Deciding to work with a financial advisor is a great step towards meeting your financial goals. However, finding the right adviser to work with can be a difficult task, which requires more effort and research. The first question to ask is whether the advisor is working for you, the client, or if they are working for a large company. If they are working for a large company, the adviser may be more concerned with pleasing the company that they work for or offering only certain products that provide the company with greater compensation. Independent advisers tend to have less conflicts of interest. In any event, here are some questions to help you get started:
1) How are you compensated?
Advisers may be compensated by fees, commissions, or a combination of both. The nature of commission business creates an inherent conflict of interest. Instead of having someone manage your investment accounts, they will sell you the investment choices, such as mutual funds, for a commission. Most people don’t work for free. If you are not paying your adviser directly for independent advice or investment management, then the adviser is likely earning commissions instead. Advisers who charge fees will receive the same level of compensation regardless of the investment being selected. As a result, the conflict of selecting specific investments that will pay more to the adviser is reduced when using an approach based on fees.
Another thing to do is review the specific investments to determine if they have a front-end or back-end sales load, also called a sales charge, which is essentially a commission. You can research sales loads for a particular investment from publicly available sources.
The exception here is with insurance. There is no such thing as fee-only disability insurance or fee-only term life insurance. The nature of the insurance business is based on commissions. Each company sets their own rates, which are then regulated by the department of insurance. The rates are set at certain amounts, which will allow the company to pay out future claims and still claim a profit (remember that insurance companies are for-profit). If your adviser also happens to sell insurance, it’s important for him/her to be independent and be able to recommend products from any company without recommending only one company for a conflicting reason (i.e. high commissions).
2) Are you acting as a fiduciary?
An adviser acting as a fiduciary is legally required to act in the client’s best interest. Failure to do this is a breach of the adviser’s fiduciary obligation.
In many cases, advisers are not acting as fiduciaries. In fact, they may not actually be advisers at all (remember that anyone can call themselves an adviser). Instead, they are subject to a less restrictive suitability standard. This means that the recommendations provided by the adviser just have to be “suitable” based on the client’s goals and objectives. This type of adviser can place the client’s assets into high cost and highly commissionable investments as long as they are suitable. It does not matter that comparable investments may be available for a much lower cost (i.e. no-load funds).
It is important to keep in mind that anyone can call himself or herself an adviser, whether or not they are subject to a fiduciary or suitability standard. In addition to that, anyone can also use the term fiduciary to try and entice the client. This is why it is so important to make sure you understand how your adviser is compensated and that all conflicts are properly disclosed.
3) Are there any hidden fees or compensation from third parties?
12b-1 fees are often referred to as hidden fees when discussing mutual funds. These fees are disclosed within the fund’s prospectus, but many individuals do not take the time to read nor understand the prospectus. Advisers are obligated to disclose any such fees upon being asked. Unfortunately, it is up to the investor to ask the right questions and read the proper documentation to discover these fees.
12b-1 fees are annual marketing or distribution fees that the mutual fund charges to the investor. The associated costs are deducted directly from the client’s investments. It is not uncommon for these fees to be paid back to the broker who recommended these investments creating an unnecessary expense and conflict of interest.
Note: Mutual funds with 12b-1 fees of 0.25% or less can still be called no-load funds. Make sure you understand all fees before investing.
4) Are you independent?
Independent advisers typically do not have to worry about anyone other than the client. Advisers working for large firms and broker-dealers may be restricted from offering certain investments or products. Even worse, the broker-dealer may provide the adviser with a list of “approved funds”, which consists of nothing but high cost mutual funds containing sales charges and 12b-1 fees.
At the end of the day, clients need to do their due diligence to ensure they are working with a fiduciary who has their best interests in mind. In addition, it’s our opinion that clients should avoid high cost mutual funds and those containing sales-loads and 12b-1 fees.
5) Do you offer propriety investments like mutual funds or investment partnerships?
Proprietary investments being offered by your adviser or his/her firm can often result in a conflict of interest. Some advisory firms may have a separate, but related, advisory firm that manages their own mutual funds or limited partnerships. As a result, the adviser may have an incentive to place your assets within the related adviser’s investments in order to earn additional revenue.
6) How much do you charge?
You get what you don’t pay for! This is true at least for investing. For other financial aspects, such as disability insurance, you do get what you pay for (higher quality policies cost more). However, for investing, the goal is to minimize expenses and allow more of your money to stay in your account(s).
With that said, advisers need to be paid for their services, just like physicians need to be paid for theirs. However, advisers should be compensated based on the value they bring. Some investors need only a checkup each year and will self-manage their accounts. Others, like many physicians, simply do not have the time or wherewithal to manage their own investments. Instead, they will select an investment adviser to manage their accounts on an ongoing basis. Sometimes the adviser’s fee will include financial planning and other times, financial planning will consist of an additional fee.
7) What is your investment philosophy?
Any investment adviser that you work with should follow a strict investment philosophy. You certainly don’t want someone who will use your money to pick investments at random, do you?
The two strategies for selecting investments are passive and active. Passive advisers will choose to utilize low-cost index funds to capture the returns of the market and minimize expenses. Advisers who take on an active management approach will attempt to find actively managed mutual funds or hand select specific stocks/bonds (or other investments) that they believe will outperform the markets. With an active approach, you typically pay a higher price whether they actually outperform or not.
Within the active and passive strategies, an adviser can use a strategic or tactical asset allocation. Strategic asset allocation involves creating an appropriate allocation for stocks and bonds based on your needs. This allocation is maintained over long periods of time and the account will be occasionally rebalanced to the target allocation when the markets drift. Tactical asset allocation is an active strategy that weights your investment portfolio towards specific asset classes based on the adviser’s beliefs about how the markets will perform in the future.
To summarize, passive and active management philosophies can be split into four different philosophies:
- Passive investment selection with Strategic asset allocation
- Passive investment selection with Tactical asset allocation
- Active investment selection with Strategic asset allocation
- Active investment selection with Tactical asset allocation
The evidence for passive investments with a strategic asset allocation is very well known. However, many continue to invest and make their decisions based on nothing more than speculation (fancy graphs aren’t worth anything if they’re wrong).
8) What is your past performance?
Past performance may or may not be a relevant question to ask an adviser. This will depend on the adviser’s investment philosophy (discussed above in #7). An adviser who manages money using a passive investment selection and strategic asset allocation does not control what happens in the markets. As a result, past performance for this type of investment philosophy can be reviewed by simply looking at previous market data. It’s important to keep in mind that this approach does not try to time or beat the market. Instead, the goal is to take a long-term approach towards minimizing costs and increasing wealth as the markets increase over time. There is much research that supports passive management as the most efficient, while the majority of active management has a history of underperforming its benchmark index over time.
Past performance becomes a very relevant topic when dealing with an investment adviser who advocates picking specific investments based on their research and analysis. This is called active management and the adviser is trying to select the best investments that will outperform and consistently beat the market. While there is a lot of evidence that shows this to be a futile exercise and poor investment philosophy, many advisers continue to handpick specific investments. With this approach, it is important to review past performance to see how consistently the adviser has outperformed (or underperformed) the market.
Disclaimer: This article was written by Tyler Rivetti. Advisory services are offered through Rivetti Investment Services, LLC, a Registered Investment Adviser. Neither Rivetti Investment Services, LLC nor Rivetti Financial Group, LLC provides tax advice or recommendations. This article should not be construed as tax advice. You should consult with a tax professional before taking any action.