Five-word answer: When s/he is also a salesperson.
Longer answer: In its first article, On the Buy Side introduced the terms “buy side” and “sell side”. As a reminder, the “buy side” is everyone who has money to invest. The “sell side” is everyone who has investment products to sell, and who gets paid for selling them.
The problem is, it’s a rare—perhaps even non-existent– business card that carries the title “investment sales”. Instead, the person whose job is selling investments will probably be called a “financial advisor” or “financial counselor” or “investment consultant”.
Why does this matter? Because people, including those on the sell side of investing, are motivated to do what they get paid for. And because many investors—the buy side—may not fully realize what these motivations may be.
Think about what happens when you walk into a car dealership. You’ll probably be greeted quite warmly—especially if you look like you’re ready and able to buy a car. And you will probably realize that, even if the business card you’re handed when you walk in the door has a title of, say, “automotive advisor”, the person proffering it is a salesperson. And that person will do her best to sell a car, because that’s how she gets paid.
And three more points: First, generally speaking, the more expensive the car, the bigger the compensation to the salesperson. Second, the salesman will be looking to sell a car from his own lot only—he won’t send you down the street to a competitor, even (or especially!) if the competitor has better cars or better deals. And third, no matter how friendly and concerned the salesperson may seem, or how intelligent and informative she may be, the bottom line is that she works for the dealership—not the customer.
Most people understand that this is how the car sales business works. What many people may not understand is that this is also how the investment sales business works.
This is not to imply that there is anything wrong or dishonorable about selling—all of business is premised on selling products and services that people want to buy. Bringing the right products to the right investors is a useful service, and people who provide this service should be appropriately compensated. But—as recent experience has shown– not all investment products are worth buying, and not all advisors have only the best interests of investors at heart.
So what can investors do to detect conflicts of interest? That’s what we’ll begin to address in Part Two of this topic.
In the last On the Buy Side article, we saw that some financial advisors and consultants are paid primarily for selling investment products, and that they may be paid more for selling some products than for selling others. It also stands to reason that financial advisors—like everyone else who works for a living—are likely to do what they get paid for doing.
So the question for the buy side—that is, you, the investor—is, how do you find out what your advisor is paid for, and whether that entails conflicts of interest?
Well, if your advisor is a Registered Investment Advisor, you can ask for an ADV Part 2. This is a document required annually of all RIAs by the Securities & Exchange Commission. It covers business practices, compensation, disciplinary history, and the educational and business backgrounds of a firm’s principals. It is well worth taking the time to read, especially since, effective in 2011, the SEC has begun requiring that the document be written in an easier-to-understand narrative form.
[As of this writing (February of 2011), broker-dealers, unlike Registered Investment Advisors, are not required to file an ADV or similar document. The SEC appears to be headed down the road toward harmonizing the disclosure requirements for different types of advisors, but this is likely to be quite a long road.]
There’s another, potentially simpler, way—two ways, actually—to figure this out. One, look at your checkbook and read the contract you signed when you hired your advisor. Two, ask (which will be discussed in the next On the Buy Side article).
Why look at your checkbook and your contract? To see if you have actually paid out of pocket for your advisor’s services, and, if so, for what, exactly.
For example, did you pay by the hour for professional advice from a financial planner? If so—and assuming there is no other compensation stream to the planner—then what you paid for was a financial plan and advice. Did you pay a flat fee for an investment project? Then what you paid for, most likely, was answers to a specific question or set of questions at a particular point in time.
If you wrote a check, you know exactly how much you paid, and, when you look at your contract and at the final product you received, you should have a pretty good idea of what you got for your money.
What you might want to think about is what you didn’t get, and what you might, therefore, still need. For example, if you paid an hourly fee for a financial plan, how will you implement that plan, and who will help you? If you paid a project fee to get answers to specific issues at a point in time, what happens when new issues arise, or the original situation changes?
Next time, we’ll look to how to find out about fees if you didn’t write a check to your financial advisor.
In the last On the Buy Side article, we began to look at the issue of how financial advisors are paid, starting with the simplest case. This is where you engaged an advisor for a specific task, and paid him or her directly, such as by writing a check.
What if you didn’t write a check? Then perhaps you paid a percentage of the assets being managed, and that amount was taken out of your investment account. If so, what you paid should show up as a line item (a separate amount) on your investment statement. And what you paid for was the ongoing management of a certain dollar of assets.
If you didn’t write a check and you didn’t pay a line-item fee, you still paid– it will just be harder to find out how much, and for what.
Most likely, you paid for one or more investment products, in the form of fees and/or commissions that were deducted from the return of your investments before that return was reported to you. You will need to read the governing documents—for example, the mutual fund prospectus or private equity fund private placement memorandum– in order to find out, in concept, what you paid.
“In concept” here means, for example, what percentage of the asset value or what percent of the pre-fee profits were charged as fees. Then you may need to take out a calculator to figure out how approximately many dollars the percentages translate to.
[Future articles on this website will provide extensive discussion of various kinds of fees, how they are calculated, and what actions they may encourage.]
Finally, what about that other way of finding out what your advisor is paid? That is, by asking?
No investor ever needs to hesitate to ask about investment advisor fees. Investment advisors do get paid, just like anyone else who provides a valuable service. Investors have every right to know how much, and for what. It’s their money, after all.
A straightforward question about fees should elicit a straightforward answer. A financial advisor who won’t tell a client, readily and in plain English, how much the client is paying, and for what, should cause a second thought or two.
So ask away. The fact of asking can, alone, prove illuminating.
Next time, we’ll turn to issue of performance reporting, in a series of On the Buy Side articles on Playing with Performance.
Money managers like to look good.
That is, they like to look good professionally—by posting strong investment results. That should come as no surprise—strong investment results make clients happy, and happy clients often mean an increase in assets under management, and a concomitant increase in compensation for the money manager.
Strong investment results also gratify the ego—wanting to feel successful at one’s chosen vocation is a pretty universal human trait.
So far, so good.
The problem is, investment performance reporting can be very complicated. The same numbers can be presented in different ways, leaving different impressions. So this series of On the Buy Side articles will deal with the many ways performance numbers can be presented, and the different impressions each presentation may create.
So let’s start by specifying what we mean by “posting strong investment results”. What we mean is, (1) generating strong absolute performance—that is, making money; (2) generating strong relative performance—that is, beating a benchmark; or (3) both.
So let’s suppose you are sitting down with one of your money managers for an annual review of your portfolio. She brings out a nicely bound presentation, which shows your portfolio holdings, gains and losses, and returns compared to benchmarks. As you walk through the return section of the book, what nuances might deserve your attention?
One of the simplest variables to look for in the way performance is reported is in the title of this On the Buy Side article.
The terms “gross” and “net” refer to the practice of reporting returns before (that is, gross of) or after (that is, net of) the fees charged by a money manager. Fees are deducted from a money manager’s return before the client gets his or her portion, and therefore a gross return will always be higher than a net return.
As a buy-sider, why do you care? You care because the net return—not the gross return—is what you get to keep. [And actually, you only keep whatever is left of the net return after you pay taxes on it—this will be the subject of future posts.] A return that is posted only in gross form creates the impression that you made more money than you actually did.
How can you tell if a reported return is gross or net? The information should be right there in the title of the performance graph, or in the legend on the performance chart. If it isn’t, look in the footnote disclosures.
If you still don’t find it, ask. It’s important.
To sum up: The use of gross returns allows reported absolute performance to look better than it actually was, from the buy-sider’s standpoint.
Next time, we’ll look at how relative performance can sometimes be made to look better than it was.
In the previous On the Buy Side article, we imagined a meeting between you and one of your money managers, in which you were walking through an annual review of your portfolio.
The purpose of that article was to begin discussing methods of calculating performance, and the nuances that you, as a buy-side investor, should be aware of. In particular, we looked at how the presentation of returns gross of fees can make absolute performance look better than it actually was.
This time, we’ll look at relative performance—that is, manager performance compared to a market benchmark.
The terms “total return” and “price change only” refer to whether dividends have been included in the calculation of the benchmark to which your manager’s performance is being compared. A “total return” includes dividends; a “price-change only” return does not.
As a buy-sider, why do you care? Because it is a lot easier to “beat” a benchmark calculated on a “price change only” basis than it is to beat the same benchmark calculated on a “total return” basis.
For example, the total return to the S&P 500 for calendar 2010 was 15.05%. The S&P’s “price change only” return for calendar 2010—as presented in a performance report I recently reviewed– was 12.78%.
There’s a second reason you should care about how the benchmark return is presented, and it is this: You can actually buy an index fund tracking the S&P 500, and, if you do, you will receive the dividends, not just the index’s price change. Thus, only the total return of the benchmark provides a true apples-to-apples comparison with the total return the money manager has earned.
How can you tell if the performance presentation you are viewing uses the easier-to-beat price-change-only benchmark? One clue is the use of the word “index” in describing a benchmark. Very often, an “index” return, such as the NASDAQ Index, does not include dividends.
Another way to tell—and admittedly, this is much harder– is to know what the benchmark total return actually was, so that, if you are presented with a number that doesn’t look correct, you recognize that fact. Benchmark returns are reported in many major newspapers, and on websites like Morningstar.com.
And finally, as with everything in your buy-side investment life… When in doubt, ask.
In the next On the Buy Side article, we’ll begin to look at annualized returns, and how this statistical technique can make reported returns look smoother than they actually were.
Welcome to “On the Buy Side” (“OTBS”). We hope you find these articles to be useful and educational in your investing life. That’s the whole idea.
First, a definition. Who or what is “on the buy side”, anyway? You are—if you have money to invest. Investors collectively are known as the “buy side” of investing, while those who have investments to sell are—logically enough—known as the “sell side”. (More on this is a future post.)
Given that there are hundreds of websites and blogs devoted to investing—not to mention lots of people who would like to tell you where you should put your money—why bother with this one? What makes this different?
Well, for starters:
- “On the Buy Side” intends to provide substantive education and background to wealthy investors, who may or may not consider themselves to be financially sophisticated—but who know they need to be armed with knowledge in managing their own wealth (or in overseeing their outside advisors). Over time, the blog will build a cumulative body of knowledge that should help any investor become a more-savvy buyer of investment products and services. And it’ll be written in plain English—not investment-speak.
- The author of these articles—Elizabeth P. Anderson– has more than two decades of experience in choosing specific investments and managing portfolios on behalf of the owners of large, sophisticated pools of capital, such as the Princeton University endowment. (A full bio is here.) Ms. Anderson has spent her career being—not selling to—the client.
- It focuses on what’s knowable and controllable.
For example, it isn’t possible for any investor, no matter how wealthy, to control what the general investment climate will look like two years from now—or tomorrow, for that matter. It is possible for any investor to decline deals that are overly skewed toward enriching the deal’s sellers—if the investor knows what the deal terms mean, and what they imply for the split of profits between investor and seller.
Or again– It isn’t possible for an investor to know what the future return on a specific fund will be—but is possible to know that a fund’s track record of past returns has been statistically smoothed to make it look better than it actually was.
So if you’re looking for predictions about politics, or whether the deficit will be brought under control, or which developing countries will be most attractive ten years from now, this isn’t the place. I have no crystal ball, and frankly, neither has anyone else. But if you want to focus on what you can know, and what you can do, to make your investing life more successful, start here.