An Important Question To Ask Your Investment Advisor: “Are You Doing Your Job?”

Date: September 15, 2011

by Roger Tan, SIAS Research @ September 15th, 2011

When asked the question “Why do you need to tell an investor about the current market condition when you have already structured an efficient portfolio for him?” A financial professional answered: “By showing an investor how well I know the market, I can impress the customer and build confidence and trust with the investor and I can sell…”, I will stop there.

Many investment advisors in the industry seem to lack a simple feature – proper academic knowledge. This lack of knowledge leads these professionals to provide poor investment advice and structure inefficient portfolio allocation. In this article, I will discuss the industry of investment advisory.

Who is an Investment Advisor?

The investment advisor comes in many forms. First, there are the financial consultants and relationship managers you see in the bank branches. To help enhance investment advice and create a differentiation factor, banks also hire investment consultants and investment counsellors to serve priority banking customers. For the wealthy, there are the private bankers and the investment advisors in private banks. Under insurance firms, there are the financial planners. Finally there are these groups of professionals who are not sole agents of any product providers or banks; they are the Independent Financial Advisors.

What are the differences between these groups of investment advisors? We can differentiate them by a few factors, namely: function, customer segment, and remuneration.

Financial consultants, relationship managers, and private bankers in the bank are basically there to help serve bank customers in specialised areas such as investments, mortgage, and transactions. They are the sales staff of the bank and are remunerated according to the amount of sales they bring in. They are differentiated by the market segment they serve. The financial consultants serve general mass market customers while relationship managers serve priority customers. Private bankers are dedicated to serve high value customers.

Investment consultants, counsellors, and advisors are investment specialists that provide knowledge support to the sales front. They provide market updates and advise on investment portfolio structures for more wealthy customers. Their objective is to enhance sales volume of the sales front. Investment consultants and counsellors usually serve the priority banking level while investment advisors serve private banking customers. They are usually remunerated on a fixed salary basis with performance bonus at the end of the year.

Independent financial advisors can be seen as a mixture of the two groups of people above. They usually provide not only investment advice but also insurance advice to their customers. They differentiate themselves by not representing a single financial institution so as to improve objectiveness in their advisory service. Their income is either commission based – from the products they sell – or fixed annual fee based on the value of their investor’s asset under their care. We will leave out the financial planners that work for insurance companies.

What is The Job of the Investment Advisor?

So what’s the job of the investment advisor? Didn’t I just answer the question in the above section? Yes, I have – but from an employer’s prospective. The question is – what is their duty to you when advising you on your investments?

There are three main objectives that an investment advisor should fulfil:
1. Understand the customer’s investment risk-return preference
2. Allocate investors’ investment funds along the efficient frontier that fit the risk-return preference of the investor
3. Attempt to create investment outperformance – or alpha – by either timing the market or selecting the right investments.

Before an advisor can advise on or construct a portfolio for an investor, he or she must be able to determine the risk-return preference of the customer first. This will ensure that the portfolio selected is not mismatched.

Once the advisor understands his or her customer’s risk-return preference, he or she should ensure that an efficient portfolio is constructed for the customer. An efficient portfolio is one that will provide the highest possible return given the level of risk selected or the lowest possible risk given the selected returns.

The fulfilment of these two objectives is the fundamental role of the investment advisor. The selection of a risk-return efficient portfolio – and frequent rebalancing of the portfolio – will help ensure that investors own a portfolio with risk fitting their preference at the offset. Does helping investors maintain a risk-return efficient portfolio mean that their investors will not lose money? Of course not; the aim of an efficient portfolio is to minimise non-systematic risk – which the market does not compensate investors for undertaking – and focus risk taking on systematic risk. The level of risk that an investor should undertake would have been discovered by the financial advisor in objective 1.

Once the advisor has ascertain a suitable portfolio for the customer, he or she can then help to advise customers on how their investments can achieve possible outperformance – also known academically as alpha. In general, alpha can be achieved by two strategies – the selection of the right company or funds and/or appropriate timing of investments. In stock or fund selection, the advisor would have analysed the fund or stock and determine which stocks are undervalued or which funds will outperform the benchmark. In market timing, the advisor attempts to temporarily shift allocation from the efficient frontier portfolio determined in objective 2– the jargon is over-weighing and under-weighing. The deviation strategy is formed from analysing market trends and development.

Are the Blind Leading the Blind.

So are the investment advisors doing their job? Unfortunately I have not met one that has. In general, financial advisors are enlisted to do one main job for their employer – to bring in sales. That objective is clear and present – no sales, no bonus. Do the independent advisors differ in behaviour? They have to feed their family too.

To be fair though, financial advisors do not put their responsibility to investors in second place intentionally. Ultimately, if their actions signal irresponsibility, they will lose those customers and many financial advisors will swear that their investors’ interests are important. The problem probably lies in the fact that they are as “blind” as the investors themselves.

The answer given to my question in the opening paragraph is a real event. None of the attendees in the programme could answer the simple question; which I have answered in the section above. The purpose of giving market updates to an investor is not to assure him or her of the advisor’s ability but to give market timing suggestions for investors to consider. Before suggesting market timing tactics, the advisor should ensure that he or she has already fulfilled objective 1 and 2 discussed above or has explained the danger of such a speculative strategy to the investor.

Unfortunately, most advisors see market updates and market research findings as ways to market products and meet sales target. How else can you sell investment products to customers without breeching the statutory requirements of basis? This – from their prospective – is fulfilling their responsibility to their employer and investor at the same time.

One Eye People Are Senior Management.

Could the people at the top solve this issue of “financial advisory blindness” in financial advisors? I would argue that the behaviour on the ground is an outcome of the top management’s action.

The notion that the knowledge gap observed in financial advisors can be solved by management stamps from the assumption that management themselves are knowledgeable. That is a daring assumption. I have once mentioned to a senior management personal of wealth management about a fund assessment model – the three factor model. The person could hardly comprehend what I was saying. Why do financial institutions employ such a person as top management? I can only speculate that the hiring decision must have been made by another one eye jack.

What Can Investors Do?

Though I may not have met a financial advisor who has fulfilled the duties I have stated, it does not mean that they do not exist. They are hard to find and, like all good things in life, they do not come cheap.

Investors should put more importance in assessing how well a financial advisor fulfils the first two objectives since these are the fundamental services one is looking for in an advisor. Advisors that can provide market timing and/or stock or fund selection value add should be considered a bonus and not a rule. Advisors who only attempt to provide market timing or stock or fund selection should mainly be used for information gathering purpose. Finally advisors, who attempt to build confidence in you by reciting market updates, who use the excuse of trust to introduce you new products, and who use friendship to help him or her achieve targets, should be totally avoided.