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Trust vs. Performance: a False Choice


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Trust underpins any important, sustainable relationship.  Your relationship with your investment adviser is no different: before you let anyone craft and manage your investment portfolio, you must trust them implicitly.  But you should also care about their professional competence – specifically, their risk-adjusted performance over time.

Unfortunately, trust and performance have long been treated as competing, or at least incompatible, criteria in the hiring or retaining of an investment adviser.  This a false choice – we believe performance can and should be a fundamental component of the trust you place in your adviser. 

On Trust

Trust is clearly a basic and necessary condition for hiring an investment adviser. Indeed, Registered Investment Advisers (RIA) typically solicit clients based on trust, experience, and dependability.  This trust is typically based on personal relationships, mutual friends and colleagues, socio-economic closeness, or persuasive communication, and rarely on any objective assessment of the adviser’s practice. 

Let’s first distinguish between two types of client ‘trust’ in investment advisers.  The first is security from expropriation or theft.  Such trust should be a given: it is absurd that an investor should choose among advisers based on which adviser is least likely to steal their savings.  Notwithstanding the media frenzy around isolated cases like the Madoff scam, advisory clients enjoy significant legal and regulatory protection from fraud.  Strong securities laws, verifiable national and state registrations, background checks, and separate custody of client assets, all limit outright criminality in wealth management. 

There is, however, another aspect of trust, recently explored in the finance literature, which has to do with “reducing investor anxiety about taking risk.”  Here, investors ‘trust’ advisers to take risks with their investment portfolio that they are not willing – due to a real or perceived lack of knowledge or discipline – to take themselves.  Even if they can invest directly with some competence, investors gain significant value from ‘outsourcing’ their risky investment decisions to an expert whom they trust.  Absent this trust, they would not be invested in risk-appropriate assets based on their life circumstances and goals.  So, by psychologically allowing clients to take appropriate investment risk, trust becomes a legitimate and central part of the client-adviser relationship, and one that grows with time. 

(Note: Any ‘anxiety-reducing’ value that an adviser offers a client is separate from the value a client derives from asset allocationdiversification, or outperformance, all of which taken together should determine whether an adviser is worth the fees they charge.)  

On Performance

Risk-adjusted performance, properly measured, should theoretically determine competition among advisers for client assets.  Over time, funds should flow to better performing advisers and advisers should compete over fees, services (increased breadth or greater specialization), or both.  Yet this could not be further from the actual outcome.  If mutual fund performance is any indication of investment adviser performance, the worst performers tend to charge the highest fees.

So why do clients all but ignore performance when choosing an adviser?  There are two major causes.  First, the performance data itself are largely absent.  The wealth management industry lacks a third-party, objective, centralized database of adviser performance at any level.  Even where data are collected, they to be at the aggregate level across clients, or in the form of model portfolios.  Since each client typically has a unique investment mandate and special investment goals and financial circumstances, performance data aggregated across diverse clients is unhelpful.  Model portfolios are a poor substitute for client-level data.  And to complicate matters further, investment advisers are legally limited in how they can calculate and publish performance-related information.   

But issues with capturing and analyzing performance data, while significant, are surmountable – we’ve done it here at Finom.  There is a actually deeper, underlying reason why advisers are averse to sharing and ‘leading with’ their performance.  It is simply not in their financial interest to do so.  The logic is straightforward.  If manager-specific trust empowers advisers to invest client wealth in risky assets, and if advisers generally charge based on the riskiness of the investments they manage, then advisers have every incentive to invest in ‘hot’ (increasingly risky) assets to earn higher fees.  Since ‘hot’ asset classes historically underperform ‘value’ or even benchmark indices, advisers underperform their benchmarks in the long run, especially after fees and expenses.  And who wants to ‘lead with’ underperformance in a client meeting? 

Perversely, the riskier the portfolio, the more the client ‘trusts’ the adviser, and the less likely she is to fire a poor performer.  And worse, rather than speaking truth to money and risk reducing such trust (and fees),  advisers may pander to clients who like ‘hot’ assets, thereby building even greater trust (and earning even higher fees).  This dynamic reduces investor mobility to better performing managers, ensures high fees, and cements the gravitational pull that large advisers exercise over client assets.

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