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By three methods we may learn wisdom: First, by reflection, which is noblest; Second, by imitation, which is easiest; and third by experience, which is the bitterest.”
The inner workings of the financial services industry tend to be a mystery for most people on the outside peeking in. To the untrained eye, there is little recognizable difference between a commercial bank, investment bank, broker dealer, investment management firm, mutual fund or insurance company – to many outsiders, which include the most educated among us, they all appear to function as one and the same.
In reality, the above industries not only specialize in different segments within financial markets, but also cater to a specific clientele with specialized needs. For example, commercial bankers generally take in deposits and make various loans to either institutions or individuals, while investment bankers underwrite (issue) corporate securities such as stocks and bonds and work on mergers and acquisitions.
However, at the end of the day the entire financial services sector has one major thing in common – that is, the method in which they make money. Large or small, complex or simple there are only two ways to generate revenue and outperform your peers. You can either be an aggressive risk taker, which is traditionally what the larger institutional trading houses such as Goldman Sachs have excelled at over the years, or you can focus efforts on aggressive marketing, which is where Wells Fargo, a commercial bank believes they possess a competitive advantage. Putting any historic unethical or illegal practices aside, that is it.
I started my career back in late 1997 on the trading desk of a regional broker dealer who specialized in mortgage backed securities. After reading Michael Lewis’s well- known exposé “Liar’s Poker,” during my first year on the job, I became more certain the risk side of the business (the trading and investing side) was what interested me most. At the time, I knew I didn’t want to be forced to sell stuff to anyone, regardless of the high level of sophistication or the potential upside rewards many people were intoxicated by. Later-on in life, I came to realize we are all always selling – be it physical or financial products, an idea, or ourselves, we all need someone on the outside to buy in. The difference today is that I am selling something (or really asking people to buy into something) that is mine (me, my firm and my philosophy), which is something I believe in strongly, with all my heart and soul.
Many wealth management operations largely employ advisers who have a background in selling products. Transitioning professionals such as ex-attorneys also appear to make a seamless transformation, as they are usually good with words, can learn financial concepts fairly quickly, and come off polished to most people. These professional advisers are great at building relationships and tend to have the physical appearance as well as the social connections one would expect of an adviser/investment manager; however, from my experience many of these men and women are unqualified to advise or manage complex client investment portfolios. As a result, a large proportion of investments made inside these portfolios are often filled with their respective firms’ proprietary products such as mutual funds, which are sponsored by the adviser’s company and generate large additional fees (see February 2019 newsletter for my critique on mutual funds and advisers who heavily rely on them).
Take Morgan Stanley for example, a well-respected full-service investment bank that operates a highly successful wealth management franchise. According to Personal Capital, a discount robo-advisory firm, Morgan Stanley charged clients in the year 2017 a 2-2.5% advisory fee with an average mutual fund expense ratio of 0.44%. Therefore, estimated total annual fees came to between 2.42-2.92%, a hefty sum which was then absorbed by their clients (see article and table here).
Paying large fees may go unnoticed when markets are making new highs, but eventually the chickens come home to roost. As sure as night follows day, markets correct and volatility reappears. It’s during times like this when clients need us most and inferior service becomes more apparent.
For example, if the S&P 500 were to drop by -30%, a professionally managed account under most circumstances should decline by less. If this were not the case, then in retrospect the investor would have been better off fully invested in a low-cost ETF (Exchange Traded Fund) index, tracking the S&P 500 and saved on adviser coaching expenses. After-all, we’ve all heard the cliché that investors need to stay the course... but who really has the temperament to stay the course in the face extreme levels of volatility or large draw-downs, particularly if the investor is way over his/her skis on risk and nearing retirement? Investors will pay investment advisers and managers to manage risk so they can sleep at night – in return, investors hope to partake in a significant portion of the upside when markets are behaving, while limiting the downside when things get ugly.
Maybe I am being a little unfair. After all, my critique is with the professionals and the well-known firms who hold themselves out to the public as investment managers, when possibly their expertise and experience could be geared more towards financial planning. For readers who do not know the difference between the two, I’ll summarize an excerpt published over Investopedia.com, “What is the difference between portfolio management and financial planning?”. Simply put, financial planners perform a comprehensive process aimed at meeting short or long-term financial objectives, such as saving for college or retirement. A financial planner can help their clients answer important questions such as: Am I saving enough to meet my retirement goals? How much house can I afford? When should I start taking Social Security? What type of investment account is optimal based on my unique situation? Investment and portfolio managers on the other hand are specialists, who execute the investment side of the plan. They follow financial markets, build portfolio’s that meet the investment return objectives of their clients, analyze and select investments, manage risk, and rebalance as warranted. One is not better than the other, they are complimentary. This is why clients should know the difference and understand what expertise they are paying for.
In our wealth management practice, we specialize in both investment management and financial planning. In most cases, clients retain us solely to manage their investment portfolio, while others may ask us to only help with their financial plan – which, if not an investment management client we will do for a fee. Whether a prospective client seeks to utilize our full services or not, it really makes little difference from our perspective. To us, it’s about meeting the needs of our clients while offering quality services at a fair fee.
So, does your wealth manager measure up?
On financial markets, I have been switching back and forth from modestly optimistic to prudently cautious. More often than not, I remain prudently cautious. The bull market is ten years old (about the longest on record for the U.S.) and on a broader level, global economic statistics have been decelerating. At this point, most economists and market strategists would agree that we are in the midst of a late economic cycle growth environment. The bond market started to sniff this out in the fourth quarter of last year and despite Fed Chair Jay Powell’s hardcore dovish pivot in late December, bonds continue to perform fairly well despite a remarkable equity rally. If investors were to look towards continental Europe or Japan, they’d see a signification portion of their sovereign debt offered at negative yields. Broken and crazy if you ask me, but it does make our interest rate market appealing by comparison, with U.S. 10-year notes trading around 2.50%. Going forward, I think the path of least resistance in our rates market is to lower yields across the curve.
U.S. equities are a bit more difficult to call. I have less conviction here as I have been grappling with two theories. The first is more optimistic and makes the case that the market could have much more to run on the upside - similar to the run-up seen in 1998 through 2000, where the Fed was forced to become dovish during the Autumn of 1998 in response to the Russian economic crisis, which led to the blow-up of the infamous hedge fund Long Term Capital Management. On the other hand, this market could be similar to the year 2000, in which the Fed was tightening policy through the middle of 1999 to early 2000 in the face of a strong stock market rally, which eventually led to the bursting of the dot.com bubble. I’m not saying things will play out this way, but where history doesn’t repeat itself, it often rhymes. Either way, I think taking some chips off the table and allocating a larger percentage of one’s portfolio to non-credit sensitive U.S. government debt would be a prudent move despite recent favorable performance. Therefore to summarize, the equity sectors I like are large-cap tech, selective emerging markets, such as Mexico, interest rate sensitive sectors such as housing & REIT’s, as well as asset classes that respond positively to U.S. dollar weakness and attempted reflation which include energy, gold and gold mining stocks.
Justin Kobe, CFA Founder & Portfolio Manager
Advisory services through Cambridge Investment Research Advisors, Inc., a Registered Investment Adviser. Securities offered through Registered Representatives of Cambridge Investment Research, Inc., a broker-dealer, member FINRA/SIPC. Cambridge and Pacificus Capital Management are not affiliated.Material discussed is meant for general illustration and/or informational purposes only, and it is not to be construed as investment, tax, or legal advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary. Therefore, the information should be relied upon when coordinated with individual professional advice. These are the opinions of Justin Kobe and not necessarily those of Cambridge Investment Research, are for informational purposes only, and should not be construed or acted upon as individualized investment advice. Investing in the bond marketis subject to risks, including market, interest rate, issuer credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies is impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Diversification and asset allocation strategies do not assure profit or protect against loss.