary, you should do your homework first and talk to your advisor.  If you’re really smart, you probably have professional institutional managers handling all this for you, instead of treating it like recreation, which far too many people do.

It’s worth noting that when anyone makes an equity purchase, what is received is partial ownership of the net assets of a company and a share of all the future earnings generated by those assets.   It’s interesting that Ken Anderson, CFA, noted that since Value Line had estimated BNY’s book value per share at around $25.15, it would appear Mr. Buffett paid a zero premium for these assets.

BNY Mellon is not a stranger to our clients.  It is currently the largest global custodian, entrusted with $24 trillion of other people’s money and is one of the 10 largest asset managers in the world with over $1 trillion of discretionary money management.  It is also the largest global trustee of funds borrowed by others, servicing over $12 trillion in outstanding debt; so, it’s no wonder they’ve earned the highest credit rating among U.S. banks by third party rating agencies and have received numerous awards as the top-ranked client service organization in the world.

So, why is Warren Buffett interested?  You will probably have to ask him to get a correct answer, but I believe there are some hints, contained in the article I cited above:  The Bank of New York Mellon is generating over $800 billion of new capital per quarter that isn’t needed for servicing debt; that’s $3.2 billion per year available to increase dividends, buy back shares, or expand operations through organic growth or acquisitions.

There’s maybe another reason, too.  Warren Buffett, unlike most investors if history is a guide, doesn’t appear to go for `home runs’ like so many others.   According to Alice Schroeder, author of the unauthorized biography of Warren Buffett, entitled, Snowball, during her presentation at last year’s Value Investing Conference held at University of Virginia’s Darden School of Business, Mr. Buffett seems to aim for a `good enough’ standard which she has calculated at around 15% annually.  Without going into detail on her detailed analysis of numerous Warren Buffett investments – including those going all the way back to his first one in 1959 –  it would seem he looks at the price, the terms, and the people, and would seem to provide us with a little insight as to his philosophy:  Seeking companies with an ability to earn 15% on investment (ROI) within the business, letting future market value take care of itself.

The lesson:  It’s all about process and philosophy.  And, like building a house, it begins with a plan.  If you don’t’ have one, contact your advisor and get started.  That’s your best advice. 

Jim

Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER™ and in his 20th year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California.   IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description.  Nothing contained herein should be regarded as tax or legal advice and the reader is urged to seek competent counsel to address those issues.   The above represents the author’s opinion and should not be regarded as investment advice which is provided only to IFG clients upon completion of a formal financial and investment plan.   For questions or comments, you can reach Jim at 805.265.5416 or through the IFG website, www.indfin.com.

How The Advice Landscape Is Changing

Jim Lorenzen, CFP®

Jim Lorenzen, CFP®

When I first entered the investment business, it was the traditional way:  I was a stockbroker at a major `wirehouse’ firm.   I went through training in the local branch; then, after passing my Series 7 and 63 exams qualifying me to be a registered representative (that’s what virtually all `stockbrokers’ are), I headed for company training in New York where I sat through daily classes – all of which were really commercials from the company’s various divisions promoting its products to the salesforce.

  • The in-house domestic stock management group taught us about the company’s stock funds.
  • The in-house foreign and global stock management group taught us about their funds.
  • The various bond managers conducted sessions on their various bond funds.
  • The unit investment trust divisions conducted sessions on their various UITs.
  • The money management division conducted session on their various `managed money’ offerings

 

You get the idea.  It was all in-house products and in-house managers which, in those days at least, could not be transferred to another firm if the investor wanted to leave.  There were no presentations from outside fund companies or product providers; and the term `no-load’ wasn’t even in the vocabulary.

The firm’s national tv commercial campaign touted that their success was measured by their investor’s success using the `one investor at a time’ mantra to stress personal attention.  Of course, when I got back to the office, it was easy to see how success was measured.  All you had to do was go into the `break room’ and look on the wall to see who was winning the contest for a free cruise – and only sales of company products qualified.  Friends of mine who worked for competing firms at the time told me it was no different there.

A lot has changed since those days, at least outside the walls of the major `wirehouse’ firms – I can’t speak for them since I’ve been gone almost two decades and wouldn’t be privy to what’s going on these days – as many `captive’ registered representatives began going `independent’ by opening up their own offices and affiliating with independent broker-dealers who weren’t in the product manufacturing and distribution business.

Over the last ten years even those who were independent RRs began to move away from the product `representative’ business model to a pure advisory model, sparking much controversy about `suitability’ vs. fiduciary practice standards.

Today, middle and retail market investors are now able to access a broad array of investment consulting services through smaller, independent consulting firms – services which are a mirror-image of the scope of services provided to larger institutional investors.  Costs have been dramatically reduced due to the smaller firms ability to operate at lower overheads by outsourcing most of the expensive back-office requirements to larger investment consulting firms that have excess capacity.

This works quite well for all concerned.  The investor now has access to a higher level – institutional level – investment services and advice, while the independent firm can operate under a fiduciary standard with time free to work directly for clients rather than divert time, energy, and resources into back-office operational issues.   Under an independent model, the advisor isn’t ‘captive’ to a single firm’s offerings; but is free to tap the due-diligence services of larger independent investment consulting firms and, through personal planning with clients, arrive at a `best fit’ for their needs without regard to product sales considerations.

As changes continue, the outlook for individual investors benefitting should be outstanding.  Corporate asset managers have realized the benefits for years.  Let’s see if individuals will pick-up on serious asset management best practices or if they’ll continue trying to pick stocks.  Stay tuned.

Jim

Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER™  and in his 20th year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California.   IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description.  Nothing contained herein should be regarded as tax or legal advice and the reader is urged to seek competent counsel to address those issues.   The above represents the author’s opinion and should not be regarded as investment advice which is provided only to IFG clients upon completion of a formal financial and investment plan.   For questions or comments, you can reach Jim at 805.265.5416 or through the IFG website, http://www.indfin.com.