We recently received a question at our website from a troubled consumer of financial advice who wondered how he might compare Pinnacle’s wealth management process to that used by his current advisor. That’s an excellent question. After all, there is no Consumer Reports for financial advisors where firms are evaluated by objective and independent experts. The best we can do is recommend a process of evaluation that will give an educated consumer confidence in choosing the right financial advisor.
Your first step is to evaluate the specific advisor you’d be working with. How long has he/she been in the business? Has the advisor given financial guidance through more than one market cycle? What are his/her professional credentials? Pinnacle requires that our advisors be Certified Financial Planners (CFP). The financial planning world is unbelievably complex, and you want someone who treats the profession as a craft that requires constant training. Does the advisor use a process that is collaborative in working with clients or does he/she disappear for a while and then show up with a “magic” financial solution?
Do you have chemistry with your advisor? That’s an important question, since you will hopefully be working with this person for years to come. We all have different personalities and enjoy working with different kinds of people. If overly expressive people who tell too many jokes get on your nerves, you might want to find a more serious advisor. Choose wisely.
You should also try to assess what experience you are likely to have as you move through the planning process. Does the advisor seem flexible in his/her approach to data gathering and plan presentation, or is it more like “my way or the highway?”
How to Evaluate the Financial Firm
Next you should consider the advisor’s firm. How long have they been in business? How many employees do they have? Are they so small that if your advisor is hit by a bus, the firm will go out of business? On the other hand, are they so large that you’d be just another face in the crowd of clients where no one really cares about you or your family?
And how about payment? How does the firm structure the fees or commissions you will pay for advice? Make no mistake: Financial firms are for profit enterprises. We recommend you find a fee-based advisor where you’re paying for on-going service to your account, versus a commission-based advisor who is paid for selling financial products. While both methods of compensation have their benefits and drawbacks, make sure you’re familiar with both when making your choice. Also, be sure to look at the Form ADV for the firm you are considering. The SEC and FINRA closely regulate the investment industry and you should check for any past lawsuits, outstanding legal issues, or other signs that the firm is not following legal and ethical guidelines. You can check with the Financial Planning Association (FPA) to see if a firm or individual advisor has any outstanding ethical issues you should be aware of.
The subject of compensation is very important. Some investment management firms charge separate fees for financial planning advice, while others charge one flat fee that includes all money management and financial planning services. Make sure you fully understand what you will be paying for “out of pocket” and what fees are included. For example, many firms charge clients based on assets under management, but those charges do not include the underlying fees of the investments in the client’s managed account (known as the “expense ratio” of the individual securities). Mutual funds and Exchange Traded Funds (ETFs) have different expense ratios: Mutual funds are often “managed,” which requires you to pay the fund manager, while ETFs are unmanaged (and therefore often less expensive).
Be certain you fully understand the fee-structure of any firm that claims they don’t charge for investing your account, especially if they utilize mutual funds to build your portfolio. Mutual funds come in many flavors, and some types (B-Shares and C-Shares) have trailing fees that only show up in the expense ratio of the funds. Also be sure to check for the fees of related firms, like the custodial firm where your securities will be held by the advisor. These charges can add up to a significant sum, so be certain you understand all of them when choosing a firm.
How to Evaluate the Investment Process
Once you understand how a firm handles its financial planning business and are comfortable with your potential new advisor, it’s time to evaluate the firm’s money management operation (if that’s part of what you’re looking for). Start by asking how the construction of your portfolio is coordinated with the result of your financial plan. Will the firm build a completely customized portfolio for you based on your planning needs? Does the firm utilize model portfolios that are not customized for any individual investor? If the firm uses model portfolios, then is the process of choosing the correct model customized for your planning needs?
The list of questions regarding investment management can get rather long, but here are ten good questions to get you started:
- How does the firm determine the proper asset allocation for your portfolio?
- Does the firm opportunistically change the asset allocation or do they “buy and hold” the same allocation with no changes?
- What securities are used to invest the allocation of your portfolio? Do they prefer mutual funds, ETFs, separate accounts, hedge funds, or something else? And of course, you should find out why they prefer the securities they use to invest.
- What analysts manage the portfolios? Is your financial planner responsible for the ongoing due diligence of your portfolio at the same time they’re responsible for staying current in every other aspect of the financial planning craft? Or does the firm have a separate team of investment analysts responsible for portfolio returns?
- If the firm uses separate analysts, how experienced are they? What is their background?
- Does the firm have a GIPS compliant (Global Investment Performance Standards) track record of performance? Is the return “supplemental” — which typically means that it is hypothetical and back-tested — or were the returns actually earned during the time period shown by the investment team currently employed by the firm?
- How often does the firm trade? What is their philosophy about taxes? What discipline do they use to determine buys and sells in the portfolio?
- Does the firm primarily make their money in bull markets or bear markets? Did they perform well over a complete market cycle?
- If the firm actively and tactically changes the portfolio asset allocation, do they make big market timing bets with the portfolio? Are they allowed to go 100% to cash in bear markets or 100% to stocks in bull markets? We don’t recommend making all-or-nothing asset allocation bets, but that’s just us. Find an advisor who fits your view of how you want risk to be managed.
- If the firm uses active management, does their investment process use skill, experience, and intuition, or do they minimize human decision-making in favor of rules-based, quantitative and mathematical methods. Both approaches have their benefits and drawbacks.
It is a daunting task for consumers to try to evaluate advisors on an “apples to apples” basis. You will find that financial advisors take different approaches to helping you reach your goals – that’s why we encourage consumers to take their time in choosing an advisor. It makes no sense to rush into a relationship that is so important to your financial future. Good consumers know when they have enough information to make a decision and move on with the process.
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