NYT on what (and what not) to Expect From A Financial Advisor

The nyt published a special section on personal wealth today. It includes an excellent article on what investors should reasonably expect (not expect) from a financial advisor. I have highlighted a couple of the points although the full article is worth reading. In fact I think the comments are so reasonable I plan on showing the article to all my clients and prospects.



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February 26, 2009
Your Money
Rules for the New Reality
By RON LIEBER

BACK in September, before we were all inured to the tottering nature of so many financial giants, investors were looking for someone to blame.

So when Prince & Associates, a market research firm in Redding, Conn., polled people with more than $1 million in investable assets, it wasn’t any great surprise that 81 percent intended to take money out of the hands of their financial advisers. Nearly half planned to tell peers to avoid them, while 86 percent were going to recommend steering clear of their firms.
In January, Prince took another poll of people with similar assets, and only a percentage in the teens had engaged in trash-talking. Just under half of the investors had taken money away from their advisers

All of the bad feelings, however, raised a simple question that’s even more essential when we’ve all been so severely tested. What, exactly, does your wealth manager owe you? And what can you never reasonably expect?

Some of the answers are basic. Your financial advisers should have impeccable credentials. They should be free of black marks on their regulatory or disciplinary records. They should agree, on Day 1, to act solely in your best interest, not theirs or those of any company that might toss them a commission.But other standards are less obvious, and the carnage in the markets provides an excellent opportunity to review them.

WHAT YOU SHOULD EXPECT


A LONG LOOK AT RISK

Most of us aren’t honest with ourselves about how much investment risk we can handle. Even worse, we tend to change our minds at market tops and bottoms, making the wrong choices at precisely the wrong moments.

An accurate assessment of risk is important.....

B


A BALANCE SHEET AUDIT....

CUSTOMIZATION.....


TO EAT THE SAME DOG FOOD.....




WHAT YOU SHOULD NOT EXPECT

MARKET TIMING.....



LOW RISK, HIGH RETURN

TO BE A PEST....

Remember that you hire advisers in order to set some clear, long-term goals — which probably shouldn’t change every day in reaction to the ups and downs of the markets.

“One of my biggest roles is to take the emotion out and be a calming force,” said Lon Jefferies of Net Worth Advisory Group in Midvale, Utah. “If clients want to continually change their risk tolerance when the market drops another 300 points, that’s going to make it impossible for the relationship to succeed, because they’re changing the rules almost every day.”

Rather than calling every day to second-guess yourself and your adviser, set aside dates to sit down and examine your feelings.


CERTAINTY

This one may be the toughest to swallow. Jay Hutchins, of Comprehensive Planning Associates in Lebanon, N.H., never promises an outcome. The past year, he said, should make it easier for new clients to understand why......

.

Life, in general, is unpredictable.

And for the adviser, that uncertainty should be cause for some modesty.

Milo M. Benningfield, of Benningfield Financial Advisors in San Francisco, notes that we tend to value aggressiveness. “But when I think about the meltdown, I feel like it was overconfidence,” he said. “It was a colossal lack of modesty that led people to underestimate the risk involved and believe that they understood things more than they did.”

So to him, a big part of being modest is recognizing your own limits. “You’re more inclined to say, What if I’m wrong?” he said, adding that he often reaches out for help on insurance and estate planning matters. “I think the definition of incompetence is failing to recognize that you don’t know something.”

I must say I quite admire the above cited Mr. Benningfield for his honesty. Having worked in finance for quite a long time, I can assure you it is uncommonly refreshing.

The Failure of the Quants... Another View

Wired Magazine has a cover story that once again shows how overdependence on quantitative models (which are in turn based on historical data) can lead to too much money placed in transactions dependent on that model. A cautionary tale to say the least:

A

year ago, it was hardly unthinkable that a math wizard like David X. Li might someday earn a Nobel Prize. After all, financial economists—even Wall Street quants—have received the Nobel in economics before, and Li's work on measuring risk has had more impact, more quickly, than previous Nobel Prize-winning contributions to the field. Today, though, as dazed bankers, politicians, regulators, and investors survey the wreckage of the biggest financial meltdown since the Great Depression, Li is probably thankful he still has a job in finance at all. Not that his achievement should be dismissed. He took a notoriously tough nut—determining correlation, or how seemingly disparate events are related—and cracked it wide open with a simple and elegant mathematical formula, one that would become ubiquitous in finance worldwide.

For five years, Li's formula, known as a Gaussian copula function, looked like an unambiguously positive breakthrough, a piece of financial technology that allowed hugely complex risks to be modeled with more ease and accuracy than ever before. With his brilliant spark of mathematical legerdemain, Li made it possible for traders to sell vast quantities of new securities, expanding financial markets to unimaginable levels.

His method was adopted by everybody from bond investors and Wall Street banks to ratings agencies and regulators. And it became so deeply entrenched—and was making people so much money—that warnings about its limitations were largely ignored.

Then the model fell apart. Cracks started appearing early on, when financial markets began behaving in ways that users of Li's formula hadn't expected. The cracks became full-fledged canyons in 2008—when ruptures in the financial system's foundation swallowed up trillions of dollars and put the survival of the global banking system in serious peril.

David X. Li, it's safe to say, won't be getting that Nobel anytime soon. One result of the collapse has been the end of financial economics as something to be celebrated rather than feared. And Li's Gaussian copula formula will go down in history as instrumental in causing the unfathomable losses that brought the world financial system to its knees.

About Those Morningstar Fund Ratings....They're Not Worth Much (Now They Tell US)

The WSJ reports that Morningstar has overhauled its system for analyzing mutual funds and I must admit it leaves me mystified.

Most academic research has found that the morningstar star system is of little use in predicting future mutual fund performance. The system went through a major overhaul in 2002. A 2006 academic studies after based on a very short number of data points ( 2 years of data in a strong stock market) found the new system to have a bit more predictive power.

But based on the sweeping nature of the current overhaul, the folks at Morningstar clearly thought it was time to reinvent the wheel again.

My confusion is primarily due to the fact that when the morningstar system reviews o active managers it is trying to measure manager skill in outperforming its benchmark in risk adjusted return (something close to what academics call "alpha"). One would assume that a managers alpha would come from his ability to make buy and sell decisions in adding or deleting holdings to the fund's portfolio. Yet it seems the morningstar analysis is meant to assess the holdings of the portfolio at a point in time. Why this will tell the potential investor anything about how the manager will perform over time is hard for me to comprehend.



My comments in parentheses and italics

• FEBRUARY 24, 2009
Morningstar to Take Fresh Look at Funds
A Move to 'Institutional-Style' Analysis
By SAM MAMUDI

Investment-research firm Morningstar Inc. has unveiled an organizational revamp that will change the way its analysts look at mutual funds.
Morningstar analysts will take a broader view of the funds they cover, for instance, considering asset allocations and offering more detail on the underlying stocks...

( I find this confusing: If they are evaluating actively managed funds based on their holdings and actively managed funds are only required to report the end of quarter holdings in arrears, then how useful could this analysis be ?)

....And fund analysts will reach out more to financial advisers to find out what is and isn't working. "Financial advisers are in the trenches and know what investors want," Mr. Phillips said. "We want to use our data to get better results for investors."

(Another confusing one: Up until now Morningstar research was supposed to give guidance to financial advisors and individual investors in choosing mutual funds for their portfolios. In other words morningstar research was designed to sift through funds and tell their clients which funds they expect "to work and not to work", Now the folk at morningstar tell us that they will go to the consurmer of the advice and ask them what is and isnt working. Wasn't Morningstar supposed to know that based on their own research ?

And here's another strange one, Advisors "know what investors want" and morningstar wants to use "our data to get better results for investors". Morningstar has long presented research based on fund flows (and other behavioral finance research has shown) what investors often "want" is to chase performance,which is not good for them. It would seem more logical that morningstar should be working to present objective research no research based on investors' biases.)

Here is more from Morningstar:


Mr. Phillips said part of the change will be to provide more institutional-style analysis. "We're going to take institutional-level insights and create streamlined offerings for retail investors," he said.
Analysts will consider asset allocation when evaluating a fund, for instance, looking at which funds might better suit particular portfolios and which funds might overlap with existing holdings.
"Many people, if they own several mutual funds, don't know the holdings of those funds," Mr. Phillips said. "We can help investors know if there are cumulative holdings in their portfolios."
Another example of the institutional approach is factoring in a stock's economic moat -- the ability of companies to keep rivals at bay.
"There's been a lot of talk about Fidelity Magellan Fund and figuring out its performance," Mr. Phillips said. The fund, which was once among the largest stock funds in the world with more than $100 billion in assets, was down nearly 50% last year and has seen its assets shrink to under $20 billion.
Using the economic-moat analysis can help investors understand Magellan's poor 2008, Mr. Phillips said. While the average stock fund has 46% invested in wide-moat companies, only 23% of Magellan's portfolio is in such companies.
"That's a huge underweight in companies with strong and enduring brands," he said. In 2008, wide-moat companies were down 28% on average, while narrow-moat companies lost 40%. No-moat companies -- in which Magellan was overweight -- were down 50%.
"That's a great snapshot of Magellan's performance," Mr. Phillips said.


(<

span style="font-style:italic;">that is all very interesting information on why Fidelity Magellan performed the way it did in 2008. I'm not sure what that tells me about investing in Magellan going forward. Am I supposed to assume that Magellan's managers will "learn from their mistakes" and change their portfolio. Or should I conduct independent analysis on whether "no moat" "narrow moat" or "wide moat" companies will perform best going forward and then invest (or avoid ) Magellan based on an expectation that Magellan will (or won't) continue its "no moat" strategy ?....my head is spinning)



...."My goal is for us to look at a fund portfolio through the eyes of a fund manager," added Mr. Phillips, speaking broadly of the changes. "We want to do all we can to tear a portfolio apart and understand its risk."

(While this sounds impressive, when applied to evaluating actively managed mutual funds it seems to be a futile exercise. To "tear apart" an actively managed portfolio at a point in time, based on old data is not a very productive way to "understand the risk" of the portfolio as it is currently constructed. In the case of actively managed funds you "never know what you own" no matter how sophisticated the analysis might seem.

Contrast that with analyzing a portfolio of index funds and/or etfs. Since the holdings of those portfolios is static (except when indices are rebalanced) it would be quite easy to monitor the holdings of the portfolio, and various metrics such as p/e price/book etc. And an exercise of "tearing a portfolio apart and understanding its risk" would actually be useful.


Ironically, Morningstar does have software that will allow very useful analysis of a portfolio of index funds or etfs. It is possible to use their software to produce a report that gives aggregate statistics for the portfolio like p/e and p/b for the portfolio as well as individual stock holdings, industry and country weightings. breakdown. Morningstar is an excellent compiler of data, it is their rating system that is of little utility. Yet despite their limited usefulness it is the ratings that get the most attention. ...And morningstar collects a fee everytime a mutual fund company uses their ratings in an advertisement....but of course that couldn't have anything to do with their persistence in revising a system that is not particularly useful in forecasting performance, as they themselves admit...sometimes.)

forbes has a little video piece on morningstar ratings

and morningstar's own explanation of how to use the ratings is here, although it seems that on their website articles they often dont follow their own guidelines and simply reccommend highly rated funds.

Active Management: A Choice Only for "Deluded" Investors ?

As anyone that has read this blog would know, I hardly find this nyt article surprising


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strong>February 22, 2009
Strategies
The Index Funds Win Again

THERE’S yet more evidence that it makes sense to invest in simple, plain-vanilla index funds, whose low fees often lead to better net returns than hedge funds and actively managed mutual funds with more impressive performance numbers.

... it turns out that, after fees and taxes, it is the extremely rare actively managed fund or hedge fund that does better than a simple index fund.

That, at least, is the finding of a new study by Mark Kritzman, president and chief executive of Windham Capital Management of Boston. He presented his results in the Feb. 1 issue of Economics & Portfolio Strategy, a newsletter for institutional investors published by Peter L. Bernstein Inc.

Mr. Kritzman, who also teaches a graduate course in financial engineering at M.I.T.’s Sloan School of Management, set up his study to accurately measure the long-term impact of all the expenses involved in investing in a mutual fund or hedge fund. Those include transaction costs, taxes and management and performance fees...


....he calculated the average return over a hypothetical 20-year period, net of all expenses, of three hypothetical investments: a stock index fund with an annualized return of 10 percent, an actively managed mutual fund with an annualized return of 13.5 percent and a hedge fund with an annualized return of 19 percent. The volatility of the three funds’ returns — along with their turnover rates, transaction fees and management and performance fees — was based on what he determined to be industry averages.

Mr. Kritzman found that, net of all expenses, including federal and state taxes for a New York State resident in the highest tax brackets, the winner was the index fund.

Specifically, he assumed that long-term capital gains were subject to a 15 percent federal tax and a 6.85 percent state tax; short-term capital gains and dividends were taxed at a combined federal and state rate of nearly 42 percent. The index fund’s average after-expense return was 8.5 percent a year, versus 8 percent for the actively managed fund and 7.7 percent for the hedge fund.
Expenses were the culprit. For both the actively managed fund and the hedge fund, those expenses more than ate up the large amounts — 3.5 and 9 percentage points a year, respectively — by which they beat the index fund before expenses.

IF such outperformance isn’t enough to overcome the drag of expenses, what would do the trick? Mr. Kritzman calculates that just to break even with the index fund, net of all expenses, the actively managed fund would have to outperform it by an average of 4.3 percentage points a year on a pre-expense basis. For the hedge fund, that margin would have to be 10 points a year.

The chances of finding such funds are next to zero, said Russell Wermers, a finance professor at the University of Maryland. Consider the 452 domestic equity mutual funds in the Morningstar database that existed for the 20 years through January of this year. Morningstar reports that just 13 of those funds beat the Standard & Poor’s 500-stock index by at least four percentage points a year, on average, over that period. That’s less than 3 out of every 100 funds.

But even that sobering statistic paints too rosy a picture, the professor said. That’s because it’s one thing to learn, after the fact, that a fund has done that well, and quite another to identify it in advance. Indeed, he said, he has found from his research that only a minority of funds that beat the market in a given year can outperform it the next year as well.

Professor Wermers said he believed that it was “.exceedingly probable that any fund that has beaten the market by an average of more than one percentage point per year over the last decade achieved that return almost entirely due to luck alone”

“By definition, therefore, such a fund could not have been identified in advance,” he added.

The investment implication is clear, according to Mr. Kritzman. “It is very hard, if not impossible,” he wrote in his study, “to justify active management for most individual, taxable investors, if their goal is to grow wealth.” And he said that those who still insist on an actively managed fund are almost certainly “deluding themselves.”
What if you’re investing in a tax-sheltered account, like a 401(k) or an I.R.A.? In that case, Mr. Kritzman conceded, the odds are relatively more favorable for active management, because, in his simulations, taxes accounted for about two-thirds of the expenses of the actively managed mutual fund and nearly half of the hedge fund’s. But he emphasized the word “relatively.”

“Even in a tax-sheltered account,” he said, “the odds of beating the index fund are still quite poor.”

no comment needed other than I (and many many others) have been saying this for a long time

Quote of the Day

"The most inmportant financial innovation of the last 30 years is the automated teller machine"

Paul Volcker in a recent address at Columbia University Busines School

Time to Turn Off that Business Channel

The NYT today has an interesting article on the financial media. The article was sparked by the appearance on CNBC of "Dr Doom" Nouriel Roubinni and "The Black Swan" (and my favorite financial author, Naseem Taleb ( you can view the video here on you tube). The happy talk folk on CNBC especially the insipid perma bull Dennis Kneale tried to spin the analysts to see the glass as half full but neither would have any of it. As Roubbini has said on other occasions "the light at the end of the tunnel is an oncoming freight train".

The reporter David Carr writes of the exchange

Last Monday on “Power Lunch” on CNBC, there was a segment that many people noticed and passed around the Web. Under the rubric “Turning the Corner,” Bill Griffeth and some of his colleagues were interviewing Nouriel Roubini, a professor of economics at the Stern School of Business at New York University, and Nassim Taleb, a derivatives trader, author and theorist about randomness.

Mr. Griffeth started things out briskly by saying, “What would it take to make you bearish on this economy right now?”

You mean bullish, his co-host, Michelle Caruso-Cabrera, interjected. They cracked wise about Freudian slips, but the entire segment, it turned out, was about trying to somehow find the horns of a bull on two ferocious bears. ....

“But that’s not the end of the world, is it?” Mr. Griffeth asked plaintively. Mr. Roubini indicated it was sort of getting there, with a recession that will be three times as long and three times as deep as the previous two.

Sensing the thickening gloom, Mr. Griffeth pivoted away to Mr. Taleb and said, “You’re not as bearish as Nouriel, are you?” Well yes, as a matter of fact he was. “We have the same people in charge, those who did not see the crisis coming,” he said.

In studio, Dennis Kneale of CNBC broke in and said, “Let’s get back to the real purpose of doing this, because we know the forecast is dark and continuing dark,” and then went on to fish for one metric, any measurement, that suggested the economy was “turning the corner.”

His guests did not play ball, and later they looked slightly aghast when asked what they would invest in and what was in their portfolios

The article's larger point is the built in bias for optimism in financial journalism. Most importantly it includes some sage advice on fixating on the kind of material fed on business news outlets that need to constantly churn out material:

Dave Kansas has been covering personal finance for decades. He currently works at FiLife, a personal finance site jointly owned by IAC/InterActiveCorp and The Wall Street Journal and just published a book, “The Wall Street Journal Guide to the End of Wall Street as We Know It.”

“I try not to watch CNBC. I don’t keep a TV near my desk because I don’t want to get caught up in the hourly changes. The idea that you can pick stocks and beat the market is sort of silly no matter what kind of market you are working into,” he said. “Bernie Madoff was able to deliver steady returns, but we know now how he did that.”

The whole tidy ecosystem of cause and effect — the belief that there is something rational and meritocratic about high finance — has burned away along with the billions of dollars spent to bail out its chief practitioners. When the reporter on the radio says, “Stocks were down 2 percent on news that the jobless figures were worse than expected,” is there any reason to believe him?

“The headline that you will never hear is ‘The market was down 110 points, a random fluctuation in a very complex system,’ ” said Eric Schurenberg, the former managing editor of Money magazine who is busy building — get this — a financial Web site for CBS. “No one has ever known what was going to happen, but there is this temptation to act like you did. But that fantasy has been exploded.”

(the above strikes mea rather ironic comment by the former managing editor of a magazine that purported to do exactly that)

the article concludes with some simple and useful advice on business journalists and long term investors:

To engage their audience, business journalists need to act like things are changing all the time. As it turned out, what didn’t change much was the fundamental lessons: have a diversified portfolio, don’t buy more house than you can afford, don’t take on more debt than you can support, or trade on the margin.

More on Harvard's Endowment

It seems many endowments have put themselves in a difficult dilemma. In the quest for increased returns they have moved into more and more complex and difficult to monitor asset classes. In order to monitor such investments it would be logical to conclude that the endowments would need a larger and more highly skilled staff. Yet because of the investment losses caused because of these strategies the endowments are looking to reduce staffs. Logically it would follow that unless the endowments simplify their investment strategies they are setting themselves up for more unanticipared losses from poorly monitored or chosen investments in the future. Yet at least for Harvard (below) there is no mention of a change to a less complex investment strategy.





Harvard's Endowment, Beset by Losses, to Pare Its Staff


By CRAIG KARMIN

The Harvard endowment, stung by declines of more than 20% in recent months, says it will eliminate a quarter of its staff, or about 50 jobs, this year.

The largest college endowment in the U.S., Harvard finished its June 2008 fiscal year with a chart-topping 8.6% gain, bringing total assets to $36.9 billion. But like most endowments, it has stumbled badly in the months since. The university has said it is bracing for a 30% decline for the fiscal year ending June 2009.

At about 200 people, Harvard Management Co., which manages the endowment, has a much larger staff than most other endowments. That is because HMC portfolio managers invest about 30% of the funds themselves. At other endowments, including historically top-performing Yale, the staff picks outside managers to do the direct investing, and staff rarely run above 30 people.
[Mendillo, Jane]

"When we ... asked whether our company was appropriately sized and structured for the markets we operate in today, we concluded that the time was right for a significant rebalancing of our staff and our functions," Jane Mendillo, head of HMC, said in a statement.

A Harvard spokesman added that the staff cuts would include but weren't limited to the endowment's investment professionals.

Because of its size and strategy, Harvard is in many ways unique among endowments. Consultants said there isn't yet an industrywide trend of staff cutbacks.

But Daniel Jick, head of HighVista Strategies, said it wouldn't surprise him to see larger schools contract endowment staff in the months ahead, if only through attrition, as colleges try to trim costs wherever they can. His Boston-based firm manages endowment money, often for small schools that in effect outsource the task.

"Asset levels at endowments are down 25% to 35%," says Mr. Jick. "If you think of your investment costs as related to the size of your asset base, then your costs just went up."


Some alumni and faculty members for long have publicly criticized the seven-figure compensation packages paid to some Harvard endowment managers, which far exceed payouts to the university's deans or Nobel laureates. These detractors have urged the university to cut endowment staff and outsource asset management like most of its peers do.

For the most-recent academic year, HMC paid its top six managers $26.8 million. That figure reflects performance bonuses for the year ended in June, and HMC has said that compensation at this level is necessary to attract and retain talent.

Late last year, Harvard President Drew Gilpin Faust sent a letter to the school's deans warning that severe turmoil in global markets had led to an endowment decline of at least 22% from July 1 to Oct. 31, though the actual decline would likely be greater once estimates for private equity, real estate and other less-liquid assets were included.

The endowment declines would lead to budget cuts, the president indicated, and the school has sold $2.5 billion in bonds to raise additional funds.

a href="http://online.wsj.com/article/SB123394376374757733.html">The WSJ reports on staff cuts at Harvard Endowment

Perhaps a sign of the future comes from the wsj report that Harvard seems to have trimmed its equity allocation

* FEBRUARY 12, 2009

Harvard Endowment Cut Stock Holdings


By JOHN HECHINGER

Harvard University's endowment, the largest in higher education, cut by two-thirds its direct holdings of publicly traded stocks and funds during the market plunge in last year's fourth quarter.

As of Dec. 31, Harvard Management Co., which oversees the endowment, held about 70 stocks and publicly traded funds that were valued at $571 million, according to a filing with the Securities and Exchange Commission. Three months before, the endowment held about 200 stocks and other vehicles valued at just under $2.9 billion.....



The filing offers only a limited look at the Harvard endowment, valued at $36.9 billion as of June 30 and one of the nation's most closely watched investors, with a stellar long-term investment record. About 70% of the endowment is overseen by external managers, whose holdings on behalf of Harvard wouldn't be included in the filing.

In addition, publicly traded securities make up only a fraction of the endowment. Harvard recently said its goal was to have a third of the endowment in U.S. and foreign stocks, with the bulk of the rest in such assets as real estate, timber and private equity, which wouldn't appear in the SEC disclosure document.

Still, the filing could indicate shifts within the endowment, which fell at least 22% from July 1 through Oct. 31. Harvard has told the campus to brace for a loss of 30% in its endowment in the fiscal year ending June 30. The school has said it will have to undertake budget cuts.

In July, Jane Mendillo took over management of the endowment. Last week, the endowment said it would eliminate 50 jobs, or a quarter of its staff.

The endowments stock allocation has gone from 8% of the portfolio to .15% of the portfolio according to the article yet the asset allocation is for 33% stocks, Even leaving leeway from this number, something seems to be amiss.

It could well be that Harvard like other endowments is facing a "liquidity dilemma" related to their large allocation to alternative assets. Hedge funds and private equity have proven difficult to convert into cash to use for current expenditures forcing many universities to cut back on activities normally funded by their endowment. Additional evidence that this may be the case is that Harvard liquidated some of its private equity investments to third parties at prices reported to be as low as fifty cents on the dollar.

It seems quite likely that Harvard had to sell its most liquid investments: listed stocks to raise cash even if it caused them to be extremely underweighted in that asset class.

David Swensen, Yale's investment manager has written that endowments are "perpetual portfolios" and as such can ride out market swings and in fact would be in a position to buy asset classes when they are beaten down. In the most recent edition of Pioneering Portfolio management he writes of the quantitative techniques used to project possible large losses. He writes that Yale has a 5% probability of a decline which would be disruptive of university spending, (exactly what has occurred this year). It seems for Harvard and probably for others, not only has the decline impaired current spending it has also caused large deviations from asset allocation policy.