Bad deal for investment advisors: Clients folding funds instead of holding them

By Don Wilkinson

DFW & Associates

More and more investors are discarding their mutual funds holdings in favor of the full deck dealt by separately managed accounts (SMAs); accounts that deliver more control, better performance, little style drift, superior transparency and a realistic fee structure.

The combined assets of the nation's mutual funds decreased by $372.1 billion to $9.036 trillion in February according to the Investment Company Institute's official survey of the mutual fund industry. That's a loss from previous total assets of 4 percent. Overall, the average mutual fund lost 30 percent of its value in 2008.

Moreover, publicly traded hedge funds, billed in the last few years as a vehicle in which regular investors could get a shot at big-money returns, have done nothing of the sort lately, losing more value than an investment in the underlying funds themselves, according to The Wall Street Journal.

Furthermore, since they are no longer dictating their conditions for accepting money (i.e., post-Madoff), hedge fund managers are now getting an earful from investors demanding lower fees, better transparency regarding holdings, access to segregated accounts and no lock-up periods.

Like the proverbial town crier, Bernie Madoff has triggered a huge wake-up call to investors: There has to be a better way to build wealth than succumbing to riding the bus with mutual funds.

Contrast that to the separate accounts industry, which has seen assets build for more than 35 years to more than $780 billion today. SMAs have often swirled with industry downturns but have steadily been making inroads among more affluent clients and knowledgeable advisors. These more astute clients/advisors see mutual funds as a commodity comingled with other defenseless investors and regularly delivering poor returns for high and hidden fees.

Many believe that the recent Madoff madness marks the end of an era. The high-net-worth preferred client is taking the blinders off and backing away from investing his or her assets haphazardly as never before. Now, many less astute, disengaged or uneducated investors are doing the same.

This unusual atmosphere created by the economic downturn, government intervention into failing financial enterprises, and Madoff or dishonest Wall Street peers has penetrated the investor psyche as never before -- some think even more so than the 1929 Depression. This new era is just beginning, and will change the financial services landscape forever. If advisors wish to retain clients and attract new ones, they had better change their mindset from investment management to asset management.

Investment management

The term "investment management" has been used in a variety of ways, but for simplification, I want to group all stockbrokers and advisers offering mutual funds, hedge funds and the like who receive their compensation on a commission basis as investment managers.

For the most part, those stockbrokers and advisors serving the average $50,000 client with individual equities and/or mutual funds, I place into this category. I should add my congratulations, for these advisors are putting up with a lot of client handwringing and emotional outbursts that could be a daily occurrence during this crucial time in our financial services business. The money that $50k investors have at risk could be their only assets -- prompting them to call more.

For instance, this investment management group has usually advised clients to stick with the "buy-and-hold" theory of investing. During September 2008, the S&P 500 stock index plunged almost 9 percent, its third-biggest decline since World War II. The Dow Jones industrial average fell nearly 778 points, or 6.98 percent, to 10,365.45 as reported in the New York Times.

With the rough seas we have experienced, the forecast indicates to me that the buy-and-hold theory may be bad advice. This advice was especially popular with advisors from 2001 through 2007. During this time, losses were short-lived and investors usually recaptured their portfolio position with gains soon after, but no longer...

In 2008, losses were consistent for the whole year, causing the majority of fund holders to experience losses as high as 30 percent to 40 percent. Better advice now would be to tell the client to put his portfolio in a downside protection position when it appears losses are imminent. That could be an SMA, which gives quick access to cash, short-term bonds or inverse ETFs. In fact, that would be the profile of the "asset management" group defined next.

Asset management

Asset management is a broad term; not something you can easily get your hands around. It's too easy for advisers to think of asset management as simply controlling the financial assets of a client. But Robert Michael, owner of Aegis Asset Mangement, offers a better definition than most:
    Asset management is a process that guides the gaining of assets, along with their use and disposal in order to make the most of the assets and their potential throughout the life of the assets. While doing this, it also manages and maintains any costs and risks associated with the assets. It is not something you can buy, but rather a discipline you must follow in order to maintain those assets.
You'll notice that the definition brings costs and risk to the playing field. In my mind, this is the important difference between investment management and asset management. Thus, if the advisor desires the status of a true asset manager, he or she must serve clients with a different mindset during these rough times. A good place to start is by comparing the fee structure between investment management and asset management.

As you know, the stockbroker's esteem has dropped a few notches since the recession was officially declared in December 2007 (or maybe September or November 2007, depending on who you ask). In fact, firms like Goldman Sachs and Morgan Stanley, now classified as holding banks after being "rescued" by the government's stimulus package, title their brokers as asset managers or financial advisors.

Commission compensation

A stockbroker by another name is still a stockbroker -- someone who buys and sells stocks and bonds on commission. The problem with the universal commission system is that it irritates clients who don't like to see up-front sales charges and commissions. This attitude has been magnified like never before. Many clients now (post-Madoff) question commission-based planners and stockbrokers as to what their motivation is to keep buying and selling. Who is he or she working for; the client or themselves? This method of compensation awards the planner for engaging their client in active trading. This may even lead to churning -- an unethical practice of excessively buying and selling in a client's account. It's the reason why a lot of brokers are leaving wirehouses in favor of going with independent broker/dealers to call themselves planners.

Fee-based compensation

In direct contrast to the old way of doing things is the fee-based structure of compensation, endorsed by more and more independent financial advisors. Fee-based revenue is receiving pay for performance. With the advisor utilizing a fee-based system, the client can be sure that a specific asset product will not be pushed in his or her direction. It's less likely that the client will encounter hidden sales charges, and most often will avoid transaction costs (trading stocks), as well.

Plain and simple, advisor fees are a percentage of the client's total portfolio amount. Most clients can accept that the more the advisor can increase the value of the portfolio, the more the adviser will be paid -- the less the client loses, the less advisors lose too! This puts incentive on the table. This is a win-win situation in the mind of the client who benefits seeing the value of his portfolio climb (or drop). Nevertheless, this suspicion of not knowing how and why an investor's stockbroker is being paid has dissipated.

As such, managed accounts operate on a strictly fee-based payout system.

Costs and risk

Recall the terms "costs" and "risk" in our asset management definition. The way advisors get paid (the costs), is No. 1 on the minds of investors these days, and they are also concerned about other aspects of the maintenance of their portfolios.

Transparency is a vital issue

Don¡¦t forget that the Madoff debacle touched nerves of investors left wondering if advisors are on the level with financial advice. Risk also has a higher priority with investors than before, as is transparency -- especially following Madoff. Keeping a poker face, as mutual funds routinely do with clients by not revealing holdings within the funds, charging hidden fees, and delaying reporting of up to six months of portfolio progress (after the horse is out of the barn), will no longer be acceptable.

You can add to the transparency issue the concept of "style drift," named for the propensity of mutual fund managers to invest in other financial areas as to what is defined in the fund prospectus. But few clients read their prospectus. What happens when the client wakes up after significant losses thinking he purchased a large-cap U.S. fund only to discover the manager had put a large amount of capital in international stocks? Not the end of story.

Managed accounts give light and air to the client's portfolio. Separate account investors can review their accounts almost on a daily basis. Their stock performance review is readily available on close to a real-time basis. The client can quickly grasp the status of his or her account: performance, trades, research data and tax information -- all online from their home computer.

The recent clamp-down of hedge fund redemptions by fund companies has incensed investors. This is something that does not happen with separate accounts that routinely provide transparency and few, if any, restrictions on liquidity. Trade plus two days is certainly better than never getting it at all under Madoff.

Performance is predetermined to be better

What about performance? Lew Nason, president of Insurance Pro Shop, is about as strong a critic as you will find on mutual funds. He says only 4 percent of the 8,000 or so diversified U.S. stock mutual funds have beaten the performance of the S&P 500 Index over the past 10 years ending in 2007 -- and that's not even counting 2008.

Furthermore, Nason says the average return for the S&P 500 Index over the past 48 years is only 5.82 percent. Now, subtract the average expenses of 4.05 percent (includes sales charges, 12b-1 charges, expense ratios and transaction costs) and your net return is only 1.77 percent. And that's only if you were lucky enough to have found a mutual fund that performed as well as the S&P 500 Index did over those 48 years.

Read my lips, it's the expenses -- the costs of owning mutual funds cut severely into funds' returns. Think of the 401(k) holders who were depending on building their wealth with funds to enrich retirement. These folks, losing 35 percent to 40 percent of their retirement funds to huge mutual fund losses in 2008 will probably have to prolong their working lives. Disappointment understandably runs deep among those who have $9.4 trillion in U.S. mutual funds, according to Nason.

How do separate accounts stack up in performance of returns? One sentence says it all. Mutual funds with higher trading costs and built-in tax limitations create a post-tax return that potentially delivers less performance than a similar separate account. The unbridled aspects of separate accounts potentially can improve performance and give the advisor/client more control over the portfolio.

As an advisor, you should know that separate accounts are no longer just the privilege of the high-net-worth clients or large institutions. Although the best match is an investor who posses a minimum of $100,000 or more in investable assets, many SMA programs are open to moderate income investors in the $50,000 minimum range.

Also, the evolution of separate accounts is continuing. The unified managed account (UMA) is a professionally managed account that is rebalanced regularly and can encompass every asset management vehicle (e.g. stocks, bonds and exchange traded funds [my preference]) in an investor's portfolio. The UMA combines all of the assets into one account with a single registration, offering the advisor and client even more control, transparency and simplicity.

Play your hand as a wealth manager

So with all the risks and fees revolving around funds -- including scandal -- do you really want to run your practice as an investment manager?

As a wealth manager who can oversee several platforms managed by third-party firms, you can be in a position to take mutual fund assets from your competition. As a wealth manager, you will have to communicate clearly the benefits of separate account management versus mutual fund investing to prospects and clients. If you can do that successfully, there has never been a better time to make the shift and do this. Remember, know when to fold them and know when to hold them!