Paradigm Shifting

I grew up in the investment business in the early 1990s on the ginormous fixed income trading floor at the then Merrill Lynch in the World Financial Center in New York City.  It was a culture of trading and instant gratification. “What have you done for me lately?” covered no more than that day, often less. I frequently argued that we should consider the interests of our customers – among of the biggest investment managers, pension funds and insurance companies in the world – in our dealings so as to build long-term relationships and enhance longer-term profitability even if it meant making a little less in the near-term.

I got nowhere.

We called our accounts “clients” to their faces, and I thought of them that way, but they were customers at best and marks at worst to virtually everyone on the floor, and especially to our managers.  We didn’t call them “muppets” like the guys (and it was almost all guys then) came to at Goldman Sachs, but we may as well have. Our mission was clear.  We were to make as much money for the firm as we could as quickly as we could. Lunch was a long-range plan.  In his first and funniest book, Liar’s Poker, about our counterparts at Salomon Brothers, Michael Lewis got the tone, the approach and the atmosphere precisely right.

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Of Cabbies, Portfolios and Clients

Being in New York City recently and riding in a fair number of taxis over several days, I was repeatedly reminded that NASCAR has nothing on Manhattan cab-drivers.  Flying up the West Side Highway while weaving in and out of traffic was both exhilarating and terrifying.  I was also reminded that cabbies drive in much the way that people typically manage portfolios – alternately “putting pedal to the medal” and slamming on the brakes.

We do that for a variety of reasons.  To begin with, we tend to focus on short-term results above longer-term performance and the investment process.  In the shorter-term (and sometimes longer!), even the best process can underperform and even a dreadful process can succeed (sometimes it’s better to be lucky than good). We also respond to marketing that is passionate and certain to the exclusion of work that is careful, measured, thoughtful and honest, which can cause us to act rashly.  In general, we like to be told what’s right rather than be shown what’s working. That preference leads to ideological rather than data-driven decisions, and that’s a huge problem.

If you think I’m wrong, or even if you are unconvinced, listen to the political marketing that will be virtually omnipresent this fall.  Most of it will be cast in moral rather than practical terms. It’s the way we’re built.

Advisors and money managers are prone to these same defects, of course.  This is largely understandable in that they (we) are human (obviously) and thus subject to the same foibles as everyone else.  Moreover, they (we) are responsive and responsible to clients, and no client is entirely comfortable with losing money or underperformance no matter how thoroughly the plan and its risks were explained and agreed upon.  For example, risk mitigation sounds great to clients when they are terrified, but they still tend to be pissed when the markets rally (even temporarily) and their lower risk portfolios underperform the high-flyers.

For advisors, the key question is how to respond to these realities.  In my view, that means deciding whether to build a business for the long-term or merely to trade-as-you-go. That means acting as a fiduciary and building a business via fees rather than commissions. Some clients won’t be satisfied with the long-range view and it hurts to lose clients.  Moreover, it’s usually harder to attract clients without shiny objects and claims of certainty.

That’s unfortunate, but nobody claimed this was going to be easy. I know that the long-term doesn’t pay the bills when one is just starting out (and getting to “critical mass” within a fee context can be very difficult), but once established with the right type of client, sustaining such a business is easier and it’s also a lot more fun. Best of all, it’s the right thing to do. Instead of reacting to the next new thing or the latest gyrations of the markets or the talking heads on CNBC, you can actually build relationships and, in the process, help people reach their goals and even their dreams.

Do Fiduciaries Produce Better Returns?

Much regulatory and legislative activity since the financial crisis of 2008-09 has focused upon the desirability of providing a comprehensive fiduciary standard of care within the financial services industry.  The general (if superficial) assumption — and one I share — is that investors would benefit from the application of this higher standard of care throughout the entire industry.  It seems axiomatic that if investment professionals put their clients’ interests ahead of their own, clients should benefit. This year’s Quantitative Analysis of Investor Behavior from DALBAR examines that assumption.

The 2012 QAIB concludes that:

• It is impractical to try to distinguish between “selling” and “recommending;”
• The number of available professionals may become limited on account of anticipated lower compensation due to the implementation of a fiduciary standard, so a fiduciary relationship should demand a premium;
• Investment professionals should develop and use a pricing structure reflective of the time spent and the skill level of the practitioner as well as reflecting both fees for services rendered and compensation for achieving desired results; and
• A universal fiduciary standard “will limit a professional’s willingness to introduce any but the lowest risk investment alternatives” and negates the value of creating portfolios “that reflect the investors’ goals,” suggesting the need to use a process that allows clients to make informed decisions with full knowledge of expected returns and potential losses. 

There is much to commend these areas of inquiry and further research is indeed warranted in these areas.  I agree that it is impractical to try to distinguish between “selling” and “recommending.” However, I am less convinced that lower compensation via a universal fiduciary standard will result in fewer competent advisors, particularly since finance professionals are exceedingly well paid overall. Even after a 16 percent decrease and a wide disparity between top and bottom, Goldman Sachs employee average pay exceeds $135,000. I’m not even certain that overall compensation will ultimately be reduced (even if I expect it to — the greater risk is that it will be harder for newer professionals to enter the field because fee-based business builds “critical mass” much more slowly). I also suspect that advisor pricing will sort itself out.

The QAIB doesn’t mention structural challenges to a uniform fiduciary standard.  For example, in the same way that a Ford salesman cannot be expected to recommend a Chevy even when it’s in the customer’s best interest, how can we expect a fiduciary advisor to deal with products that may serve a client’s needs but are not available on his employer’s platform? 

The most interesting potential area of inquiry is how a fiduciary standard impacts investment strategy.  I don’t see the fiduciary advisors I know being afraid to recommend portfolios with a modicum of appropriate risk.  Failing to meet one’s goals by earning too little on one’s investments, while a longer-term risk, is no less significant a risk than general drawdowns and no less subject to client complaints.  Moreover, while fiduciary advisors have been quick to criticize the NBER “advisor sting” study as inherently flawed and not applicable to them (for example, here and here), despite the intuitive appeal of the idea that fiduciary portfolios ought to outperform non-fiduciary ones, it remains unsettled as to whether that is actually true.  I am anxious to see a comprehensive study comparing performance data from and of fiduciary and non-fiduciary advisors.  Then we can begin to answer the question posed by the title of this post and by the 2012 QAIB:   Do Fiduciaries Produce Better Returns?

Edited to add (4.18.12 @ 2:30pm PT):  My friend Gil Weinreich of AdvisorOne followed my lead here and asked Lou Harvey of Dalbar about this issue.  You may read about it here.