The Second Opinion: What Should You Be Looking For?
I have been approached a couple of times to offer a second opinion on a person’s investments. I know what I do, but I wondered how “second opinion” is presented by financial institutions and their investment advisors. A quick search yielded several results, including an article by Jason Heath in MoneySense responding to a frustrated inquiry from a household of DIY investors who couldn’t find a source for a suitable second opinion that didn’t involve a sales pitch.
One should not blame an investment advisor who asks for the business of those seeking a second opinion. If that is the business model under which they practise, the only way they are going to be compensated for the time they put in is by managing the investments of their clients.
However, the offer of a second opinion can be part of the more egregious practices of some advisors who criticize a client’s existing portfolio and proceed to offer unrealistic promises like steady 12% annual returns. While a 12% return, or greater, may be possible in any given year, most well-managed investment portfolios are likely to earn long-term average rates that are much lower and that will fluctuate dramatically around that average year by year.
The (Limited) Advantage of the Advice-Only Financial Planner
I like to think the second opinion is the kind of service where someone like me shines, an advice-only financial planner who is compensated by a fee unrelated to any products sold or assets managed. However, there are regulatory limitations to what we can do. If I do not sell investment products, I cannot be licensed and, therefore, I cannot provide specific investment advice. In other words, don’t expect a recommendation from an advice-only planner to buy a particular investment.
What Kind of Second Opinion Can You Expect from an Advice-Only Planner?
In my opinion, a proper analysis of an investment portfolio best comes in the context of a comprehensive financial plan. A couple with young children who owe money on credit cards or a line of credit may want to focus on paying off those high-interest debts before investing. On the other hand, the potential for a larger Canada Child Benefit may encourage them to balance the debt paydown against the advantages obtained from contributing to their RRSPs. Put another way, an investment portfolio needs to be developed in consideration of income and expenses, assets and debts, the availability of tax credits and deductions, and whether they have adequately insured themselves against the risk of a catastrophic loss, among other things.
Having established that an investment portfolio needs to be determined in the context of a household’s larger financial situation, what might an analysis of an existing investment portfolio look like?
Analysing an Investment Portfolio
The classic image of an investment advisor is someone who selects individual stocks with the hope of outperforming the market. If they are part of a larger organization, such as one of the major banks, they will be backed up by a team of analysts with a list of recommended selections. Despite this image, the average retail investor will more often find that they have been recommended a portfolio of mutual funds. This is all to the good, I think, because the diversification benefit of mutual funds simply cannot be achieved in any meaningful way with individual stocks.
Diversification is often identified as the “only free lunch” in investing. It involves combining investments with different characteristics in such a manner that they complement each other. The classic diversifiers are stocks and bonds. Stocks tend to provide greater returns over the long term but can be much more volatile over the short term. Bonds provide a steady stream of income and generally fluctuate much less than stocks in any comparable period. Mixing those two types of investments allows investors to gain a reasonable return with less volatility.
However, not all combinations of investments provide this sort of diversification. Sometimes there can be a lot of overlap. This kind of ineffective diversification can lead to “diworsification” (coined by Peter Lynch, I believe), the addition of investments to a portfolio in a manner that worsens the trade-off between risk and return.
An Example Portfolio
An individual came to me several years ago with a mutual fund portfolio of about $50,000. This was the asset allocation of his portfolio at the time.
His advisor, who had implemented the portfolio above, was now proposing that the portfolio be changed to the following:
Comparing the two yields the following differences.
Cash is down a bit, from 8% to 5%. This portfolio is made up of mutual funds, which tend to keep part of their holdings in cash to facilitate purchases and redemptions.
Fixed Income is eliminated, however, dropping from 10% to zero. Preserving (nominal) value and providing income, or if you prefer an analogy, some ballast to keep the equity ship on a more even keel, is what cash and fixed income do best. Reduced their combined values from 18% down to 5% means that this change is intended to provide the potential for more growth while exposing the portfolio to greater volatility.
The changes in the equity composition are the most noticeable, however. Canada is down significantly, International equities are down by an even greater percentage, and U.S. equities, once less than a quarter of the portfolio are now approaching 60%. Why is the advisor recommending such a major rebalancing away from developed International markets toward U.S. markets?
The average Management Expense Ratio (MER) of the five mutual funds in this proposed portfolio works out to about 2.50%. To some, that may not seem like much, but remember, that figure represents 2.50% of the total value of the portfolio, not 2.50% of the gains. On a $50,000 portfolio, that works out to $1,250 per year which the investor does not get because it is taken off the top by the fund manager. Part of that $1,250 also goes to the investment advisor and the investment advisor’s firm as compensation for their services.
Let’s suppose that this $50,000 is invested in the proposed portfolio for 10 years. Based on FP Canada’s Projection Assumption Guidelines, after fees, an investor can expect a long-term average annual return of approximately 3.84%. This should grow the portfolio to about $72,900. Morningstar, the investment research body, has repeatedly found that fees are a reliable predictor of future returns. In other words, all things equal, the lower the fee, the more that remains for the investor. What could an investor reasonably expect if the same mix of assets could be purchased and held for 10 years but in a portfolio that cost 1% less per year to manage? The difference is $7,300. The less costly portfolio would be worth $80,200 at the end of 10 years.
Should I Analyse Performance?
A look at the asset allocation is all well and good but isn’t performance the point? I agree that performance is important, but results are only partially in the investors’ … or advisors’! … control at the best of times. Far more important is a careful assessment of the probabilities and the implementation of a process. This is not an easy way to think. Former professional poker player, expert in decision science, and author, Annie Duke, says that humans tend to default to “resulting,” the idea that the only measure of success is found in the result. Ultimately, results will come, but it is the process and the probabilities that drive the results; the results do not necessarily pass judgment on the process.
As this relates to investing, an occasional exceptional year is less important than the process of creating a properly diversified low-cost portfolio, likely achieved by most investors through index funds that cover the world’s investable markets.
A Model Portfolio
One of the things that really bothered me about the example portfolio above is that there didn’t seem to be a rhyme or reason for the selection of the proffered mutual funds. The investment advisor recommended selling all the mutual funds that had been previously used except one, and then proposed four new funds divided into four even parts, without any apparent consideration as to whether the category of the particular fund warranted that level of inclusion.
If you are doing your own investing, you may wish to consider a model portfolio to serve as a “benchmark” for the right balance. Justin Bender, a portfolio manager with PWL Capital, has some great model portfolios on his Canadian Portfolio Manager blog. Bender presents the various asset allocation Exchange-Traded Funds (ETFs) offered by Vanguard, Blackrock’s iShares, and BMO in breakdowns from 100% equity to as low as 20% equity. Below is a table of the 100% equity ETFs offered by the three main issuers:
While they do not follow exactly the same allocations or use the same indices, they are quite close and perform similarly to each other. If you want to be more conservative, and many investors do, each of the three issuers offers ETFs with various levels of fixed income to mix with the equity holdings.
You may ask about the inclusion of Canadian equities at the 25-to-30% level. Given our population, Canada is a small player in the global stock market, making up about 3% of all investable equities. However, there are legitimate reasons for this choice to “overweight” Canada, which I summarize here.
First, doing so has tended to lower the overall portfolio risk.
Second, since Canada tends to be overexposed to the financial, energy, materials, and industrial sectors, adjusting the Canadian contribution to about the 30% level puts Canada on a more-or-less even keel with the rest of the world’s exposure to those sectors.
Third, Canada’s stock market is very top-heavy. The top 10 stocks account for about 40% of Canada’s total stock market, and half of that is made up of the big banks. Getting Canada overall down to about 30% or so of the overall equity allocation sufficiently mitigates the risk of a blow-up of any one Canadian stock, even one in the top 10.
Fourth, because of the way dividends of Canadian corporations are taxed, there is a modest decrease in the taxes paid if you hold a reasonable portion of your equities in Canadian companies. Note that this is only applicable if you hold them in a non-registered account.
Fifth, sticking to a 3% allocation, as the global stock market weightings would suggest, has its rationale, but the average Canadian might be hard-pressed to maintain that low level of ownership if the Canadian stock market went up dramatically. Going as high as 50% Canadian could even be reasonable in the minds of some, and certainly, there was a period when Canada was outdoing the U.S. stock market for several years in a row. But, if you think about the long term, and need to find a level where you feel comfortable with how much you have invested in Canadian stocks, then taking the midpoint, approximately 25 to 30%, is a reasonable place to land.
Allow me to wrap up with a suggestion if you use an advisor already or are going to an advisor for a second opinion. Ask questions. What is the rationale for the asset mix that is being suggested? What are the long-term expected returns? Do they sound reasonable? Has the advisor asked you any questions? Has anything changed in your life that might prompt a different allocation? A new job? Marriage? Divorce? A new child? Has your health been compromised? Were life changes even a consideration? Any of these events and more could mean a significant change to your investments is warranted. You are paying for their services. Get your money’s worth.
This is the 186th blog post for Russ Writes, first published on 2023-02-27
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.