By LARRY SWEDROE
I do not believe that (investment advisers) can identify, in advance, the top-performing managers — no one can — and I would avoid those who claim they can do so.
— John Bogle
Paula had just inherited $5 million dollars. She was quite concerned about how she was going to manage this large sum of money, especially since she recognised that she knew little about investing. She contacted her attorney and asked him for some advice.
The attorney gave Paula the names of two investment advisers that he recommended she interview. One was an adviser who worked for a local accounting firm that had established an affiliated registered investment advisory firm. The other worked for the broker-dealer A.G. Jones.
The evidence-based adviser
Paula knew and trusted one of the partners at the CPA firm who was also an investment adviser. She decided to first meet with that firm. When she called to set up an appointment, the adviser told her he was going to send her a copy of the book The Only Guide to a Winning Investment Strategy You’ll Ever Need. He explained that the book provided an explanation of the firm’s investment philosophy in simple terms. He also explained that the firm’s philosophy was based on findings from academic research. He hoped she would read the book prior to the meeting, as that would make it more productive. She agreed to read the book in preparation for the meeting.
At the meeting the adviser explained that at the core of the firm’s philosophy was the belief that it was difficult to beat the market, and that while a small percentage of money managers did so, no one had found a way to identify them ahead of time. Thus, the firm’s belief was that the most important investment decision was not which manager to hire, but the asset allocation decision — how much should be invested in risky stocks versus safer bonds. Thus, the first task would be to work with her to determine just how much risk she had the ability, willingness and need to take. He then explained that since there was no way to determine ahead of time which managers would be among the few that would outperform, the prudent approach was to accept market returns by investing in index funds and their similar but more sophisticated versions known as “passive asset class funds.”
He then showed her the results of a study, Institutional Investment Strategy and Manager Choice: A Critique by Richard Ennis. Ennis found that for the 46 public pension plans in his database, the average margin of underperformance was about 1 percent relative to passive investments. He also found that just one generated statistically significant alpha, compared to the 17 that generated statistically significant negative alphas. And he calculated that “the likelihood of underperforming over a decade is 0.98 — a virtual certainty.”
Paula left feeling comfortable with the approach of the CPA adviser.
The next day she met with the A.G. Jones adviser. He explained that their investment approach was to hire the best investment managers in the world. They had a team of people that performed extensive due diligence so that they could find the best of the best. He asked Paula, “Isn’t that who you want to manage your money?”
Paula recalled her conversation with the first adviser. She asked the A.G. Jones adviser what he thought of indexing as a strategy. The broker responded: “Indexing is a perfectly good strategy — if you are willing to accept average returns. Our clients want to do better than that. We help them achieve that objective. You don’t want to be average, do you Paula?”
The adviser then showed Paula a list of the funds the firm was currently recommending. He also showed her the performance history of the funds. To Paula’s surprise, the firm’s list had indeed outperformed similar index funds. This conflicted with what the other adviser had said. This one had presented a compelling case. And A.G. Jones was a prestigious firm. Surely, she could trust them.
Paula was confused
Paula was now confused. She did not know which way to turn or who to believe. One of the two advisers was wrong. She decided to call the partner at the CPA firm and set up another meeting. The adviser was pleased to meet with her and said he would be happy to answer any questions.
Paula brought A.G. Jones’ list of fund recommendations to the meeting. She said: “I am confused. You told me that no one had found a way to identify which funds would outperform the market. When I met with the adviser from A.G. Jones, he showed me this list of funds they were buying for their clients that had outperformed the market over the past five years. How do you explain that?”
The adviser responded: “Paula, I am glad you asked that question. It is the question I am most often asked. You see, it is easy to identify which funds have outperformed the market in the past. Anyone with access to a database can do that. The question, however, is not whether you can identify which funds have outperformed the market. Instead, the question is whether you can identify them ahead of time!”
The adviser suggested that Paula set up another meeting with the A.G. Jones adviser and ask him two questions. He said: “First, ask him to provide you with the list of funds his firm was recommending five years ago. If the names don’t match, then you have to ask why. If the list had predictive ability, wouldn’t the fund names be the same on both lists? If the names are not the same, something must have gone wrong. If something went wrong last time, can you confidently expect that something similar will not happen with your money? I can tell you that we have suggested this to many people, and the client almost never gets to see the old list. You can guess why. And in the few cases they do get to see the old list, the names are almost never the same.”
Then he played for Paula an excerpt of an interview between John Stossel and a well-known Wall Street adviser, Robert Stovall. The interview took place on November 27, 1992, on the popular television show “20/20.” Stossel asked Stovall about the persistently poor performance of mutual fund managers. Stovall responded, “One-third of the money managers tend to beat the market every year.” Stossel replied, “Two-thirds do worse!” Stovall responded, “But it’s different ones each time.”
Different every year
Paula laughed. Was this guy serious? If it is a different group every year, how was she, or anyone else, going to be able to identify the ones that will outperform in the future? Paula then asked the adviser: “What is the other question you would like me to ask?” He responded: “Paula, we would never advise a client to invest in something we would not invest in ourselves. All of the partners in our firm, including me, invest their assets in the same funds we advise our clients to invest in. Of course, the percentage that is invested in each fund is different for everyone because it is tailored to each person’s unique situation. In addition, our profit-sharing plan is invested in the same funds. I would be more than happy to show you my brokerage statement so you can see that this is true.”
Paula told him it would not be necessary. The adviser continued: “Ask the A.G. Jones adviser to show you his financial statement to see the funds in which he has invested. Then ask him to show you the list of funds that are available inside of his company’s 401(k) plan. If the funds on both lists are not the same as the names on the list of recommended funds, what does that tell you?”
Paula was impressed with the adviser. Everything he said seemed like common sense to her. And he was able to back up every statement with facts, not hype. She thanked him for his time and promised she would return to the broker, ask those questions, and let him know her decision.
A deer caught in the headlights
Paula set up another meeting with the A.G. Jones adviser. When she asked him to provide the list of recommended funds from five years ago, he stared at her with the look of a deer caught in the headlights. He had gone through A.G. Jones’ intensive sales program. The training program had taught him to ask questions like “You don’t want to be average, do you?” But it had not prepared him for this question. He was taught to sell, and obfuscate, but not to answer questions like this. He told Paula he would have to dig up that information because no one had ever asked him that before. She then asked him to also provide her with a list of both his own investments as well as a list of the funds available within the firm’s 401(k) plan. The adviser told her he would have to get back to her.
Paula was not surprised that she never heard back from the A.G. Jones adviser. She called the partner at the CPA firm and told him she had decided to use his firm’s advisory services. The partner told her he was confident she would not regret the decision. Paula was confident he was right.
The moral of this tale is that before you trust your assets to an investment adviser, ask the questions that Paula asked.
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