01 May 2006

What the hell is wrong with financial planning? (Part 1)

Financial Planning is an industry well short of maturity in Australia.

It can be considered an infant industry - hey, it's only been going since the late eighties in Australia. Financial Planning was the logical successor to the Life Insurance Advice industry, which needed room to grow.

Like all infant industries, Financial Planning is temperamental, emotional, irrational and lacks a substantial degree of theory behind the practical... and its practitioners, likewise.

This blogger happens to be a former financial adviser, and still works in close proximity to the financial advice industry. So he's allowed to bag it.

Once upon a time, financial advisers in Australia were accorded a social status marginally below that of Real Estate Agents and Plaintiff Lawyers and marginally higher than that of sufferers of Hansen's disease.

Now, thanks to a raging bull market, clients think that financial advisers can do no wrong.

And it's being reflected in society's opinion of them, showing that their popularity has increased.

But is the industry resting on its laurels?

This blogger has noted in the past that the FPA very much appears to have favoured its licensee members, and not the public interest when it has been making policy.

For example, the tectonically slow pace of reform on adviser commissions appears to be moving in the direction of a model rejecting commissions. It is clear to even Blind Freddy that commissions for advisers is a blatant potential conflict of interest, however, the FPA could not spot a conflict of interest if it swung a cricket bat up between its legs.

Given the slow pace of policy reform from the industry's key body, which represents the vast majority of financial advisers and advice houses, what is in the offing is a potential powderkeg of recriminations and finger-pointing once the next bear market hits.

We're already seeing this in a lightweight form with the Westpoint fiasco. What would happen if the shit were truly to hit the fan?

The irony is that the whole Westpoint thing could easily have been avoided if financial advisers had stayed true to the old maxim "build and diversify".

Clients who have been burnt appear to have one thing in common - their adviser recommended that quite a large portion of their portfolio went into just this asset.

If their advisers had been a little more diligent, there would have been substantially more attention paid to a client's diversification profile.

Or, to put it another way, I find it very, very difficult to believe that all clients who were burnt required all their property portfolio to be managed by the one very small company.

But the financial planning world does some funny things these days.

Lets look at some areas that are contentious.

1. Rejection of the Efficient Market Hypothesis (EMH)

This appears to be a recent thing and appears driven by a desire by dealer groups to use products other than index funds.

Put simply, all forms of the EMH suggest that it is impossible for anyone to expect to outdo the market consistently (on average).

Which means that, if the EMH holds, a fund that approximates the index - such as an index fund - is going to represent the best bet over the medium to long term.

The problem with the EMH is that some of the underlying assumptions have not been researched thoroughly enough to be able to even underpin the hypothesis itself.

Naturally, this means that the EMH will probably remain a hypothesis for some time, yet, as a way to test it has not been found.

(Ironically, this often leads to claims by Technical Analysis proponents that the EMH is pseudoscience. Honestly, what planet are these guys from...)

It does appear that a systematic campaign to discredit the EMH is being waged by fund managers and advice houses and, sadly, this appears slanted towards selling non-index products that charge higher fees and pay higher commissions.

And perform worse, more often than not. Oh yes. The stats are available.

2. "Active portfolio management"

Following on from point one is a new twist which is one that, financial advisers are pushing active portfolio management more and more.

This appears to coincide with a rise in fee for service advice.

This, sadly, appears to be a downside in the move to more objective advice. It now becomes in the adviser's interest for a client to not be a "set-and-forget" client.

More and more opportunities will arise to "add value" to a client's financial planning requirements.

Add value. I cannot stand that term. Whenever I hear it, I see several shades of red. It is a cynical term that means, "What can we cross-sell?" And it isn't the client who benefits, it is the adviser.

What I don't get, is that they're "adding value" in contentious areas.

Why aren't they doing stuff that they traditionally haven't touched which they need to do? Such as budget planning? Debt management? Bank account shopping?

If financial advisers are going to continue to call themselves this, they need to be able to justify this title with some more extensive work.

Otherwise, hey. Why don't we just call them "investment advisers" cause that's all they appear to do.

Back to active portfolio management, though.

The most annoying thing about his is that it is a straightforward example of financial advisers not heeding their own advice. Financial advisers tell you to hold your investment for a suggested time horizon. What kind of example is a financial adviser giving when they tell you to drop an investment and switch into another?

I recently spoke to a former colleague of mine and asked him, "What benefit is to be gained by doing this?"

His answer told many stories: "You've got to be seen to be doing something."

Seriously, this is no way to do business.

Let me make this perfectly clear.

A. Financial advisers do not have to be seen to be doing anything. This is a stupid rule perpetuated by stupid American management consultants.

B. If a financial adviser makes a recommendation which they then vary a year later, they at least should have the decency to say that they made a mistake the first time. Then, they should count the "mistakes" that they made. Do they outweigh getting it right? If they do, why should they think that they're any good?

C. Will incurring unnecessary Capital Gains Tax (CGT) events every year really help their clients?

How on earth advisers can advise with conviction if they keep changing their minds is beyond me.

3. A move towards directly owned assets

This one is a direction that I figure that financial planners had to go in eventually.

However, some advisers have gone well beyond what I would consider prudent in recommending these.

Basically, a managed fund allows someone to benefit from either a portfolio that replicates an index, or is managed by a fund manager who has a reasonable degree of skill in excess of the average schmo.

Either way, there are economies of scale cost-wise that the average investor cannot hope to replicate.

Also, in the case of active fund management, you are piggybacking off some of the brightest fund management sparks in the world.

Currently, advice houses plug direct ownership as a way that an investor can keep their costs down and their investment performance up.

This is a furphy. And I'll tell you why.

No adviser who is this good as a stock picker will be a financial planner.

The other small issue is that most client's diversification profiles do not lend themselves to direct investment.

The thing about clients' risk profiles is that they specify a maximum degree of risk that is acceptable to a client.

Clients then look at the maximum return that they are willing to aim for given a certain degree of risk.

For about 90 to 95% (my guess) of clients, lower amounts of risk for higher returns are achieved through diversification.

Advisers are supposed to take all of this into account.

Of course, beyond a certain amount of diversification, that higher potential return for a given level of risk becomes hard to come by.

Some have said that this level of diversification can be achieved by purchasing as few as 15 assets per asset class.

But you still have to pick them. Could you?

At the very least, it is said that at extremely low and high risk profiles, diversification becomes less effective.

But then as I pointed out before, 90 to 95% of people lie in between.

(Hell, if purchasing the family home is considered to be an investment decision, most Australians who own or are paying off their houses have what could be considered to be one of the most inappropriate investments ever)

The only thing I can conclude from the push to directly owned assets is that it is another "value add".

Stockbrokers have been doing this sort of stuff for years - and clipping the ticket every time a trade is executed.

Financial Planners now are doing it as a value add - hey, this fee for service thing really pays off.

It requires more intensive maintenance, more work, more transactions, and, not surprisingly, more Statements of Advice.

And you can be sure that some clients who use these services would, of course, be better off buying and holding an index fund.

What is going on?

The above are only some of the questionable tacks that financial planning these days has embarked on.

In Part 2, we'll look at someone who believes that he has the answer as to why this revolution is going on, and who stands to benefit.

Standard but necessary disclaimer: This is not advice. Only a complete idiot would think that any of this constituted advice. Are you an idiot? I didn't think you were. If you are in any doubt as to the content of this, see a good, independent financial adviser immediately. They do exist.

No comments: