The Four Flaws Of Fund Management
The crucial mistake that many investors make comes from not grasping four simple facts about funds and fund management:
First, the goal of an average fund management company is not to make you wealthier. Its to make itself wealthier, through gathering as much money as it can from investors and charging as high a set of fees as it can for looking after those assets. A fund companys true business model is to be an asset gatherer, not an asset manager.
Second, this means that the average fund manager is not incentivised to manage your money in the way thats best for you. Instead, he or she is incentivised to draw in as much money as possible from new investors, while losing as little as possible to existing investors taking it out. That is what his bosses want and doing what his bosses want is the best way to secure his career.
Third, it is not possible to beat the market consistently over short periods. A good investor will outperform over five years, but quarterly performance is essentially random. Unfortunately, the industry is becoming increasingly short-termist. If a manager underperforms significantly for a couple of quarters, they will come under pressure from their bosses, because weak performance could lead to impatient investors pulling out their money.
The Magic Of Compounding
Another important reason to leave your investments untouched for several years is to take advantage of compounding.
When people cite the snowball effect, theyre talking about the power of compounding. When you start earning money on the money your investments have already earned, youre experiencing compound growth.
This is why people who start the investing game earlier in life can vastly outperform late starters. They get the benefit of compounding growth over a longer period of time.
Determine If You Need A Financial Advisor
Financial professionals can be a big help when youre trying to map out your future, but you dont need to hire one to be successful with your savings and investment goals.
If your employer provides a 401, for example, many times the plan will offer the option to invest in target date funds. These types of investments will keep your retirement savings on track without too much required oversight from you or a financial professional.
You still may need additional investments, such as an individual retirement account and a taxable brokerage account. If youre the kind of person who likes to be super hands on, you can sign up for one of the brokerage firms such as Charles Schwab and TD Ameritrade.
Yet creating and maintaining a balanced, diversified portfolio can take a lot of time and research. If that feels overwhelming, you can always work with the so-called robo-advisors, which typically manage your money for you. These platforms which include Betterment, Schwab Intelligent Portfolios, Vanguard Personal Advisor Services, Ellevest and Wealthfront are generally less expensive than working with a human financial advisor, but they may not provide the same level of customized advice and solutions.
Maybe you dont want to map your financial future on your own, or you have a more complex financial situation, such as stock options or perhaps you help out with family financial obligations. That may require a face-to-face conversation with a human financial advisor or planner.
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How To Choose The Right Investment Management Firm For Your Needs
Choosing an investment management firm is an important step in building wealth. Choose the wrong one and you risk losing your investment to poor management and high fees. Not every firm is right for each investor. Here are some strategies you can use to find the right investment management firm for your needs.
Question To Ask Yourself
What type of help are you looking for?
I just need to get started investing for my financial goals: A robo-advisor may be the best fit if youre just starting out or only need investment management. For a low fee, these computer-based services choose and manage an investment portfolio for you. Some also offer access to financial advisors if you have questions about your investments or your goals. Robo-advisors often have low or no account minimums, so its easy to get started.
» Need more info? Learn about robo-advisors.
I want personalized financial advice, but dont need to meet my advisor in person. There are a crop of services offering online financial planning for less than youd pay a traditional in-personal financial advisor or financial consultant. These companies provide complete investment management and holistic financial planning the major difference is that youll meet your advisor virtually by phone or video chat rather than in a local office. Most services pair you with a dedicated advisor or certified financial planner some less-expensive options offer access to a team of advisors.
I want a local advisor or a wider array of financial advice: On the other hand, if you want in-person financial planning or have a more complex situation, you may decide a traditional local financial advisor is right for you.
Not sure? Check out our cheat sheet for how to choose a financial advisor.
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There Is A Good Chance That You Are Not Getting The Service You Think You Are Paying For
Lets suppose you decided that all you need is help with financial planning. You should go to a financial adviser, right? Well, not so fast. Financial advisers are not keen to charge you a flat fee for the financial plan and for the time to meet with you afterwards. They would much manage your money for you for a 1% permanent equity stake in you.
What makes them deserving of such a bounty? Many dont even try to produce above-average performance. Of those who do, a good portion does it half-heartedly and with little chance of success they own a basket of large, well-known blue chip stocks and bonds that they know will be familiar to their clients and that they hope their clients will not blame them for if they dont do particularly well. After all, how poorly can you possibly do investing in such icons of American industry as General Electric?
Understanding Fund Management Styles:
After filtering out fund managers on the basis of their experience and qualifications, we come to the most important feature of a fund manager their investment style.
The way a fund manager invests can be categorized into many types of styles. Each style caters to a certain risk appetite and fits best for a certain point in the economic cycle of the stock market.
Broadly, fund management styles are of three major kinds Growth, Value, and Blend. Let us understand them in detail.
1. Growth Style
As the name says, fund managers which invest with a growth style tend to invest as per the growth potential of the security, which they attribute to the current and future corporate earnings.
These managers choose to focus on companies that are leaders in the sectors they operate, with high retained earnings which indicate more potential for growth.
This style is best for when the market enters a bullish phase, as these successful stocks do even better in this phase. However, it is tough for the manager to maintain returns at the time of a downward spiral in the economy when the situation is bleak for all stocks.
2. Value Style
This style of investing derives profit by investing in undervalued securities.
Fund managers who work in this style purchase undervalued equity at lower prices, then hold them till they reach their peak price.
3. Growth At Reasonable Price
The GARP style is a combination of the growth and value style.
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Ask These Four Questions
1. Can you please send me the investment returns for each of your investment strategies for the last three calendar years?
2. Is your investment return data prepared by an independent organisation?
3. Can you please show me a peer-group return table i.e. how the investment returns for each of your investment strategies compare with the returns of similar portfolios managed by other managers for the last three calendar years?
4. Once I am a client, will you show me how my investment return compares to the average return of a peer group of similar risk portfolios every year?
Be Realistic About Your Needs
Each investment management firm offers customers a different level of service. Some full-service wealth management firms take ownership of the entire process, from monitoring your investments to buying stock on your behalf to maximize your returns. Others, such as discount brokers, may cost less than full-service investment management firms but require you to actively manage your own investments.
If you want the expertise and management from an experienced investment broker, a full-service firm is likely a better choice. If you want to trade your own investments and feel confident doing so, you may not need this level of service. This depends on your actual needs.
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Look For Reasonable Fees
In comparing active managers, you arent necessarily looking for the cheapest fee. After all, you wouldnt choose a surgeon based on who had the lowest bid. At the same time, fees should not be so expensive that they take a big chunk out of your investment returns.
Look for fees that are around the middle of the pack among investment managers you are considering these should be no more than one percent for equity funds, and less than half that for bond funds.
How Do You Protect Your Best Interests
The best way to protect yourself is to choose a financial analyst who voluntarily minimizes the conflicts of interest in their business model and voluntarily adheres to a fiduciary standard higher than the one the SEC enforces, says Barbara Roper, director of investor protection for the Consumer Federation of America.
Look for advisors with the CEFEX certification, which audits firms and advisors and certifies them as meeting a true fiduciary standard.
Its also important to keep in mind that brokers may have a different pay structure than advisors. They may make money by selling you products that are okay for you but are not necessarily the best for you.
Dont be shy about asking prospective advisors how theyre compensated. Watkins also recommends asking whether an advisor is open architecture or closed architecture.
Open architecture means that the advisor can sell anything to you. Closed architecture, conversely, means the advisor is limited in what they can sell, often because theyre receiving some sort of compensation from whoever is marketing the investment, like a mutual fund manager.
It may be best to actively find someone who is open architecture, and seek out advisory firms that are fee-only, paid exclusively by the client, so you know third-party incentives arent involved at all.
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Key To Choosing An Investment Manager
The key thing to look for in the investment manager selection process is a sound and disciplined investment philosophy. The next thing to review is the investment process, particularly security selection. Things should be understandable and reasonably simple. If you cant understand it, the manager probably doesnt. A historical track record is only evidence of skill. A proper manager search will establish whether the historical performance is skill or luck.
You: Identity Anxiety Money
The above quote is the heading of the first part of an investment classic from the 1960s, The Money Game by Adam Smith. The point is that your identity and your anxieties are frequently more important than money and determine how you approach it. In my career as a value investor friends have frequently come to me for financial advice. I have found that peoples underlying needs and desires can be broken down into three categories:
1.Financial Planning You have complicated future needs for your capital that involve different time horizons. You need someone to sit down with you, understand how and when you intend to spend your money, and come up with an investment plan that matches the time horizon of your current and future wealth with how you intend to spend it. Perhaps an annual follow-up meeting would be helpful to make sure you are on track and that your goals have not changed.
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Vet The Financial Advisor’s Background
If you elect to work with a traditional financial advisor, you’ll need to vet them. Verify any credentials they claim to have and check to see if they’ve had any disciplinary problems such as fraud. It’s not a bad idea to do this as well if you work with an online financial advisor, but most will do the vetting for you.
We also have a list of 10 questions you should ask a financial advisor including whether they hold to a fiduciary standard, what their fee structure is and how frequently you’ll be communicating.
Find The Best Financial Advisor For You
A financial advisor is a certified expert that provides guidance on personal finances, tax laws, investments and asset management.
Some financial advisors resemble coaches. They can help you make basic financial decisions and teach you solid spending, saving and borrowing habits. They can also perform high-level investment management for the wealthiest individuals and businesses.
Heres a summary of the main types of financial advisors out there:
Investment advisers
Investment advisers know market conditions and can help create an investment plan tailored to your financial goals. Youd pay them a fee for their advice about whether and when to trade specific securities.
Its worth noting that an investment financial adviser is purposely spelled with an e instead of an o,” to specifically identify legally regulated investment professionals.
An investment adviser must be registered with the Securities and Exchange Commission and a state securities regulator. The term is not interchangeable with financial advisor, which has a broader scope generally refers to brokers and is not bound to a fixed legal definition.
Stockbrokers
Stockbrokers buy stocks and bonds on behalf of their clients. Theyre usually associated with a brokerage firm and can make trades for both retail investors as well as institutional investors.
Certified financial planners
Robo-advisors
Many advisors use a hybrid model which combines some personal interaction with robo-offerings.
Estate planning
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How Are They Paid
There are different ways you can pay a CFP. Some charge a commission based on the products you buy from them, while others charge a set rate based on the size of your portfolio. You want someone whos as invested in your portfolios growth as you are.
Be wary of hiring anyone who earns a commission on what they sell to you theyll be more interested in earning that extra money than making sure what theyre selling is the best fit for your needs.
Dont Let Cost Be Your Only Deciding Factor
When it comes to hiring an investment firm, dont let cost be your only deciding factor. A less expensive wealth management firm may offer you less expertise and returns. After all, it is better to have a smaller percentage of large returns than a larger percentage of a loss. With investment management firms, you often get the quality that you pay for. This doesnt mean you should choose the most expensive firm instead, embrace a balanced approach by signing up with a knowledgeable and trustworthy firm that falls into the middle of the range.
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Meet Potential Financial Advisors Or Brokers
Once youve identified some potential advisors that meet your requirements, start making calls and set up appointments.
Whether its knowing more about your financial advisors credentials or a detailed explanation of their pay structure, dont be afraid to ask for what you need. After all, your lifes savings are at stake.
Questions to ask before hiring financial advisors
Here are some questions you can ask:
- Who are your typical customers?
- How will we communicate with each other?
- How much will I pay and how is that number determined?
- How are you compensated?
- Are you compensated for recommending certain products?
- How do you choose investments and products for your clients?If charged an annual percentage, will it be billed quarterly or monthly?
- Do you charge by the hour?
- Do you have a fiduciary duty to your customers?
You should also ask questions about your specific situation:
- Say youre a divorced woman in your 40s, does the advisor have other clients in the same boat?
- If youre a small business owner, do they have experience with that specialization?
- If youre just starting out in your career, have they worked with millennials or Gen Zers in the past?
If an advisor doesnt want to discuss these details, move on to someone else. Its important you choose an advisor who is transparent about how theyll handle your finances and answer any questions you might have.
Choosing Investment Managers: A Guide For Institutional Investors
As investment practitioners, we all know that we are supposed to avoid the curse of buying high and selling low. After all, thats what so-called mom-and-pop investors do. Institutional investors you know, the multibillion dollar endowments, pension funds, and the like that hire professional managers with the help of sophisticated consultants are the ones making all the right moves. Right? Wrong.
Many institutions, even the large, sophisticated plan sponsors, end up buying high and selling low when it comes to hiring investment managers. How can that be? Many institutions hire managers who are in favor and fire them when they are out of favor, only to hire a different manager who exhibits a better performance record often harming the performance of their own plan assets. This is what is known in the trade as chasing performance.
Why would they do this? Shouldnt they be more sophisticated about navigating the pitfalls of investing? Well, behavioral finance provides us with some clues. So do agency costs. And the interaction between the two can create a truly lethal mix. The problem isnt just found in suboptimal performance. These hidden costs stand in direct conflict with institutional investors fiduciary duty to clients and beneficiaries.
Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.
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