The New Reality of Financial Advisors and Investors

Abstract

It is important to assess investor use of financial advisors in light of the financial crisis, and to examine the performance of investors with financial advisor accounts and those with broker accounts.

Legal issues concerning financial advisors and brokers include the continuing confusion among investors in differentiating the two, and regulatory failure to clarify sufficiently the lines of confusion since passage of the Investment Advisers Act.

Issues concerning the “financial duties” of financial advisors are applied more easily with knowledge of its elements, and the importance of identifying advisors who follow these duties. Financial advisors now manage almost 50% of household mutual fund assets.

The financial crash and its huge losses made it more important for investors not to place “blind faith” in financial advisors. Numerous Investors have “fired” their advisors or have reduced the assets invested with them. It is most essential for investors to be their own “CEOs” in financial advisor relationships.

Many nervous financial advisors eager to retain clients have adopted less traditional strategies and assets with a variety of fees and risks requiring expert choice and professional management.

“Buy-and-hold is dead” has become a common cry since the crash, but failure to design, construct, and manage portfolios with proper diversification does not negate the strategy. The failure lies not with diversification, but with its proper implementation.

The recent “Black Swan Event” could not have been prevented or limited because portfolios in general were not modeled with correct non-normally distributed outcome probabilities - not an easy task.

Since the crash, “alternative investments” have become a “new wave” for financial advisors, which, when properly defined, provide positive risk-adjusted returns and low correlation with traditional asset classes. These investments include hedged equity, market neutral, commodities, and currencies, and their use should reflect investor risk preferences and advisor and/or client expertise.

The word from hedge fund thought leaders is that during financial crises, standard risk/reward trade offs go “out the window,” and risk taking punishes investors, not rewards them. Hedge fund portfolios have been too correlated to market returns. The first step to alternative investments is not to increase portfolio risk but to truly diversify, and, second, to select a financial advisor who implements portfolios that truly hedge risk.

In a 2009 study with a unique German data set, the first analysis finds client investor accounts managed by the bank’s financial advisor outperform accounts invested with its broker. The second analysis compares the characteristics of client investors with financial advisor accounts relative to those with broker accounts. The third analysis uses client investors with the same characteristics in both the financial advisor and broker accounts. These more properly formulated results find broker accounts outperform financial advisor accounts across all performance measures.

We know direct sold mutual funds outperform broker sold funds, and here it appears that broker accounts outperform financial advisor accounts, adjusted for investor characteristics. Such an adjustment has not been feasible in former studies.

Behavioral finance argues it is plausible to understand financial market events that include investors who are less than fully rational, and it is based on two tenets: limits to arbitrage that make it difficult to undue asset price dislocations caused by trades of less than fully rational investors, and results from psychology that find and define the biases of less than fully rational investors. Under these conditions, asset prices deviate from efficient market “prices are right,” but there still remains “no free lunch.”

Keywords: financial advisors, investors, financial crisis, legal issues, fiduciary duties, buy-and-hold, Black Swan Event, alternative investments, hedge risk, investor characteristics, broker accounts, advisor accounts, behavioral finance

JEL Classification: G2, G23, G28