All Nerd's Eye View Blog Articles On Investment Planning

Why Reverse Churning Is About To Become A Big Advisor Problem

August 4, 2016 07:54 am 14 Comments CATEGORY: Investments

Historically, churning - where a broker encourages excessive trading in a client's account in order to generate a large volume of trading commissions - has been a significant regulatory concern. In fact, the rise of fee-based brokerage and wrap accounts, and the ongoing shift to advisory accounts, has been driven heavily by regulators encouraging the switch, specifically because brokers who aren't paid based on the number and frequency of transactions don't have any incentive to churn accounts. However, it now appears that the efforts to stamp out churning may have been "too successful" - giving rise to an emerging new problem: reverse churning.

In this week’s #OfficeHours with @MichaelKitces, my Tuesday 1PM EST broadcast via Periscope, we look at the concept of "reverse churning", where an advisor charges an ongoing investment management fee, and how it is likely to be a growing regulatory concern in the coming years, as the DoL fiduciary rule spurs a massive shift towards various forms of fee-based brokerage and advisory accounts.

Arguably, the regulatory concern about reverse churning - where advisors charge an ongoing investment fee but fail to provide any substantive ongoing investment services - is appropriate. However, the scrutiny on reverse churning raises troubling concerns when paired with the growing popularity of using index funds, ETFs, and passive investment approaches. How is an advisor supposed to justify an ongoing advisory fee when the right thing for the client to do might really be to do nothing? And what if the bulk of the advisor's AUM fee is actually for other non-investment (i.e., financial planning) services, paired together with an otherwise passive investment portfolio?

Ultimately, the regulators may be pressured in the coming years to more clearly delineate the difference between true reverse churning, and a prudent passive investment approach. But in the meantime, advisors that charge AUM fees - especially those who espouse a passive investment philosophy - would be well served to clearly and rigorously document exactly what they do for clients on an ongoing basis, to avoid the risk of a reverse churning allegation in the coming years!

The Tax Risk Of Too-Tax-Efficient Investment Strategies

August 3, 2016 07:01 am 13 Comments CATEGORY: Investments

Judge Learned Hand once famously stated that “Any one may so arrange his affairs that his taxes shall be as low as possible” and that there’s no duty to pay any more in taxes than is absolutely necessary. And the corollary when it comes to an investment portfolio might be “Any one may so manage a portfolio to defer taxes as long as possible,” given that if the investor ever intends to use the money, eventually the tax bill must still come due, but it still pays to minimize tax drag along the way.

Yet while it’s appealing to manage investments in a tax-efficient manner – or buy “tax-managed” mutual funds to do it for you – in today’s tax environment, there actually is such thing as being too tax efficient and deferring too much in taxes for too long.

The reason is that since the beginning of 2013, investors effectively face four different capital gains tax brackets (including the 3.8% Medicare surtax on net investment income), with higher rates applying to higher levels of income and larger capital gains. Which introduces the possibility that an investor is so tax efficient, and defers their tax liability for so long, that when the taxable event finally occurs, the sheer size of the gains propel the investor into higher tax brackets, who then ends out finishing with less wealth!

Which means ultimately, while “tax drag” is bad, and strategies to minimize it – such as tax loss harvesting – are valuable, doing too much tax minimization now can just cause even more harm later. Instead, for some investors, the best approach is to recognize that in low tax rate years it’s better to harvest the gains instead of the losses. And in other situations, the best way to minimize tax drag is not to buy a tax-managed mutual fund at all, and instead leverage the asset location opportunity of sheltering growth investments that generate capital gains inside of an IRA (or ideally a Roth IRA) instead.

Should Advisors Reduce Their Management Fees On Fixed Income Allocations?

July 7, 2016 08:46 am 11 Comments CATEGORY: Investments

The ongoing decline in interest rates since the financial crisis have been a boon for those looking to refinance a mortgage or businesses looking to borrow, but an immense challenge for investors that rely on fixed income returns, from insurance companies to individual accumulators and retirees. And as bond returns grind lower, it has brought a renewed focus on costs (that eat up an ever-larger percentage of a smaller return), including the question of whether financial advisors should charge less for managing a bond portfolio compared to a stock portfolio.

In this week’s #OfficeHours with @MichaelKitces, my Tuesday 1PM EST broadcast via Periscope, we look at the question of whether advisors really should be charging separate and different fees on the fixed income versus equity allocations in a portfolio, including and especially for those who also deliver extensive financial planning services as a part of their AUM fee as well.

Of course, given that the typical bond mutual fund is already less expensive than the average stock mutual fund, arguably the asset management industry has already spoken and suggested that the fees should not be the same. If only because today's low bond yields, plus the more limited volatility of bonds (at least compared to stocks), means there's just only so much opportunity to create active management value in bonds and outearn that fee in the first place.

On the other hand, the reality is that most advisors don't manage just all-bond or all-stock portfolios as a mutual fund does. Advisors typically manage blended portfolios of stocks and bonds, sometimes tactically managing amongst all those asset classes, and an increasingly large portion of the AUM fee is being allocated to financial planning services anyway... which are based on the amount of actual financial planning work to be done, and arguably remain the same regardless of how the portfolio happens to be invested.

And in fact, with the looming Department of Labor fiduciary rule taking effect in April of 2017, charging different fees for stock versus bond allocations may become a prohibited transaction anyway, at least in an IRA where the advisor has discretion over the portfolio's overall allocation in the first place. Which means that while advisors might charge less for conservative model portfolios compared to those that are more aggressive (and in theory have more active management opportunities), or begin to unbundle their planning and investment management fees altogether, but the question of whether to charge differently for bonds and stocks within the same portfolio may soon be a moot point anyway!

Why I’m Not Optimistic About Actively Managed ETFs For Financial Advisors

June 30, 2016 02:23 pm 4 Comments CATEGORY: Investments

Over the past decade, the rise of ETFs and the decline of the (actively managed) mutual fund has quickly created giant ETF behemoths like iShares, Vanguard, and State Street, while putting immense pressure on (actively managed) mutual fund companies, with US equity mutual funds in the aggregate experiencing cumulative net outflows since 2008. In turn, this has led a wide range of asset managers to try to adopt their own ETFs, seeking out ways to bring their active management process to a form of actively managed ETF (in a structure that limits their risk of being front-run on large trades).

In this week’s #OfficeHours with @MichaelKitces, my Tuesday 1PM EST broadcast via Periscope, we look at this emerging trend of actively managed ETFs, and why I am very skeptical that active ETFs will ever gain much traction amongst financial advisors.

Ultimately, the key trend to recognize is that the shift of financial advisors from being commission-based to the AUM model over the past decade has shifted the entire financial advisor value proposition. The pressure is now on advisors themselves to show the value they're creating in the portfolio design and management process. Which means they can't just buy active mutual funds - or actively managed ETFs - that the client could have bought themselves in their own online brokerage account.

Instead, financial advisors have been adopting their own internal portfolio design and investment management processes, aided by the growth of the AUM model itself that allows independent advisory firms to be larger than ever before and more capable of having their own investment process. Yet given the limited size of even the largest advisory firms, it's still challenging for most advisors to manage individual stocks and bonds. ETFs became the perfect intermediate portfolio building block.

Which means in the end, the explosive growth of ETFs and their adoption by financial advisors over the past decade may be less about a shift from active to passive, and more about a form of disintermediation where financial advisors are eliminating third-party active managers and bringing the process in-house instead (or if they do outsource investment management, they go to a TAMP or SMA solution that is not available to consumers directly). Yet if this is the case - advisors are looking to bring active value that clients cannot access themselves - it suggests that the push of fund companies to offer actively managed ETFs in the hopes that they can share in the growth of the ETF marketplace may turn out to be nothing but a mirage.

Finding The Optimal Rebalancing Frequency – Time Horizons Vs Tolerance Bands

May 4, 2016 07:01 am 22 Comments CATEGORY: Investments

Benefits Of Various Tolerance Band Rebalancing Thresholds At Different Look Intervals

Rebalancing plays a crucial role in ongoing portfolio management, both to ensure that the overall risk of the portfolio doesn’t drift higher (as risky investments can outcompound the conservative ones in the long run), and to potentially take advantage of sell-high buy-low opportunities. The caveat: it’s not entirely clear how often a portfolio should be rebalanced, in order to achieve these goals.

The conventional wisdom is to rebalance a portfolio at least once per year, and possibly even more frequently, such as quarterly or monthly. A deeper look, however, reveals that more frequent rebalancing will on average have little impact on risk reduction, even less benefit from a return perspective, and just racks up unnecessary transaction costs along the way.

Instead, the research suggests a superior rebalancing methodology is to allow portfolio allocations to drift slightly, and trigger a rebalancing trade only if a target threshold is reached. If the investments grow in line and the relative weightings don’t change, no rebalancing trade occurs. However, if these “rebalancing tolerance bands” are breached, the investment – and only the investment – that crosses the line, is then bought or sold to bring it back within the bands.

The one caveat to the process of tolerance band rebalancing is that it requires ongoing active monitoring of the portfolio itself, to ensure that you know when a threshold has been reached. Fortunately, though, a growing number of rebalancing software tools are available to help advisors track each investment, its rebalancing thresholds, and even automatically calculate and queue up the rebalancing trades necessary to bring the portfolio in line again!

Stress Testing To Ensure You Really Have A “Diversified” Portfolio?

March 23, 2016 07:02 am 14 Comments CATEGORY: Investments

Layers Of Effective Portfolio Diversification

While it’s commonplace for investors to hold multiple investments in a portfolio – often comprised of mutual funds or ETFs that in turn hold dozens or even hundreds of underlying positions – the reality is that even multi-asset-class portfolios aren’t always really diversified.

The fundamental problem is that holding many different investments that are all aligned to the same “base case” market scenario – and all go up together – may be equally at risk to decline together if an adverse event happens instead.

For instance, a “well diversified” portfolio holding US stocks, emerging markets, commodities, and corporate bonds, may be invested into multiple asset classes – but they would all be expected to go up in a growth environment, and all would likely decline severely in a recession!

Of course, the investments that don’t go down in a recession, from “defensive” stocks to government bonds, are also the investments likely to perform the worst if markets continue to rise. But in the end, that’s the whole point of diversification – to own investments that will defend in the risky events, even if it means giving up some upside in the process. Or viewed another way, being well diversified means always having to say you’re sorry about some investment that’s not moving in the same direction as the rest!

And given the complexity of today’s investment environment, and the typical multi-asset-class portfolio, a growing range of tools are becoming available to “stress test” various risky scenarios, to help determine whether a portfolio is truly diversified, or just holds a large number of investments that are all expected to go up – and down – in an undiversified manner!

Dollar Cost Averaging May Help To Manage Risk But On Average It Just Reduces Returns

March 9, 2016 07:01 am 23 Comments CATEGORY: Investments

Rolling One-Year Results Of Lump Sum Vs 12-Month Dollar Cost Averaging

Conventional investment wisdom suggests that dollar cost averaging is a good approach to allocating investment dollars over time. By always investing a constant dollar amount, the strategy ensures that fewer shares will be bought as prices rise, while more shares are purchased if prices decline, bringing down the average cost per share in the long run. The only question is over what time horizon it’s best to average in.

Yet as it turns out, the answer is “none”. In reality, a dollar cost averaging investment strategy doesn’t actually enhance returns in volatile markets that have similar upside gains and downside losses on a percentage basis. And given that on average, markets go up more often than they go down, choosing to dollar cost average is more likely to just leave gains on the table (and the longer the time period, the greater the risk of foregone returns).

However, while dollar cost averaging may not be likely to enhance returns in the long run, it is still a risk management technique. Over the dollar cost averaging time period itself, the diversification of the “new” investment and “old” investment may actually produce superior risk-adjusted returns. And given that the pain of losses is more severe than the joy of gains, risk-averse investors may prefer to dollar cost average simply to minimize the potential regret of not doing so and seeing markets decline shortly thereafter.

Nonetheless, for investors who are comfortable with the risk of their portfolios, and aren’t specifically seeking a “regret aversion” (or at least, regret minimization) strategy, in the long run the best time horizon for dollar cost averaging is simply to invest all the money immediately – at least, presuming the investment was desirable to own in the first place!

How Portfolio Rebalancing Usually Reduces Long-Term Returns (But Is Good Risk Management Anyway)

December 23, 2015 07:01 am 11 Comments CATEGORY: Investments

Impact On Expected Returns And Risk Management Of Regular Portfolio Rebalancing

The conventional view of portfolio rebalancing is that it is a strategy to enhance long-term returns by periodically selling the investments that are up (and overweighted) to buy those that are down (and underweighted), in the process of realigning the portfolio to its original target allocation.

Yet the reality is that because most investments go up far more often than they go down, systematic rebalancing is actually more likely to just consistently liquidate the best-performing investments to buy ones with lower returns instead – especially when rebalancing across investments that have very significant return differences in the first place (e.g., rebalancing from stocks into bonds).

As a result, rebalancing may be helpful as a risk management strategy – otherwise higher-returning stocks would compound to the point that they are significantly overweighted relative to lower-returning bonds – but it’s only when rebalancing amongst investments with similar returns in the first place that rebalancing provides a return-enhancement potential.

Ultimately, the fact that rebalancing may actually reduce long-term returns isn’t a reason to avoid it (even if returns are lower, risk-adjusted returns may be improved if the risk is reduced by even more), and sometimes returns really can be enhanced (when rebalancing across similar-return investments, such as amongst sub-categories of equities). Nonetheless, it’s crucial to recognize the role that rebalancing really does – and does not – play in a long-term portfolio!

Capturing An Excess Return Premium For Illiquidity Is A Privilege Not A Right!

December 9, 2015 07:01 am 10 Comments CATEGORY: Investments

Liquidity may be an appealing characteristic for an investment, but a growing base of research is finding that illiquidity may be even more desirable. Because ironically, demand for illiquid investments is so low, that they appear to carry a persistent excess return premium – a view popularized in recent years by those like David Swensen of Yale Endowment, who racked up a whopping 13.9% annual return for the past 20 years in large part by relying heavily on illiquid investments.

Of course, the first caveat to investing in illiquid assets is that it is only appropriate for the portion of investments that the investor can afford to segment into illiquid holdings. Yet the more significant (albeit more nuanced) danger of investing in illiquidity is that the return premium is only a benefit for an otherwise sound investment. For a bad investment, owning one that is also illiquid just compounds the problem by locking the investor in!

And notably, a bad investment is not just one with poor economic fundamentals, but also one where the interests of the investment manager and the investor themselves are not well aligned – leading to situations where even an appealing investment at first turns out to sour later, as has occurred with illiquid investments from various hedge funds, to certain life insurance and annuity products, and more recently with nontraded REITs.

Yet perhaps the greatest misalignment of interests is simply the one that occurs when illiquid investments are sold by salespeople who benefit in the short-term while an investor is locked into the illiquidity for the long run. In other words, illiquid investments may be one situation that is especially appropriate for the involvement of a fiduciary where long-term economic interests are aligned – which goes a long way to explain why illiquidity has served institutional investors like the Yale Endowment so well, even as for the individual investor it so often goes awry!

NSR Invest Platform Aims To Open Peer-To-Peer Investing Marketplace To Advisors

November 30, 2015 07:01 am 11 Comments CATEGORY: Investments

In today’s low-interest-rate environment, the pressure is on for advisors to add value when it comes to fixed income allocations. Yet unfortunately, some of the most appealing segments of the fixed income markets to generate higher yields – such as peer-to-peer (P2P) investing – have little or no means to fit into the typical financial advisor investment platform.

But that may soon change, as peer-to-peer analytics and management solution NSR Invest prepares to launch the first integration of P2P investment platform Lending Club to ‘traditional’ advisor portfolio analytics solution Orion Advisor Services. The ultimate goal – to make it feasible for financial advisors to manage client investments in P2P loans, including allocating capital into individual loans (in a diversified manner), managing cash flows in and out of P2P investment accounts, and facilitating consolidated performance reporting of P2P investing and the client’s other portfolio investments. All done in a manner that advisors can even bill for their services.

Of course, the caveat is that peer-to-peer investing still has significant risks to accompany the higher yields it offers, from a material risk of default (which can only be partially diversified away) to significant illiquidity if clients unexpectedly need to sell their allocations. Nonetheless, the relatively new sub-asset-class within the fixed income environment remains appealing for yield-starved clients, and NSR Invest’s technology may finally make it feasible for, at least, independent RIAs to begin to allocate client dollars to P2P investment opportunities!