The CFA Institute addresses the fiduciary rule in a letter to Jay Clayton

by James P. Dowd, CFA


As a CFA charter holder, today I received a copy of Paul Smith's letter to incoming SEC Chair Jay Clayton.  Smith is the CEO of CFA Institute, the leading professional organization for investment management professionals.  The letter offered several recommendations, the first two of which I have supported publicly for many years as an individual and as CEO of North Capital. Beyond the specific policy ideas, Smith's letter simply and elegantly highlights the issue at the core of the debate over the fiduciary rule:  misrepresentation.   Smith's basic point:  commission salespersons have a role to play in financial markets, but that role is not providing advice with limited oversight under a made-up title "financial advisor."  The full letter may be viewed here, but these two paragraphs shine a bright light on the central issue in the debate:


"We, like the Commission’s Investor Advisory Committee , recommend that the Commission require that anyone wishing to refer to their title and/or activities as advisory in nature (e.g. “adviser” or “advisor”) adhere to the Investment Advisers Act and the fiduciary duty implied by common law interpretation of the Act. Such control of terminology would not be new to the Advisers Act, which already expressly limits use of the term “investment counsel” to those who must adhere to the Advisers Act’s requirements.


At the same time, we believe commission-based sales activities serve important client needs and give investors options for how they wish to conduct their investment activities. Whether commissioned brokers provide investment ideas or execute trades, we support that they be permitted to pursue their business activities, so long as they are clear about their roles vis-à-vis their clients. Specifically, we recommend that the Commission require that they refer to their roles with the title, “salespersons.” For too long, these sales staff have blurred the line between what they do – selling investment ideas to generate commission-based transactions – and what investment advisers do – advising clients on investment strategies and tactics to achieve their financial goals."


Mic drop.

Advisor’s Alpha:  Quantifying the Value of a Financial Planner

by Devin Frampton and James P. Dowd, CFA


Are the costs of professional financial advice outweighed by the benefits you receive in trying to build your retirement nest egg? Should you avoid this cost by undertaking investing and money management on your own, or is this a penny-wise and pound-foolish approach? If you are asking these questions then you might already have saved yourself more then you know.  The value added by a financial advisor, referred to as “advisor alpha,” varies depending on the knowledge, skill and effort of the individual investor to whom the advisor is giving advice.  If someone does a terrible job looking after their own investments, advisor alpha will be high.   If an individual does a good job on their own, then it might be substantially less.


Asking questions about your finances and investments is smart and prudent, whether you work with a professional or go it alone.  It makes sense to educate yourself while researching your options, even if you ultimately plan to work with an advisor for part or all of your planning and investment needs.   Financial planners do more than manage your money;  they can help you quantify your needs, articulate your goals, manage your time, keep your emotions in check, and deal with your family.  Some observers have likened the job of a financial planner to that of a therapist or a counselor, providing support and guidance as much as money management services.


If you have the time and interest  to become educated about finance and investments, regularly monitor the market, and critically evaluate your investment options, then you may want to handle your investments on your own.  If you do not have the time, are not particularly interested in the topic, and/or have difficulty managing your emotions when making investment decisions, then a financial advisor can save you time, money, and aggravation.  Finally, financial planning is not one product or service.  Some individuals find that they need help putting together a plan, or that they would like a second pair of eyes overlooking a plan they have developed on their own.  While not all advisors offer these types of ad hoc services, many do.  Flat fee or hourly-based engagements can be a good way to bolster your own efforts and supplement your own knowledge of specialized topics, such as investment location and tax.


What about paying a financial advisor an asset-based fee for money management?  Vanguard produced a piece on Advisor’s Alpha in 2013 that explains why professional advice can make sense for even the most fee-conscious investor:  “For some clients, paying fees regardless of whether transactions occur may seem like ‘money for nothing.’ This is viewing the advisor’s value proposition through only one portion of the cost benefit lens. The benefit and wisdom of not allowing near-term market actions to result in the abandonment of a well-thought-out investment strategy can be underappreciated in the moment.”   The piece continues:  “ advisor’s alpha (that is, added value) is more aptly demonstrated by the ability to effectively act as a wealth manager, financial planner, and behavioral coach—providing discipline and reason to clients who are often undisciplined and emotional—than by efforts to beat the market.”  In short, the goal is not to outperform the market, but rather to outperform an investor working on his / her own, without professional advice.


Another study by Terrance K. Martin Jr., Ph.D. and Michael Finke, Ph.D., CFP® compared profiles of planning and advice over the span of 14 years. The four categories were Comprehensive Planning, Planner Only, Self-Directed, and No Plan. Martin and Fink noted that few academic studies had attempted to quantify the value provided by a comprehensive financial planner, so this one was one of the first to draw any such conclusions.  As they wrote in the  Journal of Financial Planning:  “Those who had calculated retirement needs and used a financial planner (which likely captures those who used a comprehensive planner who follows a more thorough planning process that includes retirement needs assessment) generated more than 50 percent greater savings than those who estimated retirement needs on their own without the help of a planner.”

Their report continues:  “When average retirement wealth was examined by survey year (1994–2008), households with a comprehensive strategy to retirement planning consistently recorded higher mean values of accumulated retirement wealth.


In conclusion, professional financial advice is not right for all investors, but understanding the value of a good advisor will help lead you to a successful outcome, whether you work alone, receive ad hoc advice from a professional, or hire a comprehensive, professional wealth manager.  Ultimately you must make the decision that feels right for you.

Throwing the Baby Out with the Bathwater – a Rare Miss for Jack Bogle

Warren Buffet wrote in his annual letter this year: "If a statue is ever erected to honor the person who has done the most for American investors, the hands- down choice should be Jack Bogle." Bogle, the founder of Vanguard Funds, helped launch an investing revolution when he created the first index mutual fund some forty years ago. A core premise of index investing is that most active managers (investment professionals who would try to out-perform the index through stock selection) do not beat an unmanaged index. And extensive academic research has shown that after considering fees, expenses, and taxes, very few managers have been able to beat the index. Proponents of the efficient market theory, including me, would say that this conclusion is only logical: market prices reflect all available information about stocks, the market is generally efficient, so it's tough to out-perform given the drag of management fees, transaction costs, and taxes. Some, perhaps even Bogle himself, might go as far as to suggest that any outperformance by an active manager is solely a result of luck, not skill. But not me. I believe that markets are generally efficient, but not entirely efficient. And while most managers do not exhibit enough skill to outperform the market on a consistent basis, some have and some do.


So I was not surprised, but I was somewhat disappointed, to read Bogle's remarks made at the CFA Institute's annual conference in Philadelphia last week. In commenting about "smart beta," which describes a suite of strategies in which certain equity risk factors or "betas" are favored in an otherwise passive-style investment approach, Bogle said: “It suffers from the assumption that past data—heavily mined—will identify factors that provide sustainable performance and leadership in the future. Mark me as being from Missouri on that because it ignores the principle [sic] of reversion to the mean, or RTM, one of the most important things you need to understand about financial markets and stock returns and market returns and mutual fund returns. It’s a huge mistake to ignore RTM.” Bogle has a point. The investment profession tends to fall in love with investment fads and trends, creating new products that cater to those who wish to take advantage of the latest and greatest theme. He continued: "...popular fads drive product creation in the fund industry. That’s great for fund sponsors, and awful for fund investors." The problem with this generalization is that it lumps together, then summarily dismisses, every strategy, structure, and idea that is not a plain vanilla equity index fund.


Certain risk factors that fall under the smart beta heading, such as "value" and "small cap," have been well-documented to offer excess return compared to the broad market index. Surely Bogle knows this, since the same academic researchers who demonstrated the value of indexing subsequently highlighted the empirical out-performance of these risk factors. Eugene Fama was awarded the Nobel Prize for economics in 2013 for his work to develop the Efficient Market Hypothesis. During the past few decades, Fama has collaborated with Kenneth French to formulate the Fama-French three factor equity model. Based on extensive statistical research of U.S. (and subsequently global) stock prices, Fama and French demonstrated that a financial model that incorporates three factors, rather than the one beta factor in the Capital Asset Pricing Model (CAPM) ---- the model that encapsulates the essence of the Efficient Market Hypothesis---better explains stock price movements. What are the three factors? Beta --- as in CAPM--- Value v. Growth, and Small v. Large risk factors. The three factor model does not discredit the intrinsic value of indexing, Bogle's life's work. It reinforces and extends it. I have had the privilege to hear Fama discuss the implications of the three factor model. It is not a free lunch --- there is no free lunch in efficient markets ---- but the additional two factors, value and small cap, do offer the possibility of higher systematic returns (along with higher systematic risk) than a broadly diversified portfolio without these risk tilts.


At North Capital, we have integrated the value and small cap risk factor tilts into our core equity portfolios, and our clients have benefitted (and, we believe, will continue to benefit) from the over-weighting of these factors. Is it absolutely necessary? No ~ the expected return available from plain vanilla indexing (core equity beta) accounts for the vast majority of the total expected return from a strategy that also incorporates a small cap tilt and a value over-weight. But if the empirical data shows the availability of excess returns, and there is a logical explanation for the empirical result (value: when you shop sales, you save money // small cap: human capital, which is not measured using conventional accounting metrics, is far more impactful in a small company than in a large company), then why not take what the market has to offer?


Obviously this type of analysis opens the door to.... systematic active management. If small cap and value factors offer additional returns for investors, what about other risk factors? In this context, Bogle's point about mean reversion is a fair one. Smart beta comes in many different flavors, and there is no shortage of quantitative active managers peddling new factors in an attempt to harvest, package, and sell the hope of excess return to investors. Many such factors have a long-term expected return of zero, so a short-term period of out-performance offers little besides a marketing narrative--- a precursor for the type of investment fad that Bogle warns about.


Think of new smart beta risk factors this way: there is a room of one hundred coin flippers. Each flipper claims a particular "skill" in flipping coins--- call the skill "smart coin flipping." Each flipper can make only one flip per year. On average, after five years, 1/32 or about 3% of the coin flippers will have called the correct side every single time. A large percentage of flippers will have have called 4/5 or 3/5 of the flips correctly. Are these flippers smarter than all of the others in the room? Not hardly. The key lesson here is that in analyzing statistical data (and the fundamentals underpinning the data) to identify sources of excess return, one must evaluate very large data sets and use intellectually rigorous analytical techniques to avoid bias and form logical conclusions. I believe Fama and French did this in their work, and subsequent academic research has supported their conclusions. The same cannot be said for the full myriad of new smart betas, some of which are cooked up with limited data, a shallow knowledge of statistics, and weak fundamental analysis---- the successful coin flipper, packaged as "smart beta" for the retail investor. When I evaluated hedge fund strategies for Bear Stearns, over a decade ago, we had a parade of quantitative managers pitch us backtested strategies that promised excess returns and high Sharp Ratios. We used to say that we had never seen a backtest that we would not want to invest in. If only it were so easy. I am confident that allocators today must have the same experience on a weekly basis. After all, market data is more abundant and accessible than ever, computers are fast and cheap, and any 23-year-old with rudimentary training in statistics knows how to program in R. How easy, then, to create a quantitative model that out-performs the index (on paper, and in the past)! The emergence of "smart beta" is, in the extreme, simply a repackaging of this same elixir for a new channel ---- retail ---- that is in love with indexing but cannot give up on the hope of higher returns.