On flawed investment styles

Do it yourself – I would absolutely encourage everyone to manage their own accounts. This however, requires countless hours of reading, research and maintenance every week, and a level of expertise commensurate with a successful professional. Sometimes that’s not saying all that much though… But anyway, as a DIYer, you can never take your eyes off of your money. This is very hard to do, especially if you are the average mom and pop investing for the “long-term.” This is where you might see a selection go up 10% in a few months, and then reverse back to flat, netting nothing if lucky and losing money in alot of cases. The problem with the DIYers seems to be their avoidance of making a buy/sell decision. DIYers are quick to buy stock, and very reluctant to take a profit when it exists, preferring to “let it ride so I don’t gotta pay Uncle Sam, grrrrr.” Any number of events could reverse their fortune, and unfortunately DIYers are usually the slowest to react, capitulating and selling at the worst time, driven by fear of losing even more money. This usually happens after months or years of denial. I personally would never trust anyone besides myself to manage my money, that’s originally why I got into this business – to learn how to handle money. Unfortunately, this strategy has a high risk of failure for un-informed non-professionals. Dead money all over the place.

Buy and hold has been exposed as passive, dangerous, and negligent given the events of the last four years beginning 2007. From the year 2000 to the year 2010, the S&P 500 index went virtually nowhere. 0% return over ten years. Now that’s dead money! If you must follow a buy and hold, longer-term strategy, be sure that you are 100% sure you can ignore drastic fluctuations and stay invested over full economic cycles, i.e., 20+ years without caving to the emotional and psychological aspects of investing. And do yourself a favor and build something into your little “long-term model” that makes it ok to want to take money off the table when things get scary. And once you’ve built that in, go to cash the first time you feel uneasy, or scared for your money, and the thought of wanting to secure it enters your mind. The experience of being 100% in cash after netting what initially felt like a less-than-backflip-inducing 6 or 12% return, while the world around you crashes and crumbles for six months is a feeling that cannot be properly described; it can only be experienced. It’s wonderful.

Mutual funds are an ok investment if you plan on holding them for more than 20 years. Not kidding, 20 years. The only long-term investors I’ve seen in my practice that have had good success have all held their stocks or MFs for 60, 40, 20 years…. even then, for optimal performance, you’d want a no-load, Morningstar rated 5-star fund, you’d want to watch out for a change in fund manager, and be prepared for drastic fluctuations in account value over the years. Mutual funds often lag other managed pools of capital, meaning that fund managers are typically slow on the uptake with respect to emerging trends, or stocks slowly falling from favor. A random side note… large endowments require approval from the board of directors to change investment strategy, and these meetings happen quarterly, just so you get an idea of how slow some large pools of assets can be.

Often times in the beginning with me, a new client will remark and say “wow, you trade like almost every week, what are you doing?” My reply is that when you invest money with a mutual fund, the manager is running a commingled pool of assets and trades everyday as well, making small adjustments, realizing profits and losses, re-allocating when situations change and such. Or at least that’s what he’s supposed to be doing. However, because of the way MFs are structured, the investor in them does not see the interior moves within the fund; the only thing reported to investors is the daily change in net asset value of the fund. This provides some marginal conveniences to the investor, such as simplicity of tax reporting, and the ability to “buy and forget”, provided of course, the market continually goes up and everything the fund owns is roses. But it also presents the problem of something very bad happening intra-day, deciding you want to sell, and then not being able to redeem shares until the fund re-calculates with the results of that day’s large losses. Illiquidity really kills you when it matters most.

As an investment manager, it does not matter whether you are running $4M or $400M, it’s all about percentage gains and losses. I could very easily go to work at a mutual fund company, with the goal of rising through the ranks and eventually being given the reigns to a portfolio. Of course, with this decision comes a measly salary compared to the responsibilities of the job, countless bureaucratic issues and other business-culture nonsense to deal with, and constraints on what moves I can make in my trading. For example, many funds have specific objectives (i.e., only invest in bio-tech, or energy companies, or small-cap stocks with a market value of less than $100M.) If I was ever going to manage a large fund, it would be structured much more like a hedge fund, with zero restrictions from above on moves that I could make. Until then though, it’s far easier to work with a small group of retail clients and apply what I know as a portfolio manager.

Managed accounts – Sometimes I get cold calls on my cell phone from third-party firms pitching their managed accounts to the tune of four or five calls a week. They want me to recommend to my clients that I take their assets and hire this third-party to manage them, putting me in the position of middle-man and buck-passer, as well as the only person who would talk to my clients if shit hit the fan. I generally hang up within 20 seconds. Managed accounts are very similar to MFs; they are trending as the passive financial advisor’s alternative to mutual fund investing. Advisors at large firms are constantly pursued, pitched and steered towards managed accounts, and sometimes they are the firm’s own proprietary products! This makes sense for the large firm; it creates operating efficiency, allowing the money managers to focus on managing money, and the financial advisors to focus on bringing in new assets full-time. This stems from the older methodology of a firms “buy-sell list”, where the firm would publish a report saying XYZ stock is a buy and ABC stock is a sell, and then they would have the firm’s brokers on the phone all day buying and selling stock in line with the firm’s analyst’s recommendations. I can tell you from my experience, that when many wall street firms place a “buy” rating on a stock, they are often late and often have ulterior motives; perhaps their investment banking division has a vested interest in a stock they helped bring to market going higher, or their prop trading desk is stuck in losing position. Yes, they’d sell those losing shares to their own clients. Read the news. And also when the independent institutional buyers dry up, they attempt to push the retail investors into the stock to help maintain the price. All the while, you’ll see the smart money sell into this new wave of buyers. When I see upgrade after upgrade on a stock, it often raises a red flag, and I look to be extra cautious on the stock and I tighten my stops. Analysts, on average, are not right as often as you would like to believe. Sometimes it’s not even the analysts fault, being pushed to upgrade a stock from the higher-ups for many different reasons. I’d never accept a job as an analyst either. Not enough compensation for the job and the garbage that comes with it.

Annuities, variable annuities in particular, deserve a word as well. Anytime an advisor sees new assets come in and the investor claims to be a long-term investor, you will always see them consider trying to sell the investor a variable annuity. The annuity companies are very good at attracting new money. Countless riders are added to the policies, some guaranteeing the greater of either the highest anniversary value, highest all-time value (high water-mark), or an arbitrary annual return, say 10% guaranteed annually on the separate account upon redemption of the fund or annuitization of the policy. They have even gone so far as to structure the thing so that the investor does not see a fee charged, at the same time paying the advisor a sales concession almost double that of a MF. Up to 8%, last I checked, on the assets deposited in the VA! In short, there is no other product on the market right now that advisors are more incentivized to sell than the VA. They present a wonderful option. VAs usually require a 10 yr lock up period though, meaning you cannot change your mind and take an early withdrawal without paying a significant penalty, assume say 10% of the assets. Given the promises they have to deliver on, it should be obvious to you why they need your money for ten years. And frankly, given the collapses in the banking and insurance industries that we’ve all just witnessed, they give me pause. A lot can go wrong in ten years. But in short, VAs are a financial advisors dream sale. Bring in a new client, present a no-lose situation, lock up their money for ten years, collect an obscene commission ($80,000 on a $1M annuity), not have to manage the money, never have to talk to the client, and once again, they are freed up to go find more assets. Then in ten years try to sell them another one. Sometimes a VA is a great choice for an investor; more often than not though, they are pushed on an investor when they are not optimal due to the high sales concessions.

If you happen to like all that the annuities have to offer, that’s great. Buy a no-load VA from a fee-based investment advisor (not a commission broker/registered representative) and you’ll be in much better shape. Consider that the highest concession paid to brokers available amongst MFs is about 5%, and the highest stock commission allowable by FINRA guidelines is 4-5% on a round-trip transaction. This is usually much lower due to competitive forces. (For example, before I became a fee-based advisor, I would usually charge between 3-3.5% on the buy side; and to compensate for the higher turnover associated with an actively managed account, I would always move money to the sidelines (sell stock) for a small fee (less than $50) regardless of the size of the position. I would also do this on the buy side sometimes, with reducing the drag from commissions in mind. This arrangement worked well.) But given how the compensation scale lines up, you can see why the VA is so popular among brokers and financial advisors. If you’re a commission broker, and you can sell just one $1M annuity, you’ve got yourself a down payment on decent home from the commission on that sale alone. REITs, limited partnerships and private placements also have very high payouts to brokers, are also highly illiquid and rarely prove to be profitable to investors from the positions I’ve seen in people’s portfolios.

Another thing to consider: Ask your financial advisor what their payout ratio is. This will usually cause them to stammer and mumble some answers back to you in an attempt to weasel out of answering the question. The reason is this: many wire house advisors only work off of a 35-50% payout grid. Meaning they only earn 35-50 cents on every commission dollar charged to the client. Many regional houses will start someone off at 60-70% and try to keep them below 80-90% for as long as they can. You can see why such advisors, especially young ones, are always looking for the big commission ticket – because they’ve signed a bad deal with their firm and still need to eat. What kind of person would manage people’s money and give half of their earnings away to the broker dealer? That’s ridiculous. Right now I am paid out on a grid that starts at 90½%, and goes as high as 97.5% as my production increases. If I were to open my own RIA firm, that number would be 100%. Stupid people sign stupid deal sheets – these are questions you should be asking to be sure your financial advisor has a good business mind. Make sure he has a high payout, otherwise I’d say he’s either a rookie or an idiot.

RM ~Mar 2011

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