An investment manifesto

Two investors, Mr. and Mrs. Smith, who I know well, were bemoaning the performance of their mutual fund investments the other day. Back in 2003 they had a lump sum of money they wanted to invest. This money was by no means meant to sustain them in retirement as they were well away from it at that point. From speaking to them it's clear they wanted their money to grow a bit but deep down they are very conservative investors, evidenced by the fact that their desired approach now is to go all-in to GICs (I will discuss this in my next post). I've heard this story a ton of times from other colleagues, friends, and family members and the background info I collect is always the same.

They went to one of the Big Banks and used an in-house investment adviser. The individual seemed knowledgeable enough and showed them that with the specific fund he was recommending or the specific allocation created by the mix of funds he was using, they could expect a roughly 8% annual rate of return on investment. See my previous posts here and here to learn why this is only partially true. Then he invested their money and the rest is history. I'm not sure what funds he invested in or how often he changed the funds. But the fact that he was able to achieve 0% return on investment over an 8 year time frame is astonishing and pathetic. And exceedingly common.

What is the defense of advisers when questioned about these results? The Big Crash in 2008 did you in. When I heard this was the defense leveled in this particular case as well, I decided to dig a little deeper to answer 2 questions.

1. What was the return of a balanced portfolio of low-cost index funds with a lump sum investment starting in 2003 and ending today? Maybe this adviser merely matched the market.
2. Not knowing what funds he used, what is the likelihood of choosing such a poor portfolio given the investment needs and style of the clients?

Question 1:
Since the time period in question was marked by one of the largest stock market declines in history, it stands to reason that the more aggressively a portfolio invests in equities and less in fixed income funds, the lower the return should have been. The data bear this out. However, even the most aggressive mixed portfolio (35% Canadian equity, 32% US, 33% international) of low-cost index funds still yields a return of 4% annually. In order to achieve such dismal results, the adviser would have had to invest in 100% US equity which would have been absolutely idiotic. It is clear this was not the case but demonstrates the magnitude of failure.

Question 2:
What if the adviser knew nothing else than past performance? If he created a conservative portfolio of 60% bonds, 20% Canadian stocks, 10% US stocks, and 10% international stocks, as guided by the couple's investment style, he could pick funds in 3 ways as I see it. He could choose the top performing funds in each fund category for the years prior to 2003. Or he could choose the lowest performing funds (although this may seem ridiculous, in financial markets, battered investments usually rebound quite nicely). Finally, he could just recommend a balanced fund. This is one of those prepackaged funds made for investors with different styles. The Big Banks sell them and so do all the big investment houses. I've used TD in all my examples but only to make the data field manageable. But tellingly, back around 2003 I was in a similar situation to this couple and was recommended something similar by a TD adviser. More recently I was recommended the newest rendition of this product by a different adviser so it seems this approach is popular.

If the adviser chose the top-performing fund his company sold in 2003 based on past performance in each fund category (fixed income, Canadian, US, Intl) and purchased them and let them sit, he would have gained this couple 4.13% per year. If he picked the worst, only proving my previous point, he would have achieved 6.82%. And if he put them in TD Managed Income in 2003 and then switched it to the fund du jour in 2009, TD Comfort Conservative Portfolio, they'd be at 4.49%. Not too shabby in all cases. And the second example is quite remarkable given the market returns. But no bank adviser that I've ever met would try and sell a client on investing in the worst funds going even if it does make mountains of sense.

So here I was at an impasse. This man had clearly achieved the impossible. He had added no value to the investments for these clients. In fact, he had subtracted value. Could that be so? Could not some other reasonable selection method have led to this failure? What if he was cycling the portfolio? What if, every year, he reviewed the past year's performance in each fund category and changed what fund he had the money invested in based on which fund was tops, or conversely, which was in the can? Close, but no cigar. Selling everything and reinvesting in the top performing fund in each category from the previous year yielded a 5.65% annual return, 3.5% in the case of the worst funds. (This does not disprove my previous point as the performance he was assessing was only annual. Each time he purchased there was a good chance he was still riding a wave of success.)

But there must be a way to construct a conservative investment portfolio (assuming he cared even a little bit for his clients' investment style AND considering that even the most aggressive mixed index portfolio still didn't suck as bad as 0%) and completely strike out. Turns out there is....almost.

If I look in hindsight NOW at the worst funds performing over the last 10 years in each fund category for TD and construct a theoretical conservative portfolio with a $100 000 lump sum investment back on January 3, 2003 (as I did for all the projections noted through GlobeInvestorGold, of which I am a paid subscriber), I achieve a return of only 1.25%. Now this couple didn't tell me their return was 0%. They used the term "practically nothing". To many people, gaining only $10 000 on $100 000 (just using this for arguments sake) over 8 years would be considered just that, especially considering that the annual rate of inflation over the same time period was 2.05%. In real terms, they actually lost money.

But I digress. What are the odds of constructing such a disastrous portfolio? First of all, consider that there would have been nothing but chance guiding the purchase of these funds in 2003 as they were not really on the radar. Decidedly mediocre. Only in 2011 with the gift of hindsight can I truly see that they were awful.

Just for shits and giggles though, let's run the odds. To do this I must determine how many funds existed in each category with TD in 2003 and then multiply the odds together. For Canadian Equity it was 1 in 20, US Equity 1 in 16, International Equity 1 in 22, and Fixed Income 1 in 20. So to pick the lousiest 10-year fund in each category would require 1 in 140 800 odds. However, given the frequency with which I hear this story from other investors, this may well be one of the most common rare occurrences in our universe.

Either this adviser was incredibly unlucky, created a portfolio with an asset allocation that was so out of tune with the needs and desires of the clients, or churned the portfolio relentlessly to generate commissions. It might seem that in the first instance, the adviser could be forgiven. Sadly I'm not in a forgiving mood today. If he would have kept it simple by creating a conservative balanced portfolio with broad-based mutual funds (I won't be so daft as to suggest an in-house bank adviser would recommend index funds), purchased them once and just let them be, at absolute worst they'd be sitting at 4% annualized return. That is something I know that they could live with.

The important lesson from this story is that it really doesn't matter who Mr. & Mrs. Smith are, how much money they had to invest, their investment style, or which bank they used (or in a broader sense, with few exceptions, which financial adviser they used). The fact is that the same thing happened to thousands of Canadians in the last 8-10 years. But it all gets written off as normal. It's pushed aside as a natural result of investing in the equities market. "That's the risk you take with investments" we're told and we tell ourselves. But it's not. The fact of the matter is, not taking risk is just as, if not more likely to result in poor returns AND it is the very nature of the investment advice culture that creates poor returns. I hope to prove the last two points in two followup posts, so do please read on!

But what am I to do, one might ask. I don't have time to invest on my own. I don't have the knowledge. I vehemently disagree with both precepts on the basis of my own experience but I'm willing to concede the point because these topics interest me. Educating myself in these matters is not a chore, it's a hobby. That will not be the case for many. So here is my revolutionary manifesto for investors:

1. If you are relatively far from retirement or have a small portfolio, you may want to consider educating yourself. Or just do as little reading as is necessary to construct a Couch Potato Portfolio a la Money Sense (just Google Money Sense Couch Potato Portfolio and you'll be laughin'). The advice I give below would be so expensive for someone with a small portfolio, it would eat away most returns you may achieve. As well, many fee-only advisers won't look at small investors. Finally, in most cases, if the portfolio is small and/or the investors are far from retirement, there isn't a lot of complexity there and you should be able to figure out most of it on your own, with the help of some knowledgeable friends (none of whom sell mutual funds please).
2. If you are closer to retirement or have a large portfolio, or your retirement investments consist mostly of assets you will sell, you need professional help. I rail against traditional financial advice, but even I will be seeking help as I creep over 50. If you have a large portfolio, you can likely afford a professional fee-only planner. These people strictly offer financial advice. They sell no products so their advice is unbiased. Even if your portfolio is meek, if you are closer to retirement, you need assistance. Planning becomes much more complicated as you near the time when you will need to use your retirement funds. There are tax considerations, annuities, RIFs, estate planning, etc. etc. As well, as you get closer to retirement, you need to think about protecting what you've already built. All of this should be done with professional, knowledgeable, and unbiased advice. I'm willing to bet you'd miss out on at least 2 of those factors if you search for it at the bank. So don't. Check MoneySense for directories of fee-only planners. Or call around and find some. They're out there, though not in droves yet.
3. If you are at any stage, consider a sober second opinion. This is the option offered by Weigh House Investor Services. Check them out. They basically take a look at your portfolio and investment plans and tell you (although not literally) whether you are off the rails and need to fire your adviser or whether he's a damn genius and you should bring him brownies. Even if you are a DIYer like myself, they have a nifty DIY coaching program where they are there to help when you need it and review everything with you once a year, just to make sure you don't think you know more than you actually do.

Regardless of which option you choose, do yourself a favor. Either go it alone or hire someone whose paycheque does not depend on or is not partially composed of commissions and trailer fees from the products they sell. It's your money. You earned it. So don't let someone else piss it away.