Guest Article: DSC Index Funds

Posted by Jim Stark on Feb 8, 2010 | 2 comments

This is a another guest article by Jim Stark. Jim Stark is a pseudonym for a practicing Canadian financial advisor.

Why are there no DSC Index Funds?  On one hand, pretty much any advisor knows that there is no such thing as a DSC index fund and why that is so.  On the other hand, many retail investors probably never thought about it- and likely wouldn’t be able to accurately explain why this little wrinkle exists even if they did.  There’s likely a pretty severe disconnect on this- a topic that could have applications in the fields of practice management, ethics, client suitability and advisor ‘value propositions’ to name a few.

(Note: there actually are DSC Index funds these days, but they are far from ubiquitous – Preet)

In order to be clear, it needs to be underscored that mutual fund companies “manufacture” products, while financial advisors “distribute” them.  Obviously, no one could be expected to distribute a product if no one is manufacturing that product in the first place.  So, to modify my original question in the interest of specificity, “why don’t mutual fund companies manufacture DSC index funds?”

I’ll try to grapple with the question by confessing my concern right off the bat.  To me, this is a case of undue bias.  I would hope that all readers would agree that in an advisory relationship, the interests of the client should always come first.  Still, advisors are absolutely allowed (indeed, expected) to advocate for whatever products and processes they feel are best and are absolutely allowed to choose their own business model, too.

Many advisors insist that they are “independent”.   When asked by someone who understands the industry, however, one quickly finds that many “independent” advisors have an attitude that is similar to Henry Ford’s early take on car colours: “you can have any colour you want, as long as it is black”.  My take on those advisors who use mutual funds is that they effectively tell their clients that they suggest that they can: “have any mutual fund they want, as long as it pays an embedded compensation”.

This isn’t a topic that is confined to index funds, obviously, since there are dozens of credible actively-managed mutual funds available that never make it on to many advisors’ product shelves, either.  I chose to explore index funds because in the case of actively-managed funds, advisors can always find a similar fund that offers an embedded compensation and skirt the ‘advisor value’ conversation that might otherwise ensue.

The problem, as I see it, is when the business model drives the product recommendations to the potential detriment of the client interest.  The implicit premise of much financial advice is that the advisor is more likely than a layperson to reliably identify outperformers in advance.  Indexing drops all pretense of doing that.  As such, it begs the question of what one might reasonably expect from an advisor.  It has been suggested that the three primary functions of good financial advisors are to:

1. Spot problems and identify solutions.

2. Motivate people to act/change their behaviour.

3. Help people to emotionally detach from investment market events.

Notice that picking stocks and picking people who pick stocks (i.e. picking actively managed funds) is not on the list.  When talking about index funds that offer no embedded compensation, there’s no product alternative available today that has a similar mandate, but with advisor compensation built in.  In essence, advisors that use a commission model simply do not offer index products to their clients.

Obviously, the absence of a DSC index option would be a complete non-issue if actively managed products were demonstrably superior.  But what if substantial evidence suggests otherwise?  What if there are a number of clear and compelling reasons for a rational, self-interested investor to prefer an index product?  That brings us to what I believe is one of the fundamental questions in our industry today.  Where does one reasonably draw the line in regard to required disclosures regarding the risks and limitations for competing products and strategies where the relative efficacy of two or more alternatives is not obvious?

When giving presentations to ten or more members of the public, what if the following disclaimer was used:

The views expressed are those of (advisor name) and are not necessarily shared by (firm name).  Debate regarding market efficiency, the usefulness of fundamental and technical analysis, active vs. passive management and the efficiency of payments is ongoing.  To date, neither side has been able to claim unchallenged victory.

I cannot help but notice that people who favour active products and strategies, but fail to compare the two are not required to use the disclaimer.  The question that it begs is: “if neither side has been able to claim unchallenged victory, then how can an independent advisor recommend only one side to clients with a clear conscience”?  The corollary is: “how can it be acceptable to avoid an important disclaimer by simply avoiding a direct comparison”?  At the very least, shouldn’t all advisors be required to disclose that both alternatives exist, irrespective of the approach they favour- especially if there’s a reasonable possibility that the alternatives they favour is inferior to the one being recommended?  The industry hides the ugly truth by tolerating the non-disclosure of material considerations that could alter the decision-making process.

From my vantage point, the issue is not whether or not advisors should be allowed to advocate for one product line or business model or another.  Clearly, they can do whatever they feel is best.  The issue is whether or not they should be allowed to deliberately withhold credible and viable alternatives from their clients and still be considered independent professionals.

Thanks Jimbo. So what do you guys think? I realize this is written more towards advisors (as Jim’s articles usually are), but there is certainly food for thought for everyone.

Research or Marketing Gimmick?

Posted by Jim Stark on Feb 2, 2010 | 2 comments

This is a another guest article by Jim Stark. Jim Stark is a pseudonym for a practicing Canadian financial advisor.

So I hopped on to my computer one morning and typed in the phrase “scientific method” into my search engine to see what came up. Click here for the  definition that our friends at Wikipedia use. Then read the following:

As far as I can tell, the preponderance of evidence supports the notion that the majority of active products and strategies fail to outperform and that the ones that do cannot be reliably identified in advance. It’s sort of like lottery tickets. The majority of tickets sold are losing tickets and the ones that are actually winners cannot be reliably identified until the winning numbers are called. The obvious rhetorical question that begs asking is: “Should advisors actively encourage their clients to buy lottery tickets?”

To be absolutely clear, everyone (advisors and investors alike) is entirely entitled to do what they personally feel is best. My concern is when people make decisions (and recommendations) without a reliable basis of factual evidence and fail to disclose that lack of reliable evidence. Is the question of appropriateness of approach one of fact or opinion? If it is a question of fact, there is considerable empirical evidence in support of passive products and strategies. If it is a question of opinion, then surely it ought to be disclaimed as such. What I find particularly telling is the notion of full disclosure. Irrespective of how you might personally feel about this conundrum, do you fairly disclose this fact/opinion and bring both alternatives to your clients?

Thanks Jimbo – ’till next time! -Preet

Great Expectations

Posted by Jim Stark on Aug 24, 2009 | 0 comments

This is a another guest article by Jim Stark. Jim Stark is a pseudonym for a practicing Canadian financial advisor. The article is written to financial advisors, but we both thought that readers of this blog would appreciate it.

Take it away Jim…

Great Expectations

Of all the Dickensian references to choose, you’d think something more akin to Oliver Twist’s “Please sir, may I have another?” might be more apt in describing what people might reasonably be thinking about their current financial advisor. Still, it seems many financial advisors have difficulty in seeing eye to eye with the people they hope to serve and assist. My own view is that this is more accurately described by the more contemporary movie line of “what we have here is a failure to communicate”. In essence, most advisors are good people who have good intentions and most people working with advisors want nothing more than clear directions about what should be done and expected. Unfortunately, part of the miscommunication is due to expectations that are presumed, but not promised; implied but not codified. As in any healthy relationship (think of your marriage or your work life, for instance), a lot of trouble can be avoided if all parties can agree to the rules of engagement at the outset.

An obvious example here is the notion of making reliable forecasts. There’s simply no evidence that anyone can reliably “make the big call” about market tops or bottoms or when currencies will peak or when or by how much interest rates will fluctuate. Here’s an old Benjamin Graham quote that I’m fond of:

If I have noticed anything over these 60 years on Wall Street, it is that people do not succeed in forecasting what’s going to happen to the stock market.

If any investor thinks an advisor can do this, that person is almost certainly deluding themselves with a false and unreasonable sense of security. Of course, if any advisor aids and abets in this sentiment, that would constitute a fairly clear signal that that advisor is less than reputable, too. When looking for someone to work with, it is likely most important to find someone who is aligned with your own values, philosophical approach and world-view. Questions to consider might include:

• Does the advisor espouse active trading or a buy and hold approach?
• Will the advisor contact me with ideas or is it up to me to initiate contact?
• Are we going to do business over the phone, via e-mail or face to face?
• Will we use individual securities, mutual funds, notes or other vehicles to build our portfolios?
• Are we going to work together or will I grant the advisor discretionary trading authority?

In every instance, you could ask yourself those same questions, but think about your own answers. In other words, irrespective of what the advisor believes, what do you believe about those things? Here’s the important part: there’s no single, definitive right answer. Many elements of portfolio management are more art than science. That being said, you’re likely to be more compatible with someone who thinks similarly.

It might even be said that finding a good fit comes down to just two primary elements:

1. What is the most appropriate modus operandi for doing business; and
2. What are the most suitable levels and types of contact needed to do so?

The first question deals with value propositions and business models. If you’re an active trader who believes in fundamental and technical analysis, then look for an advisor who thinks and acts like you do. Speaking for myself, I believe both fundamental and technical analysis are a waste of time and money. I don’t believe in forecasting, fund picking, stock picking or market timing. If someone comes to me wanting to work with me because they heard good things from a colleague or relative, but who wants to do those things, I politely advise them to keep looking- no matter how much they have to invest.

Regarding the second question, there are many relationships that end up on rocky shoals for no other reason than having unreasonable expectations set at the outset, then not adhered to. Both parties can be guilty of this and neither constituency (advisor or client) can be said to be lily-white. What matters is that the two sides can come to a working accommodation of one another’s legitimate interests on an ongoing basis in order to reach reasonable and mutually-agreed objectives over long timeframes. What one client calls regular contact, another might call annoying and overbearing pestering.

The old saw about children comes to mind. You can ‘treat them the same by treating them differently’. As a result, for advisors, there’s really no substitute for keeping the lines of communication open and being adaptive. In the end, advisors have to ask clients what their expectations for contact are. Meanwhile, clients absolutely need to speak up if they’re feeling uncomfortable, too. Most elements of communication can be addressed if both parties are willing to listen with the intent of hearing and respecting the other side’s point of view. Perhaps the industry could develop a ‘know your advisor’ questionnaire and/or form to be completed upon opening a new account. Maybe the people at e-Harmony could branch out a little in their matchmaking enterprise. No matter what you think about the current level of communication, that sort of service could certainly be useful.

Another though provoking article from Jim Stark, with my thanks. I should have another one posted next week.

Is Warren Buffett Managing Your Money?

Posted by Jim Stark on Aug 12, 2009 | 8 comments

This is a guest article by Jim Stark. Jim Stark is a pseudonym for a practicing Canadian financial advisor. The article is written to financial advisors, but we both thought that readers of this blog would appreciate it.

Take it away Jim…

The thing about the ongoing ‘debate’ between active (markets are largely inefficient) and passive (markets are largely efficient) management is that no side has been able to score an incontrovertible ‘knock-out punch’. By the way, I use the term ‘debate’ loosely, as I’m unsure if you can call it that, given that few people in the active management camp seem willing to truly engage the logic and evidence that goes into a real debate. I digress…

The point that I make repeatedly is that the large majority of active managers lag their benchmarks and that the few that actually beat them are pretty much impossible to identify in advance (i.e. their performance does not ‘persist’). This is a compelling two-pronged argument, but many people have pointed out that one need only identify one (that’s right, one) person who can reliably be identified as a market-beater and victory for the active management side would be realized. Overwhelmingly, the one name that is thrust forward when it comes down to this is: Warren Buffett.

I have nothing but admiration for Mr. Buffett (who has encouraged most investors to use passive products more than once). By the way, “most” means at least 50% + 1. It means if 8,000 read this article, Buffet thinks at least 4,001 and one of them should use passive (assuming readers represent a representative sample of overall investors). With great respect, however, pointing to Buffett and saying “checkmate” rather misses the point.

What’s the use of going through the trouble of finding that one in a million person who can reliably beat the market if you don’t- you know- actually hire him to manage your money? It makes about as much sense as developing a foolproof way if picking winning lottery numbers- and then never buying a ticket! If a tree falls in the forest…

My impression is that MFDA registrants (Mutual Fund Dealers Association registrants – Financial advisors who can only sell mutual funds, GICs and Government savings bonds. They represent about 75% of all Canadian financial advisors- Preet) are somewhat more pro-Buffett than IIROC advisors (Investment Industry Regulatory Organization of Canada licensed advisors – they are allowed to also sell individual stocks and bonds and ETFs and other investments – Preet). It’s just my impression. The thing is this – MFDA registrants couldn’t hire Buffett to manage their clients’ assets if their lives depended on it. Berkshire Hathaway is a security and buying Berkshire Hathaway for clients requires a securities licence. Why people who are not licenced to sell securities extol the virtues of someone they cannot actually hire and an investment they are not licenced to sell makes no sense to me. If you’re an MFDA advisor who likes Buffett, please write to me to explain yourself. Don’t bother trying to convince me about how great the man is – I’ll only agree with you. What I want is for you to explain your behaviour to me.

(Technically, access to Berkshire Hathaway WAS available to MFDA advisors through single-security Principal Protected Notes – but the uptake was minimal and the PPN structure is all but dead for the time being anyway. Not taking away from Jim’s point, in fact it may even add to it. – Preet)

Let’s turn our attention to our Buffett-loving IIROC friends. What percentage of your client assets are managed by this icon of a man? My guess is that the number is an extremely small one. In fact, let’s open this up a little more. Who else is there with a great track record? My understanding is that it takes about a quarter century of data before performance histories can be considered statistically significant (i.e. to discern between luck and skill). How many managers (good, bad or otherwise) even have a 25-year track record? More to the point, what percentage of your asset base is managed by someone with a 25 year track record of clear market-beating performance? (Pauses for effect and to allow the reader to actually think about it). I see.

So let me get this straight: only a handful of managers outperform, but those outperformers remain largely unidentified in advance and the one person that has been reliably identified manages probably less than 1% of assets under management for the combined readership of this column? Again I ask you, if you could offer your clients a ‘bird in the hand’ instead of a ‘pig in a poke’, why wouldn’t you do it? And yet, most advisors don’t even tell their clients that passive options exist.

Thanks Jim! Look forward to your next guest article! :) – Preet