Economics

Using Financial Advisors: A Cautionary Tale

Charles retired in his mid 50s in May 2016 from a career in Canadian banking. He relies exclusively on income from rental properties and a dividend income stream from a portfolio he amassed over several years.

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If you are reading this article I suspect there is a high probability that you actively manage your investments or something has occurred which has prompted you to consider becoming more involved in the management of your money.

I strongly suggest you be involved to some extent in the ongoing management of your personal wealth unless:

  • You are extremely wealthy and your funds are being managed by a family office
  • You can generate substantially more income through your area of expertise and you have someone you trust implicitly to manage your investments (your role is to regularly review what investments are being made on your behalf).

Today’s article is a cautionary tale of what can happen when you turn over full discretion to a ‘Financial Advisor’ and you pay minimal attention to what is going on.

Note: Throughout the remainder of this article I will be using the term ‘Financial Advisor’ in quotations but please be cognizant that I am being very liberal when using this term.

Background

Several years ago, a couple (Mr. and Mrs. Investor) in their early 70s became increasingly dismayed at the results their financial advisor was generating on their 7 figure portfolio (the figure starts with a number higher than 2). They voiced their displeasure with the advisor’s superiors and their portfolio was transferred to a ‘Vice President, Associate Portfolio Manager and Wealth Advisor’ at one of Canada’s largest financial institutions.

A full review of this couple‘s investments in their Registered Retirement Income Funds, Tax Free Savings Accounts, a personal non-registered investment account, and an investment account in a company name was undertaken.

The typical ‘Know Your Customer’ due diligence was performed, totally inappropriate investments were liquidated, and the proceeds were reinvested in other investments. In addition, the standard fee structure was revised downward.

While nothing was put in writing as to what return this couple’s portfolio could expect to generate, both Mr. and Mrs. Investor recollect the ‘Financial Advisor’ indicating that he should consistently and safely be able to generate a return in excess of 3%.

Recent Events

In October 2017, Mr. Investor was attending a monthly event at a local Italian Club when he was approached by an acquaintance asking him for his opinion of this ‘Financial Advisor’. Apparently, this individual was using the same ‘Financial Advisor’ and was having some reservations about the performance of his investments under management.

Mr. Investor refrained from engaging in any detailed conversation on the matter. Upon his return home, however, he began to perform ‘back of the envelope’ calculations to get an idea how the investments had performed in 2014 – 2017. The results were less than impressive which thus prompted Mr. Investor to ask me to review the situation.

Process

I gathered the monthly statements for 4 years for 6 Canadian dollar and 6 US dollar accounts.

Using a spreadsheet, for which I provide a template, I calculated the annual returns for 2014 – 2017. I essentially replicated fields so I could analyze each Canadian and US investment account. Once I had compiled all this information, I generated consolidated Canadian and consolidated US results for each year.

Click here to download the spreadsheet now

You will note I have a row labelled Total Income (TI) and another labelled Total Inv Return (TIR) in the spreadsheet. TI encompasses just the dividends, interest, and other income actually received. TIR includes the TI revenue plus any change in market value versus the previous year end.

The reason I wanted to determine the level of actual income generated exclusive of any change in market value is because:

  • Changes in market value fluctuate and are not permanent gains until the investment is sold
  • Mrs. Investor’s primary focus was to generate income to cover living expenses and to leave the capital as part of their estate.

The only significant depletion in capital was expected to come from the mandatory annual minimum Registered Retirement Income Fund withdrawals.

In addition, Fees and Taxes (F&T) can have a huge negative impact on investment returns. I, therefore, tabulated the annual fees and taxes for each account and calculated the returns inclusive and exclusive of fees and any change in market value.

Fees

Fees are levied solely in Canadian dollars. All fees and taxes are calculated on the combined Canadian and US investments held in each account although the amount held in US investments pales in comparison to the amount held in Canadian investments.

If you don’t think fees and taxes have a significant impact on returns have a look at the following results while keeping in mind Mr. and Mrs. A negotiated a favorable rate in regards to the management of their investments.

Total income before fees and taxes as a percentage of the total portfolio value in 2014 – 2017 for the Canadian investments amounted to 2.14%, 2.22%, 2.9%, and 1.78%.

Total income after fees and taxes as a percentage of the total portfolio value in 2014 – 2017 for the Canadian investments amounted to 1.14%, 1.20%, 1.83%, and 0.96%.

Total investment returns (includes the change in market value of the holdings) before fees and taxes as a percentage of the total portfolio value during the same period, amounted to 3.06%, 0.41%, 3.40%, and 2.61%.

Total investment returns after fees and taxes during the same period amounted to 2.06%, (0.62%), 2.34%, and 1.79%.

Note:  The market value of the consolidated holdings experienced a significant drop as at December 31, 2015 versus December 31, 2014. This explains why the total income that year exceeded total investment returns.

On the US side, total income as a percentage of the total portfolio value amounted to 2.43%, 0.79%, 0.97%, and 1.23%. Total investment returns as a percentage of the total portfolio value amounted to 8.56%, 0.9%, 5.74%, and 11.32%. While the US investment returns were somewhat satisfactory, less than 7% of the entire portfolio was held in US investments.

Every time the ‘Financial Advisor’ met Mr. and Mrs. Investor, he would always quote percentages; he would never discuss actual dollar values. Percentages can be very misleading.

I don’t want to be accused of falling in the same category as the ‘Financial Advisor’ so let me give you the cold hard facts in monetary terms.

Over a four year period:

  • The investment portfolio generated ~$250,000 in income
  • The cumulative change in market value was ~$12,000; 2015 was a BAD year!
  • Fees amounted to a little over $110,000.

In addition to all the fees reflected above, some of the investments are held in mutual funds. A quick review of the management expense ratios (MERs) for these funds indicate they are generally in the 1% range. That is another drag on Mr. and Mrs. Investor’s returns.

There’s more!

Canadian investors get hit with a 15% withholding tax on US dividends except when the shares are held in Registered accounts. Rather than holding a significant proportion of Mr. and Mrs. Investor’s US holdings in their Registered accounts, they are held in the Tax Free Savings Accounts and in non-Registered accounts. As a result, Mr. and Mrs. Investor’s returns are further being negatively impacted from the taxes withheld on the US dividends earned.

Foreign Exchange

One has to wonder what the ‘Financial Advisor’ was thinking in 2014 and early 2015 when the Canadian dollar was extremely strong relative to the US dollar. Given the fees Mr. and Mrs. Investor pay for the management of their investments, I would have thought the ‘Financial Advisor’ would have taken advantage of the strong Canadian dollar.

Several economists repeatedly indicated that such a strong Canadian dollar was unsustainable over the long-term. Sure enough, the Canadian dollar weakened relative to the US dollar.

Using Financial Advisors
Just increasing the proportion of the investment portfolio invested in US Dollarsn 2014 would have likely contributed to a reasonable improvement in returns.

As an aside, when I assumed oversight of my elderly mother’s investments in mid-2015, I liquidated high fee Canadian dollar mutual funds and converted a significant percentage of her Canadian Dollars to US Dollars. I then deployed these funds into high quality US listed blue chip stocks.

The results have far exceeded my expectations. Her portfolio incurs no fees and on a portfolio that is 25% the value of Mr. and Mrs. Investor’s portfolio, my elder mother generates dividend income that is roughly 43% of the net income generated on Mr. and Mrs. Investor’s portfolio.

While the Canadian dollar has recently strengthened subsequent to early 2016, I had no intention of liquidating the US holdings to take advantage of the strengthening of the Canadian dollar; the tax liability would have been too significant.

Now, indications are that the Canadian dollar will likely experience some weakness relative to the US dollar in the coming months. You think the ‘Financial Advisor’ would have at least proposed the conversion of some Canadian Dollars to US Dollars to Mr. and Mrs. Investor? No proposal has been made to date and I strongly suspect no such recommendation will be forthcoming!

Asset Mix

As previously noted, Mr. and Mrs. Investor have multiple accounts. Each account serves a different purpose and funds in some accounts will never be accessed during their lifetime. Given this, you would think the ‘Financial Advisor’ would recommend that different assets be held in different types of accounts!

In reviewing the holdings within some accounts for which funds will never be accessed, I see several hundred thousand dollars invested in 5 year Guaranteed Investment Certificates (GICs); the ‘Financial Advisor’ essentially created a ladder of GICs. Several of these GICs were purchased when rates were extremely low so several yield ~2%.

To make matters worse, several hundred thousand dollars of GICs are held in a fully taxable account. Mr. and Mrs Investor are in the highest income tax bracket so the GIC income is going to be taxed at exorbitant rates.

Risk

While a significant proportion of the investments are held in very low risk investments on which negligible returns are being generated, there are some investments which should have never been purchased. Some of the investments are in companies which are rated Ba1, Ba3, Baa3, and BBB by the major ratings agencies (refer chart).

One of the ‘dogs’ is Cameco Corporation (NYSE: CCJ) which recently announced that due to continued uranium price weakness, production from the McArthur River mining and Key Lake milling operations in northern Saskatchewan will be temporarily suspended by the end of January 2018 and that the company’s annual dividend will be reduced to $0.08 per common share in 2018.

In February 2017, S&P Global Ratings downgraded Cameco from BBB+ to BBB. This is a lower medium grade credit rating.

Other ‘dogs’ in which Mr. and Mrs. Investor have invested include Norbord (rated Ba1), Vermillion Energy (rated Ba3), and Barrick (rated Baa3); these are all Moody’s ratings.

Then you have Boardwalk REIT. Throughout the better part of 2016, Boardwalk made a monthly distribution of $0.1875 of which $0.11795 was a Return of Capital. The 2017 Statement of Trust Income Allocations and Designations is still not available on the company’s website but I strongly suspect investors will not see any significant improvement.

Diworsification

Peter Lynch, the great value investor, coined the term diworsification in his book ‘One Up on Wall Street’. Essentially, this concept arises when you invest in too many assets with similar correlations that will result in an averaging effect.

I am far less eloquent than Mr. Lynch so I use the term ‘throwing mud at the wall’ when I describe what Mr. and Mrs. Investor’s ‘Financial Advisor’ has been doing.

I am frequently referring to the various investments statements as I compose this article. As I look at the December 31, 2017 statements I see the following:

  • Arc Resources: 142 shares
  • Alimentation Couche-Tard: 53 shares
  • Brookfield Asset Management: 68 shares
  • Canadian National Railway: 49 shares
  • Canadian Pacific Railway: 2 shares
  • Fortis: 51 shares
  • Royal Bank of Canada: 26 shares
  • Sun Life Financial: 45 shares
  • Amazon.com: 3 shares
  • Apple: 25 shares
  • MasterCard: 22 shares
  • Microsoft: 50 shares

Ridiculous!

In 2017, there were in excess of 100 ‘Buy’ transactions and in excess of 75 ‘Sell’ transactions. Fortunately, the fees Mr. and Mrs. Investor pay include trade related fees otherwise at $9.99/trade that would have been another ~$1750 in fees!

Perks

In addition to receiving inferior investment advice from this ‘Financial Advisor’, Mr. Investor has been entertained by the ‘Financial Advisor” to some Detroit Red Wings hockey games. The ‘Financial Advisor’ also brought Mr. Investor to one of Berkshire Hathaway’s annual general meetings in Omaha, Nebraska a few years ago.

I asked Mr. Investor if the ‘Financial Advisor’ ever had the courtesy of thanking Mr. Investor since Mr. Investor ultimately ended up paying for this perk. The answer… ‘No’.

Perhaps if the ‘Financial Advisor’ had paid any attention to Messrs. Buffett and Munger while at the Berkshire Hathaway Annual General Meeting he would have learned that neither of these gentlemen advocate the level of buying/selling activity witnessed on Mr. and Mrs. Investor’s accounts!

In addition, the ‘Financial Advisor’ once bragged to Mr. Investor that he spent roughly $65,000/year on Christmas gifts to his clients; the clients ultimately pay for these gifts!

Before Christmas Mr. Investor communicated his intent to transfer all accounts elsewhere. Perhaps this explains why Mr. and Mrs. Investor received no Christmas gift this year!

Final Thoughts

Folks, if you think I am making up this stuff I assure you I am not. It has pained me to pen this article but I thought it would be worthwhile to share this tale of woe in the hopes of helping readers avoid a similar predicament.

Don’t, however, take this tale out of context. There are truly some very highly experienced and ethical financial advisors well worth their fees. I certainly do not want you to walk away with the impression that all advisors are like the ‘Financial Advisor’ to which I refer in this article.

Having said this, even if you have an excellent financial advisor, I urge you to keep a watchful eye over your investments. If you have questions about what you see on your statements do not hesitate to ask tough questions.

Finally, regardless of whether you wish to outsource the management of your investments or you wish to take on that responsibility, please never lose sight of the impact fees can have on your overall returns.

Watch the Pennies and the Dollars

Thanks for reading this article. Please send any feedback, corrections, or questions to ben@suredividend.com.

Article by Charles Fournier, Sure Dividend