Wealth Management Of The Body Snatchers

Phil DeMuth, Contributor
3/17/2014 @ 11:00AM |4,974 views
Wealth Management Of The Body Snatchers
On my desk is a 76-page investment proposal from the wealth management department of a world-famous financial services firm. Having reviewed it, I can tell you this much: these aren’t the droids you’re looking for.

They approached a friend by asking him what his idea was of a good investment. ”An S&P 500 index fund,” he replied.
No fool, he. As has been shown endlessly, these simple index funds beat most managers over time. Read anything by John Bogle for the lowdown here.
Within days, their better mousetrap was in his hands. Since he had no interest in investing with them, he gave it to me for my cabinet of curiosities. Here’s what was inside:
The wealth management department proposed that he invest with two managers they selected, dividing his money evenly between them. The results of this hypothetical investment were portrayed on 29 pages of colored charts. The message was inescapable. Again and again, whether you looked at the past year, three years, five years, seven years, or ten years, these managers peeled the paint off the S&P index. No matter which way you turned the graphs, they were Toppermost of the Poppermost. Not only that, their returns were achieved with scarcely more risk than the index itself. While $1 invested in the S&P over the past decade grew to a little over $2, $1 invested by their playbook grew to more like $2.75.
In short, the report made you feel like life’s loser to even think of putting money in the S&P 500 index while rockstars like these walk the planet.
So, why did my friend pass?
20/20 Hindsight
Unfortunately, the bank neglected to provide the one thing he really needed to capitalize on their research: a time machine.
Whatever the many virtues of index funds, they do not beat every actively managed fund every year. There will always be a handful of actively managed funds that beat them. Since we can’t tell in advance which actively managed funds these are going to be, we are better off going with the index and beating most of them. Active management is a zero-sum game, so in total it has to underperform the index by the price of its significantly higher expenses. Over time, and as you move across asset classes, these benefits of indexing compound.
To look up funds that have performed better than the index isn’t shooting fish in a barrel, it’s shooting the barrel. Many are the time that I wished I had bought stock in Berkshire Hathaway a decade earlier. My next-door neighbor never tires of reminding me how he had a good feeling about Apple and bought it at the IPO. Then there’s that girl I should have asked out. We can torment ourselves forever about missed chances.
Instead, we pursue great opportunities after they have left the station, after we and everyone else have figured out they are great — or, at least, that they were great before we knew about them. I have no shortage of examples from my own investing here as well. What happens next is that they regress to the mean. In other words, the pursuit of outperforming investments, cruelly, ironically, perversely, leads to miserable returns, as we buy tickets to a succession of roller coaster rides that start at the top of the hill and ride them to the bottom. We get precisely the opposite of what we bargained for. Eventually, we wise up and go crawling to Vanguard with the few pennies we have left. John — let me in!
The interesting question is not whether [famous investment bank] is capable of looking up the names of two managers who beat the benchmark over the past ten years. To make the comparison fair, what we really need to know is the names of the managers they were actually recommending ten years ago — before they had the right answer. How did those chaps pan out? Then, did the bank perhaps change horses along the way? Did they recommend different managers seven, five, three, and even one year ago? What, then, is the cumulative record of their picks over the past decade when you daisy chain all of them together? Better than the index — or worse? I can guess. I doubt if they even remember who they were recommending ten years ago.
Expenses
I should add that the wingding outperformance colorfully displayed in the charts is before expenses. Here it gets curiouser and curiouser.
The managers they showcase charge management fees of 1.5% apiece for separate accounts. Yet, both of them run nearly identical mutual funds for under 1% in annual expenses. What, exactly, is the wealth management department bringing to the clambake?
Whatever it is, it isn’t free. I don’t know what the their fees are — curiously, amid the 76-page proposal they did not find room to mention them — but these guys typically charge 1% annually on assets under management just to turn on the lights in the morning. With a fat stack of fees compounding year after year and decapitating the top off the bar charts, one wonders what the net outperformance of these ringers really has been over the past decade. Alas, that part is not shown, either.
Executive Summary
Were they to portray the numbers honestly, who would invest with them? They are dangling these returns in an effort to lure investors into their pods, where they will be put to sleep and harvested for their fees. This is wealth management as invasion of the body snatchers.
Is the business case for institutional wealth management really just to use a firm’s famous name to take advantage of suckers? While there are suckers born every minute, the industries that depend on them — tobacco, gambling — are mostly relying on the fact that they are addicts as well. Wealth management clients are not. They wise up over time and will migrate to providers who offer value.