The Investment Scientist

Archive for the ‘Conflict of Interest’ Category

Golf ball

Is a round of golf all the value you get from your financial advisor?

Why do you charge me 1% every year regardless how well you do for me? I would rather not pay you anything for the first 5% return and split anything above and beyond that.

This is a question a prospective client of mine asked me. Let me explain why this fee arrangement is not in the client’s best interest.

Historically, the mean return of the market is 10%, and the standard deviation of return is 15%. This means the market is equally likely to go up 25% in one year and go down 5% in another.

Despite what they want you to believe, financial advisors have very little control over the market.

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Facebook Scam

Facebook Scam

Two months ago, I got a call from client of mine, who asked my opinion about an opportunity to invest in pre-IPO Facebook shares. He explained that he and his business partner were offered the opportunity to invest in a private fund that will hold Facebook shares.

I know nothing about these funds, but I told my client to stay away. As a general principle, I always steer my clients away from private funds unless they run the funds themselves. The reason is very simple: these are unregulated vehicles where there is no government oversight and there is no transparency whatever. You don’t know what monkey business they do with your money. Most business people intuitively grasp that if the private deal is about starting a restaurant; but once the deal is about buying Facebook shares, many of them throw caution to the wind.

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A Muppet

If you had a busy March, you are forgiven for not paying attention to Greg Smith’s open letter explaining why he is leaving Goldman Sachs. In his “resignation” letter, the Goldman Sachs executive sheds a bright light on the culture of this premiere Wall Street investment bank. Let me quote at length:

What are three quick ways to become a leader?

a) Execute on the firm’s “axes,” which is Goldman-speak for persuading your clients to invest in the stocks or other products that we are trying to get rid of because they are not seen as having a lot of potential profit.

b) “Hunt Elephants.” In English: get your clients — some of whom are sophisticated, and some of whom aren’t — to trade whatever will bring the biggest profit to Goldman. Call me old-fashioned, but I don’t like selling my clients a product that is wrong for them.

c) Find yourself sitting in a seat where your job is to trade any illiquid, opaque product with a three-letter acronym.

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Fee-based Financial AdvisorMany people think that fee-based financial advisors are those who charge their clients fees for service; therefore, they have more transparency and less conflict of interest. That’s exactly what the financial industry wants you to think.

Fee-based financial advisors are the financial industry’s response to the rise of independent fee-only financial advisors. Fee-only financial advisors are paid solely through fees for service paid directly by clients; they are not licensed to receive third-party commissions. Consumers rightfully associate this compensation model with integrity and unbiased advice.

Firm | Youtube | Facebook | Twitter | LinkedIn | Newsletter

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This week, a business woman came to my office for a second opinion financial review.

She explained why she came to see me: she bought a permanent life insurance policy because her financial advisor told her it is a great investment. She has been paying $3000 a month for that, and so far she has put in roughly $80k. Recently, she needed some cash and called to redeem the policy. Much to her surprise, the surrender value is only $1,300. She became suspicious of everything in her portfolio and wanted me to examine it for her.

It took me only five minutes to figure out that her financial advisor is screwing her, no punt intended.

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I was called a “wing nut” by a commenter for pointing out all the malpractices of insurance companies. Indeed, I could go nuts seeing how they mislead their customers into financial peril. They know full well that their customers are not going to read beyond the first few pages of their hundred-page contract, so they put all the goodies on the first page and keep the disclaimers on the back pages.

The following is an actual annuity contract a client of mine purchased a few years ago, much to his regret now.

On the first page of the contract, all the warm and fuzzy keywords are used: “GUARANTEE”, “fixed”, “annualized interest rate of 5.75%”. Pay attention to the following line though: This rate is subject to change each month.

Annuity Contract Front Page

Annuity Contract Front Page

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My friend is a savvy businessman. However, like most Americans, he has a misconception: he thinks financial advisors are legally bound to put clients’ interests first. This can not be further from the truth. Everybody and his grandma can be a “financial advisor.” Unlike being a “physician”, there are neither legal requirements no educational qualifications. Whether a certain financial advisor is bounded legally to act in his client’s best interests all depends on his true profession. Here is an ad hoc summary:

Professional Title Fiduciary?
Attorney Yes
Certified Public Accountant (CPA) Yes
Registered Investment Advisor (RIA) Yes
Financial Planner Maybe
Certified Financial Planner (CFP) Maybe
Wealth Manager Maybe
Insurance Agent No
Registered Representative No
Stock Broker No

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Hedge funds are often peddled as a unique asset class that has outstanding returns that are uncorrelated with the market. In reality, hedge funds are as much an asset class as Las Vegas is.

Hedge funds are a general description of private investment companies that are organized as limited partnerships with fund managers as the general partners and investors as limited partners. The keyword here is private. By law they are not supposed to be sold to the public; therefore, they are exempted from government oversight. But sold to the public they are! It is not the first time unscrupulous “financial advisors” have pushed the limit of the law, while the SEC looks the other way.

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I recently met an entrepreneur friend of mine. I was pleasantly surprised to learn that he had sold his business and was now looking forward to retirement. He has about $1mm in his 401k plan. As any shameless financial advisor would do, I asked him if he had someone helping him manage his money.

“As a matter of fact, yes!” he answered. “A friend of mine is also a financial advisor, and he helped me create a balanced portfolio.”

He related that “50% of the money will be in safe investment—a (deferred) annuity that has a guaranteed yield of 5%; the other 50% will be in alternative investments for higher performance.”

To say that I was flabbergasted is a serious understatement. With a friend like that, who needs enemies?

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You may not believe it: the term “financial advisor” is a free title. Anybody can use it; there is no legal requirement, nor educational qualification. In practice, though, generally there are three types of people who use this title: insurance agents, stockbrokers, and registered investment advisors (RIAs). Whether they are required to disclose fees all depends on what type they are.

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My friend DIY Investor found this pearl. I thought it contains incredibly good advice for young investors.

I personally had a few encounters with Google employees (to do their financial review.) In the end, I had to tell them they are fine on their own, they don’t need my help by and large. This is owing to three factors:

  1. Google provides strong continuous education on money, like this Suze Orman talk.
  2. They have a vibrant discussion forum about money inside Google.
  3. Their 401k plan is with Vanguard.

About Suze Orman, her show is the only show on CNBC that actually gives good information. Enough said. Enjoy the talk!

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I must confess: I have fallen short of the standards and requirements to become one of America’s Best Financial Advisors. To be exact, I am $497 short.

In March of last year, I received an email with a congratulatory title: “You Have Been Nominated To Be One of America’s Top Advisors.” I eagerly opened the email. It read:

You have been nominated to be listed on the most Exclusive List of Financial Advisors in America….We would love to have you as a member of this exclusive club and I have attached additional information regarding how our unique marketing model works.  We will be advertising the list of Top Advisors in the Wall Street Journal next week so I would like to get you included before the deadline on Monday.

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Listen to an insurance agent's financial advice

Invest in a Variable Annuity

Recently, a client of mine brought me the variable annuity he bought a few years ago.

Prominently displayed on the first page are the benefits of the annuity:

Death Benefit: Enhanced Guaranteed Minimum Death Benefit

Living Benefit: Lincoln Lifetime Income Advantage

as well as the fact that the money will earn an fixed annualized rate of 5.75%. Under the bold ACCOUNT FEE subtitle, it states: Account fee is $35 per contract year.

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Annuity without Risk

Annuity without Risk

Recently, I was approached by a prospective client named John, who has all of his retirement in one annuity.

I have always been intrigued by how annuities and life insurance are sold. Listening to John explain his decision-making process and reading through the annuity contract is like turning on the light bulb in my head.

It turns out that the unique selling point of this product is the “200% Step-Up of the Guarantee Amount (GA).” The way John puts in, if he just keeps the annuity for 10 years, he will get back 200% of what he put in. What is there not to like about that! After all, he gets guaranteed upside with absolutely no downside risk.

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New year resolution

Tom making his new year resolution

[Guest Post by Tom Warburton] How’s this for a New Year’s Resolution – repeat after me – I Resolve That I Will Abandon Personal Stock Picking And I Will Not Permit That Foolishness To Be Foisted Upon Me By Stock Brokers, Money Managers Or Financial Advisors.

New evidence shows up every day suggesting that it makes more sense to invest in index funds than to personally pick stocks, invest in hedge funds, invest in actively managed mutual funds or let a money manager pick stocks for you.

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These are Warren Buffet’s own words. As usual, they are as humorous as insightful.

“In 2006, promises and fees hit new highs. A flood of money went from institutional investors to the 2-and-20 crowd. For those innocent of this arrangement, let me explain: it’s a lopsided system whereby 2% of your principal is paid each year to the manager even if he accomplishes nothing – or, for that matter, loses you a bundle – and, additionally, 20% of your profit is paid to him if he succeeds, even if his success is due simply to a rising tide.

“…The inexorable math of this grotesque arrangement is certain to make the Gotrocks family poorer over time than it would have been had it never heard of these hyper-helpers. Even so, the 2-and-20 action spreads. Its effects bring to mind the old adage: When someone with experience proposes a deal to someone with money, too often the fellow with money ends up with the experience, and the fellow with experience ends up with the money


Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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