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The New Global ETF Investor - back to Contents >
Chapter 1:
From Then to Now
The Good Old Days
It used to be so simple. A stockbroker was just that. They recommended stocks and earned a commission when an investor bought or sold a stock.
My older brother was a stockbroker with Dean Reynolds in the 1970’s and I used to come by his office to listen and learn. The people and the language were, to put it delicately, “colorful”. Everyone was constantly on the phone “pitching” stocks, practicing just the right “patter” with the closing “hook”. The goal was entice a buy by telling a compelling story of a company that was going to the moon. The “story” was the key and I later often thought that former President Ronald Reagan, with all his optimism and story telling ability would have been a master stockbroker.
Sure there were some high pressure stockbrokers but there were also many fine professionals who knew the companies and industries they were recommending inside and out. They took pride in their ability to pick stocks and were highly compensated for it.
The system worked fairly well because people wanted to hear of stock opportunities and were flattered to receive a sales call. Commissions were high enough to make it a profitable business and the perceived risks in buying stocks were well known and naturally narrowed the market. Furthermore, what were the other options for investors? Mutual funds were just beginning to develop a mass market and had an 8% load. Financial planning was buying and selling the right stocks at the right time.
The Changing Landscape
Fast forward to today. There are no longer any stockbrokers. Stockbrokers have been replaced by financial advisors, investment advisors, investment representatives, financial planners, financial counselors, wealth managers and financial consultants.
With online brokerage fees at $5 a transaction, “stock jockeys” are an endangered species and the first edict to rookie financial advisors is to never answer the question: “What stocks do you like?”
Many of the grand old company names of the stockbroker era have disappeared or have been swallowed up by “financial supermarkets”. Banks, insurance companies and investment firms all seem to offer the same investment products and services.
How did all of this happen so quickly and has it been good for investors?
End of an Era
The key event was the deregulation of stock trading commission rates in 1974. This inevitably led to at first sharply and then gradually lower commissions from stock trades. This was not called the “big bang” for nothing. The painful 1973-1974 bear market, the devastating sell off of the once seemingly invincible “nifty-fifty” stocks and the ensuing market volatility soured many on stock investing. Finally, periodic deregulation of the financial industry blurred the lines between banks, insurance companies and investment firms making them virtually indistinguishable from one another.
It is indisputable that in terms of fees and choice the investor is now better off. Online trading and the explosion of financial information on the Internet and through the mass media also provide investors with a wealth of investment advice and options.
Then why are investors generally more dissatisfied and confused than ever? What is the problem and how do we fix it?
First, the investor is overwhelmed by the endless choices offered by the marketplace. Second, they misunderstand and distrust the motives of the financial professionals offering investment advice. Finally, the investor wants a talented and experienced advisor that can handle all of their investment needs with skill but wants fees cut to the bone.
Let’s start our analysis by putting ourselves in the shoes of a financial advisor.
The Unhappy and Short Life of a Financial Advisor
You wonder why anyone wants to be a new financial advisor in today’s environment.
It is a myth that all financial advisors are swimming in money. For every well-heeled advisor there are at least twenty others struggling to keep the wolf at the door. For every ten new financial advisors, only one is around after three years.
Got the picture? It is a brutal business primarily because with the exception of a small salary during training, compensation is almost entirely based on fees and commissions. And how does one attract the clients necessary to build a profitable book of business?
The “do not call list” kills the old-fashioned “smile and dial” option. Investment seminar expenses come out of your own pocket. Direct mail is expensive and ineffective without follow-up phoning. Friends and relatives avoid you at gatherings knowing you will eventually pop the question. Furthermore, the rash of lawsuits against investment firms has turned compliance departments into a terrible time consuming burden. Compliance must review all correspondence, even thank you notes, and emails are monitored as well. Seminar presentations go back and forth for weeks, paperwork for business is frustratingly endless, records of every conversation documented and even the most well-intentioned advice is questioned.
On top of this, the financial advisor must get up to speed on corporate procedures, learn financial planning, keep up on economic trends, read research on stocks, know all the details of the mutual funds they are recommending, understand the complexities of annuities, become a life insurance salesman, work on their presentation and communication skills and, I almost forgot, find some clients.
In this scenario, something has to give and it does. Only with a system to maximize the time devoted to sales can a financial advisor survive.
The equation is simple: marketing & sales = clients = fees & commissions = income. Notice that spending any more time than necessary keeping abreast of products or economic trends is not part of the equation. Become an expert on international investing, long term care or investment tax issues? Not likely.
For a moment, let’s distinguish between a fee and a commission. A commission comes from the proceeds of a specific transaction say, the sale of a stock, annuity, a load mutual fund or life insurance policy. A fee is normally, an annual and re-occurring fee for a wrap brokerage account or fund management service.
Financial advisors are usually torn between the two options. Over time, fee income can build a stream of income without the advisor’s recommendations conflicted but it takes years and big money to build this type of business. For example, take an advisor who brings in a $100,000 account to manage on a fee basis priced at 1%. After the full service investment firm takes its share, this business will lead to about $400 a year in fees for the financial advisor. Do this every week and you will be out of the business in short order.
On the other hand, if that same $100,000 was invested in an annuity, the commission to the financial advisor could be as high as $3,000. Do this every week and your annual income is about $150,000. A financial advisor would have to bring in $38 million in assets on a fee basis to earn this annual income.
Don’t get me wrong. The great majority of advisors are trying to help clients meet their financial goals but they are also humans and need to make a living. Honestly, where would you focus your time and effort if you were a financial advisor? My point is this, annuities have their pluses and minuses and are not appropriate for everyone but they pay handsomely. Naturally, advisors recommend them every chance they get.
There are many fine and well-intentioned advisors out there but you need to think through what might be the best structure of compensation. The goal is to align their interests as much as possible with yours.
In the final chapter, we will discuss and make some recommendations regarding the best way to select and compensate your advisor.
Now, let’s look at the situation from the investor’s side.
Investor Wants it All
In short, the average investor wants an advisor who takes the time to understand their goals, finances and personality quirks and offers expert, timely and unbiased advice on a wide range of complex financial issues together with excellent service: all for one low fee.
Why am I paying all these fees for such poor service and even when my account value is declining? My financial advisor never calls me or gives me any stock tips. Why does it take a week for her to get back to me when I ask a question about social security or what price I paid for that stock I bought in 1985?
Do you see the gulf between the expectations and needs of investors and the ability of financial advisors to deliver under the current system and fee structure? The investor wants a lot of attention and service and expert advice. The financial advisor needs to stay ahead of the curve by spending the majority of his or her time marketing to prospects and paying special attention to only their largest clients. He, for the most part, has no specialty and is expert only at juggling competing priorities and products.
Given this mismatch between expectations, many investors have drifted away from financial advisors and took matters into their own hands. The result was the emergence of two new types of investors in the 1980’s and 1990’s, the independent mutual fund investor and the independent index mutual fund investor. First, let’s look at the evolution of the independent investor and then its two subspecies.
The Independent Investor
The independent investor’s thinking is along these lines: “I can do a better job of investing on my own, without paying all those fees. I am just as smart as my advisor and can trade online and be in control of my financial destiny.”
This has become a huge group of investors. Roughly, 60 million Americans classify themselves as being primarily independent investors. An organization called the Independent Investors of America alone boasts a membership of 6 million. This does not include the numerous investors who primarily invest through employee sponsored 401(k) plans where plan sponsors are obligated by law to do educational seminars but are hesitant to advise participants on where to put their money for fear of being sued for giving improper advice.
For some investors, taking this approach has worked out well. For many others it has been, to say the least, less than satisfactory and in some cases a complete disaster. The problem is that most investors need to be protected from themselves. The twin emotions of investing: fear and greed, can wreak havoc on the portfolios of even the most disciplined independent investor. Most investors also need more education and training to weigh risks and make wise investment choices.
Many investors think that advisors add value by providing information and stock tips but what good advisor provides a critical check on your emotions. Common mistakes you might make are buying at the top and selling at the bottom or concentrating your portfolio in technology or your own company’s stock in a 401 (k) plan. What usually is missing from the investment process is the most important: building a balanced and diversified portfolio consistent with your investment goals, risk tolerance and time horizon. Don’t take my word for it. Dalbar research shows that the average investor during the bull market 1990’s had portfolio returns equal to only about half the S&P 500 index.
Another related question is whether it is the best use of your time to invest on your own? Wouldn’t it be better to spend this time on your profession to make more money or perhaps spend less time each day studying charts and research in front of your computer and more time with your family or on the golf course?
The Independent Mutual Fund Investor
There are 95 million Americans invested in mutual funds. Investing in mutual funds is the most popular strategy for independent investors. What could be simpler than selecting five or six reputable mutual funds and investing for the long term?
The first problem is that investors tend to trade in and out of funds at precisely the wrong times, tend to have too much exposure to large cap growth and almost no international or small company exposure. Again, it is an issue of education, discipline and patience versus fear, greed and guesswork.
The recent revelations of chicanery at some high profile mutual funds probably has many of you boiling mad. This management problem is just one of the issues that may bother you and a list that could include fees, performance, taxes, transparency and corporate governance.
Before starting with the fee issue, it is important to recognize that there are some fine mutual funds that have demonstrated consistent performance and solid management over long periods of time. My favorite mutual fund family, American Funds, has a consistent value-oriented philosophy and record and offers quality service.
Fees, Fees, Fees
According to FundExpenses.com, investors have paid over $35 billion in fees to stock and bond fund managers in the last 12 months. This breaks down as follows: $21 billion for advisor fees, $9.2 billion in 12b-1 fees for fund marketing expenses, $5.6 billion for shareholder services and $536 million for custodian fees. This staggering sum does not include sales charges on broker-sold funds or the internal trading costs of the funds.
According to a 2005 report by Morningstar, the average expense ratios of stock mutual funds is 1.45% for large company funds, 1.67% for small company funds, 1.92% for foreign equity funds and 1.81% for sector funds.
Performance
Rubbing salt in the wounds is the uneven and less than satisfactory performance of mutual funds. Morningstar looked at 10 year annualized total return figures and found that only 6% of large company value managers beat their comparable Russell index on an after-tax basis with a somewhat better figure of 22% for large company growth managers. Only in the area of small company growth was the performance impressive with 67% of fund managers beating the Russell index on an after-tax basis.
Another study by Robert Kirby, former Chairman of Capital Guardian, indicated that of the 115 U.S. equity managers in business for 30 years or more, only 36% beat the S&P 500 by some margin.
The Tax Issue
The tax consequence of investing in actively managed mutual funds is often overlooked. Those annual capital gain distributions add up and can seriously diminish returns. Investors need to pay more attention to portfolio turnover and realize that if a fund manager needs to raise cash for redemptions, capital gains distributions may be higher than expected. There is the related issue of imbedded capital gains. Let’s say you purchase shares in a fund in September. If in October the fund sells a position in IBM it has held for 10 years, the capital gains from the sale will be proportionately distributed to you even though you have only been in the fund for one month.
Transparency and Corporate Governance
Do you know who is actually handling your investments? If you read the fine print in a prospectus or interim reports, you can find out but don’t expect firms to highlight changes or problems. If you do invest in a mutual fund because of a fund manager with a stellar record, what can you do if he moves on to another fund company? You have two options: pay the capital gains or hope his or her successor is up to the job. How is the manager of your funds compensated? Is it tied to performance over three years or three months? How are fund managers supervised? What is the investment process of the fund? Is one manager responsible for covering twenty companies or one hundred companies?
These are all questions an investor needs to have answered but very few take the trouble to do so. As Peter Lynch of Fidelity aptly put it, people spend more time shopping for a refrigerator than when purchasing a mutual fund.
The Search for a Better Alternative
Dissatisfied with the performance and fees of actively managed mutual funds, many investors have turned to index mutual funds. Index mutual funds track a specific index by holding stock in all of the companies in the index. The thinking is that instead of trying to pick which stocks are most attractive, why not buy them all and ride the wave of the market?
Instead of trying to beat “the market”, index mutual fund investors seek to replicate the performance of a market index such as the S&P 500 index. Keep in mind you cannot invest in an index, only an index mutual fund which holds all or almost all of the companies in the index.
The Evolution of Indexes and Index Funds
One of the first indexes was pioneered by Charles Henry Dow in 1884. The first Dow Jones average was simply the average price of 11 railroad stocks. All the companies were weighted in the index equally as in the current Dow Jones average. An important development was in 1923 when an index of 223 securities was created which later evolved into the S&P 500 index.
This was the first market capitalization index that gave each company a weighting in the index in proportion to its market value. If a company’s market value increases relative to other companies in an index, the company’s weighting in the index will increase. There is a common misconception by investors that by investing in a S&P index fund they are buying equal amounts of 500 stocks. This is not the case since the largest 30 stocks usually represent about 50% of the value of the index.
The initial purpose of these indices was to gauge investor sentiment of the overall market but given human nature they also quickly became benchmarks of performance. “Did I beat the market index” became the consuming question asked by investors and fund managers. In this crazy world, if a given market index was down 40% and an actively managed fund in this area was down only 30%, it received accolades and moved up in the rankings. It is a mistake to get too caught up in beating an index. The key to successful investing is consistency and avoiding the sharp market declines which can take many years to make up. You and must decide what are your goals and choose a blend of investments that have the best chance of getting you there with an acceptable amount of risk.
For example, an index fund of your local supermarket would weigh each aisle and shelve filling your basket with items whether they were good for you or not and, perhaps more importantly, whether you liked them or not. If as you entered the store, you were offered this index basket, you would no doubt decline preferring to pick what you wanted and needed.
Today, there are hundreds of indices in the marketplace. These include broad indexes such as the Dow Jones US Total Market, the Russell 3000 and the S&P 1500 which include stocks of all sizes: large, medium and small. There are also specialized indexes that measure stocks in one category like small company, high tech or a particular geographic area such as a region or country.
With Vanguard at the fore, index mutual fund investing exploded during the 1990’s. Part of the attraction was the low fees. Since the fund manager simply matches the holdings of an index, therefore, turnover and transaction costs are considerably lower compared with actively managed mutual funds. Most investors chose funds that tracked the well known S&P index and its technology laden composition led to high returns during the technology boom. Investors were equally chastened during the technology implosion and bear market of 2001-2003.
Of course, financial advisors shudder at the mention of index mutual funds since they were not part of the program. Investors purchased these funds directly from companies such as Vanguard. This highlights the main problem with index mutual fund investing. The great majority of investors think index investing is limited to the S&P 500. They don’t realize that they have broader and more specialized options, and they don’t know how to blend them to put together a balanced portfolio.
Most importantly, investors are not aware of the most creative and exciting new product on Wall Street in a generation. An investment tool that combines the best attributes of stocks, mutual funds and index mutual funds: this would be exchange-traded funds better known as ETFs.
But first, let’s broaden your investment horizon and learn about the world of opportunities around you.
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