The Right Financial Advisor

Investment Advisory Firm Types and Motivations Matter

Too many financial institutions focus on increasing their revenues.

Most large financial institutions, like all companies with an extensive shareholder base, are focused on increasing revenues and profitability. As a result, the investment advisory sides of these institutions have developed and refined their training programs for their client-facing advisors to maximize profitability. Their training programs concentrate their efforts on growth and a sales mentality rather than that of investment knowledge and expertise. In most cases the actual financial acumen of these firms lie within their product creation, internal marketing, and analysis/investment departments. Many of their actual client-facing advisors have very limited education and formal training in the financial markets. While many investment firms require it, the SEC and other financial regulatory bodies do not even require a college education to obtain the licensing required to advise and sell investors given investment products.

In our experience, most financial advisors have a great level of ability when it comes to sales, but have an extremely limited scope of knowledge in the underlying investment strategies they are recommending. Rather than proposing an individually-tailored asset allocation, they will use cookie-cutter profiles to put their clients into one of a few asset allocations recommended by their parent company. For most firms, the advisor’s primary job is to “close” the client; the client’s money is invested according to a predetermined model, and the advisor then quickly moves on to the next sale. The bottom line is that the majority of investment advisors are trained to spend just as much time with each client as necessary to retain their assets under management, and not a minute more.

Focusing on revenues, many firms take their priority of profitability a step further by creating proprietary products in order to control and capture 100% of the fees paid by clients. The advisors within these firms are then further incentivized to sell these products over outside products. These advisors are regularly given a higher payout for the same level of assets managed if they are able to invest their clients in their firm’s proprietary products. In some cases, advisors are limited in that they are only able to offer proprietary products to their clients. In these cases, it is hard to fault the advisor, as they may be trying to do the best job they can with the limited selection of products they have to offer. They simply do not have the appropriate tools to do an optimal job for their clients. In less extreme cases, an advisor must make the decision of selling a product that they believe to be best for a client versus an incentivized product that they can make more than two times as much on. This is just one example of the many conflicts of interest that the financial industry is riddled with, to the detriment of many individual investors.

Let the Selling and Cross Selling Begin

Many firms turn their attention to cross-selling additional products.

After maximizing the profitability of the investment management side of the business, many firms will turn their attention to “rebalancing” and cross-selling additional products to their clients. In the case of “rebalancing,” this is a necessary risk-mitigating tool firms can use to ensure proper asset allocation. Unfortunately, too many advisors use this tool to increase their revenues. While an advisor will always have an explanation for the selling of one product for another, if he stands to profit at a greater level by the transaction, one can never be sure if the advisor’s motivation was truly in the client’s best interest. When these types of transactions are done to excessive levels, this is referred to as churning, which is illegal. The problem is how to determine whether or not the actions taken are excessive. The only way to eliminate this conflict of interest is to work with a fee-only advisor, who is not incentivized by transactional fees, and in fact has an obligation to put the client’s best interest first.

Another way large financial institutions increase their revenues is through the sale of additional products, also known as cross-selling. Some of the most lucrative financial products a financial advisor can sell are those within the insurance and annuity product markets. Insurance is a necessary risk-management tool that is appropriate for most individuals in some form. However, there are many different types, structures, carriers, and levels of insurance. Many firms incentivize their advisors to focus their efforts on selling insurance products with the highest level of fees and profitability, rather than those which the client truly needs. Again, the best way to be sure that conflicts of interest are not driving the recommendations of these products is to work with an advisor who is not incentivized by their recommendations.

Fee Only Financial Planning Is Best, but How to Choose a Financial Advisor?

Not every fee-only advisor is a good choice.

Due to the elimination of many conflicts of interest, fee-only advisors are able to completely focus their efforts on what is best for their clients. That, however, does not mean that any fee-only advisor is a good choice. Below are some factors you should consider when selecting a financial advisor:

Advisor Doesn’t Use Industry Jargon to Confuse Clients – Long ago, investment advisors realized that confusion can be a tool used to manipulate and intimidate investors. By treating the investment process as though it is tremendously vast and complex, investment advisors have been able to avoid being held accountable for their investment decisions. Furthermore, by not spending the time necessary to explain their decisions in detail, the advisor has more time to focus on more sales. Every investment advisor should be required (without using financial jargon) to explain each client’s individually-tailored investment strategy, the risks and rewards for each asset class, and the underlying strategies within each asset class. As changes are made in a client’s portfolio, the advisor should also be responsible for ensuring the client understands the reasoning behind these periodic adjustments.

Provides True Financial Planning – The term “financial planning” has been misused to the point that it has become synonymous with insurance and securities, with product sales being the real goal. True financial planning, however, is about personal strategy creation that results in a roadmap to financial security. It involves taking a comprehensive view of one’s current reality (including individual lifestyle, income, and personal relationships), establishing clear, realistic goals for the future, and setting a sound course to achieve these objectives, as well as periodically reviewing the client’s planning strategy to ensure it remains appropriate. Financial planning should always focus on unbiased advice uniquely tailored to each individual’s circumstances. It should never be about product sales or commissions.

Doesn’t Try To Sell Investment Performance – Investing is about diversification, risk mitigation, and a balanced asset allocation. At the heart of all investment decisions is the relationship between risk and return. Too many investors and advisors focus on potential performance, and do not appropriately incorporate discussions about the risk involved. Advisors selling outperformance are generally focused on making a sale, rather than the optimal allocation for the investor.

Provides Clients With a Fiduciary Standard of Care – Only work with advisors who have a fiduciary standard. This means the advisor is required to exercise his/her best efforts to act in the best interests of their clients. Investment advisors who are not fiduciaries are not held to these standards and may attempt to sell investments that are not in the clients’ best interest.

Offers Depth of Financial Expertise – Take the time to understand your investment advisor’s background, and ask for and check their references. Even if the advisor works for an extremely reputable firm, it does not necessarily mean that they have the knowledge necessary to manage your assets appropriately. Look at their education levels, years of industry experience, and credentials such as a CFP®, Master’s degree, CFA, CIMA, or similar designation, which lends credibility to their overall understanding of the financial markets.

Offers the Most Cost-Effective Share Class – If an investment advisor uses mutual funds in a client’s portfolio, the client should pay close attention to the share class, fees, and loads of the funds being used. (Loads are additional fees that are often overlooked, but are usually required to be paid when the funds are invested or sold and can be as high as 6%, with the average being between 1% and 3%) Some mutual funds have as many as 10 different funds with the exact same strategy and underlying securities. The difference between them is the fees and loads associated with each fund. These share classes were not created to benefit investors. Instead, these fees and loads were built to further incentivize salespeople. It is possible that one share class may result in a much lower after-fee return than another of the same fund. This risk can be avoided by working with a fee-only advisor.

Considers Taxes – Individual investors generally focus on pre-tax returns, and do not pay attention to after-tax returns. This is a colossal mistake, because what really matters is how much money you’re left with after taxes. To maximize after-tax returns, investment advisors need to optimize which assets are held in which types of accounts and what types of securities should be held based on the client’s tax bracket. Additionally, turnover can impact whether an investor pays long term capital gains taxes or ordinary income taxes on gains. Without a strong tax-efficient investment strategy in place, taxes can erode much of investors’ gains.

Provides an Independent Custodian – Ideally, investment firms should not act as custodians, or in other words, they should not hold their clients’ investments. Having an independent, third-party custodian provides checks and balances, and eliminates the opportunity for the Bernie Madoffs of the world to defraud investors.

Doesn’t Over-Allocate Asset Classes – Diversification and balanced investing should be at the core of every investor’s portfolio. Significant over-weights to an individual asset or riskier strategy is the quickest way to destroy a lifetime of savings. This is nothing more than gambling, and from a risk/return standpoint can be extremely detrimental.

Doesn’t Sell High-Commission Products – While most investment and insurance products have some clients for whom they are appropriate, many times advisors are overly incentivized to sell products with high commissions. While occasionally appropriate, whole life insurance and annuities are often not the most effective tools for an individual investor. The only way to be certain that these types of products are used appropriately is through the use of non-commissioned, fee-only advisor.