Regularly, I’m asked:
How do I check if my investment advisor has given me good advice?
How is your investment portfolio performing against the index (or average) of the markets in which you are invested?
And in my experience, the majority of people I ask tell me that they don’t know.
There are other factors that determine good investment advice besides performance. But it surprises me how many intelligent people don’t think to check the performance of their portfolio against the average market return. Especially when they’re paying an advisor a fee for investment advice.
Investment advisors often promote themselves on their knowledge of the market, their skill in portfolio construction and their experience in selecting great investments but it’s often hard to prove the truth of those claims.
So how can you check your investment advisor’s advice, to see if it justifies their fee?
And how do you check your portfolio isn’t performing worse than average?
If your investment advisor charges you a fee on the basis they can beat the market average, and they are not doing that, then you are wasting your money.
Understand how you’re invested (and in what you’re invested)
Your portfolio isn’t (and shouldn’t be) exactly the same as somebody else’s, because your needs and circumstances are different. So, before you can judge the performance of your portfolio, you need to understand what you are invested in.
I’ve covered investment fundamentals elsewhere so I won’t repeat it now except for encouraging you to check whether you’re holding shares, cash, fixed interest or property.
Write down the percentages in each asset class. As a general rule, the greater the proportion of cash and fixed interest, the more “conservative” and “income focused” is your portfolio. The greater the proportion allocated to shares and property, the more “aggressive” and “growth oriented” is your portfolio.
Within those asset classes, your portfolio may be weighted towards small companies over large, emerging markets over developed, value stocks over growth – and other strategies designed to produce a specific risk and return. You may even have derivatives or alternative asset classes, such as infrastructure or precious metals. Regardless, start with the broad asset classes and go from there.
You can look up the details of each investment online – and your advisor should have given you a “Product Disclosure Statement” or “Fact Sheet” for each investment when they gave you their advice.
Try to ascertain the underlying strategy used by your advisor or fund manager within each asset class in your portfolio eg. You may have a managed fund that invests mostly in large Australian companies within the ASX100.
It may seem complicated and involved but it’s an important first step in judging performance; without knowing what you have, how can you compare your portfolio to other investments?
Incidentally, if your portfolio’s investments don’t fit with your approach or make you uncomfortable, speak to your advisor immediately and find out why. If they can’t explain how the portfolio suits your needs, then it may be time for another advisor.
Understand your net return
Many advisors (and many fund managers) highlight their performance but they often present gross returns and seldom show the return after fees. Management expense, performance fees and transaction costs such as brokerage reduce your net return.
These fees and costs can be the difference between beating the index (or market average) and lagging behind it.
There are also inconsistencies in the way returns are presented.
Returns can be presented as a simple average, where the returns for each year are added up and divided by the number of years.
A simple average is fine if you want to measure someone’s batting average over a season. But with money, you do not reset back to zero each year (as you do at the beginning of a game). Rather, you begin the year with your balance from the end of the year before.
A better way to present investment return is to show the compound average.
The easiest way to demonstrate why a compound average is important, is to consider what happens to your portfolio if you have a -50% year followed by a +50% year. Instinctively, most people assume a net return of zero (which would be the average return).
However, if you have $1,000 and it drops by 50%, you end the year with $500. If the next year yields a 50% gain, your balance goes up to $750, a net return of -25% from when you started. Put another way, if you experience a 50% drop, you need a 100% gain to get back to your original balance.
Another misrepresentation of portfolio performance is to only show the annual returns of each of the investments in your portfolio. It is more useful to see your portfolio’s starting and ending balance, with a net return for that period. Volatility has a significant effect on your net return and you might have invested at a high or low point in any one year.
Also, make sure your portfolio report shows any investments you were advised to redeem during that period, perhaps because of underperformance (or expectations of under performance).
And remember; ask for a report that shows the return net of all fees, including your advisor’s ongoing fee (in my experience, you’re unlikely to be given it without asking).
If your advisor won’t provide a report net of all fees, simply deduct any advice fees and transaction costs (such as brokerage) out of the gross return over that period. The result may surprise you, and you might find you are getting a lower return than you thought. If you’re positively surprised, then you might want to hang on to your advisor.
Find a benchmark
Some advisors may highlight their success by showing their returns relative to another type of fund, the inflation rate or the current cash rate.
Don’t buy this approach, however nicely it’s presented to you, because these aren’t useful comparisons at all.
I’ve seen advisors justifying their ongoing investment advice fees based on the fact their client was invested in cash when they took over the portfolio. Even if you didn’t know you could get a greater long term return from shares than cash, I still don’t think that piece of advice deserves a huge cut of your ongoing profits.
You have to compare apples with apples. To find an appropriate benchmark, you will need to look at the assets that make-up your portfolio (as per the previous section).
If you have an Australian share portfolio containing only stocks in the ASX top 50, then you could compare your portfolio’s performance against the ASX50 index. You can look at the returns of all ASX indices online.
Managed funds are a little more complicated. A managed fund could be made up of different assets, markets, various sized companies, credit risk, etc. Look at the underlying investments and decide on an appropriate index (you can use http://au.spindices.com/index-finder/as a starter).
Managed funds are also required to make reference to a benchmark in their own literature (check the relevant funds Product Disclosure Statement online). And look at the specific funds website for a performance against a benchmark.
If you have a stock broker or advisor who recommends specific stocks from the top 20 Australian shares – on the basis that those stocks will outperform the rest – then the easiest way to check your advisors performance is to compare the return of your portfolio with the ASX20, which is published online.
Decide a time frame
Market conditions suit certain strategies at different times (value v growth, small v large cap, etc). Stocks generally require a few years investment. So you will have to decide what time frame your advisor’s strategy needs to produce a result.
Most managed funds struggle to deliver consistent returns over time (and, in fact, consistent returns over time can suggest bigger problems). When you talk to your advisor about your returns, you need to appreciate current market conditions, but without accepting excuses.
While a degree of patience and understanding is required for any investment, if the fund never performs as expected, for any reason, then your patience and understanding could significantly disadvantage you.
So, beware the excuses that are a part of an active investment manager’s armoury: telling you that the market hasn’t suited their strategy or that things didn’t work out as expected may just be the spin they apply to a lack of investment knowledge, lack of skill or a defective strategy.
Finally, decide if your investment advisor is worth their fee
If there is a negative gap between your portfolio’s performance and the average market return, then ask your advisor for an explanation. If you are not happy with the answer, then maybe your interests don’t suit your advisor’s interests.
If you are paying your investment advisor a fee on the basis that they can beat the market, and they are not, then you should think about what you’re getting for the money you pay.
While investment performance may be only one valuable element of your relationship with your advisor, if you’re paying a premium for investment advice that’s delivering no value, then the cost is probably too great.
And you might be smart to question other aspects of the advice you are getting.
It’s important to understand that performance, although an important consideration, is not the only point to consider when you’re thinking about your financial strategy and its appropriateness to your needs and circumstances.
However, it’s no coincidence that most independent advisors recommend (successful) passive investment strategies and hold themselves accountable for the net performance, after fees. As an independent advisor is only paid by you, they do not benefit from recommending an active portfolio that earns more brokerage and ongoing fees for themselves and their employers.
Speak to your advisor and if I can help you, then contact me directly at firstname.lastname@example.org.
It’s no coincidence that most independent advisors recommend passive investment strategies. As an independent advisor is only paid by you, they do not benefit from recommending an active portfolio that earns more brokerage and ongoing fees for themselves and their employers.
A “quick check” method for assessing your investment advice…
Many financial advisors love to recommend a direct Australian share portfolio and use managed funds for the other asset classes. If you want to quickly check the performance of part of your portfolio, note the stocks your advisor has recommended and check your share portfolio’s net return against the ASX index that contains most of your stocks.
For instance, if you have an Australian share portfolio containing only stocks in the ASX top 20, then compare your Australian share portfolio’s performance against the ASX20 index.
If you advisor is going to charge you a fee predicated on their ability to pick the stocks that will perform best, I’d think that you’d expect a result that makes up for that fee.
And, just keep in mind; the ongoing fee for an ASX20 ETF is around 0.24% p.a. That’s the price for buying a portion of all the stocks in that index. I would recommend far greater diversification than only the top 20 stocks in Australia, but it’s a useful comparison, as many financial advisors and most brokers recommend shares from this list.
And remember, if your financial planner is ‘outsourcing’ the investment management of your portfolio via expensive managed funds, then make sure you are not double-paying for investment advice by paying your planner a high fee for managing the portfolio (check out this article for more detail “Index v Active Funds: The Hidden Costs Your Financial Advisor Isn’t Telling You About”).
Do your homework…