When a new client was recently in the phase of interviewing our financial advisory business, he asked what one question he should ask that most prospects do not ask. It was a great question. I responded that most people do not ask in advance of establishing a relationship how the success or failure of the financial advisory relationship should be evaluated and over what time period. The reality is that we could ask that same important question when entering any long-term service-oriented relationship. But few of us do.
Charles Passy wrote an article in this week’s Wall Street Journal about benchmarking your financial advisor that touches on this subject and provides some useful insight. I communicated with Charles before he wrote the article and he adopted several of the concepts I presented to him. The article sticks largely to the limited scope of benchmarking an investment manager, rather than benchmarking a comprehensive financial advisor. The former is relatively easy (although many investors fail to do it properly) whereas the latter is quite difficult. My advice on this matter to Charles:
The first thing to understand is that there is no perfect way to benchmark any and all advisors. I actually recommend that consumers ask their advisor how they should be evaluated, ideally before the advisor is ever hired. If prospective clients do not ask me this question during the interview phase, I tell them how we think they should evaluate us as an advisor, over what time periods, and why. The consumer then needs to determine whether these benchmarking metrics fit with the advisor’s value proposition.
In the case of a comprehensive financial planner who is providing tax advice, investment management, integrated asset location, consultation on subjects like Social Security timing or Roth conversions, estate planning advice, cash flow modeling, etc., evaluating this advisor merely on the performance of the portfolio would be a colossal mistake. It is a piece of the evaluation but if investment performance is the end-all, be-all for this relationship, then the client has clearly not chosen the right type of advisor and the relationship is likely to be a failure, costing both the client and the advisor. In this type of relationship, the evaluation needs to fit with the services.
Charles does a good job in the article of highlighting many of the important concepts that should be used when benchmarking an investment manager. Finding an appropriate benchmark, for example, is one of the most critical and yet, the most ignored step. The S&P 500, for example, is a useful index but it merely provides a proxy for US large company stocks. In a typical 60% equity/40% bond portfolio, large US stocks may only constitute 20% of the total allocation. In its annual car rankings, Kiplinger’s does not compare the gas mileage of a large SUV to a compact car. They obviously compare the gas mileage of a large SUVs to other large SUVs and a compact car to other compact cars. Unless the investment manager is investing solely in US stocks, the S&P 500 is not the right benchmark for the portfolio and using it for evaluation almost always leads to poor decision making that ends up costing the investor.
Another important concept in the article is to “consider other yardsticks”. At the end of the day, the success of a comprehensive financial planning relationship should be determined by whether the client achieves their most important goals, not by whether they beat an index. The success or failure of the retirement plan brings together all components of advice, incorporating advice which may have helped to optimize a pension payout, efficiently execute charitable gifts in a tax-favored manner, or make use of tax-optimized cash flows in retirement. These are admittedly more difficult measures to evaluate. We have actually contemplated taking the worthwhile step that another advisor referenced in the article employs – using the financial plan assumed rate of return as the benchmark on investment reports or even charting the financial plan success rate as the measure that gets reported each quarter. Admittedly, many of the services that a good financial planner provides are challenging to evaluate or recommendations such as the acceleration of income for tax purposes require a lifetime to properly evaluate.
I also communicated with Charles about an additional component of evaluating financial advice that almost never gets reported. However, I think for sake of space, he deferred the topic of evaluating risk for another day. My comments on the subject to him were as follows:
But where most advisors fail to provide useful data is on the risk side of the benchmarking. Perhaps the managed portfolio outpaced the benchmark index mix by 0.5% but if the downside volatility of the portfolio was double that of the index mix, was that a success? If the advisor provides a slightly higher return than the relevant index but the drawdown in the process was 40% for the portfolio vs. 15% for the index, was that success? There are a lot of ways to quantitatively measure risk and no one perfect way, but risk metrics definitively need to be part of the evaluation. Examples of risk evaluation include standard deviation of the portfolio vs. the index portfolio, semi-variance, and maximum peak-to-trough drawdown. Return does not just happen in a vacuum – it comes with some level of risk and that needs to be evaluated.
Basic mathematics makes it clear that an investor who is either contributing funds to a portfolio or distributing funds from a portfolio is impacted by the volatility of a portfolio. Specifically, an investor earning a 6% return can make more money than an investor earning a 7% return, depending on the levels of volatility (we will get further into this at a later date, in case the math is not clear). Not evaluating an advisor on a factor (risk) which is under the control of the advisor, impacts the retirement plan success, and is easily measured, is a mistake. We believe that the industry will get this figured out at some point but, in the meantime, we make it a point to transparently disclose risk measures to help our clients in their evaluation.
There is no perfect way to evaluate an advisor just like there is no perfect way to evaluate a doctor, a teacher, or an attorney. The most important thing for anyone to do is to set expectations early for what is to be expected, how the relationship should be evaluated, and over what time period the evaluation is appropriate. If everyone agrees on those items, then the relationship is far likelier to be a success for both the client and advisor.