4 Questions You Should Be Asking Your Financial Advisor

1.) What am I paying in fees ALL-IN?

It’s the sage investment advice du jour: lower your fees! With the growing skepticism over managers’ ability to consistently produce alpha (or equivalently, the ability to consistently identify managers, a priori, who are able to produce alpha), comes the consolation that reducing costs, all else equal, is a surefire way to boost returns. The most obvious investment cost is the expense ratio attached to a fund. This is the fee charged by the manager to do the job of deciding which assets to hold in the fund. An “active” strategy, wherein the the manager attempts to identify assets that will outperform in some sense, requires time, research and talent — all of which cost money and are not even guaranteed to succeed. Better to just fire the highly-paid, ivy-educated investment manager and simply try to copy an existing index. Despite some claims that passive managers are rotting the innards of capitalism, this was a much needed and inevitable evolution of the market.

An example: I was discussing one of the prominent robo-advisors with someone who travels in “fintech” circles. I questioned why he chose to invest with them as opposed to simply purchasing a “target-date” fund from a place like Vanguard. After all, if they are both just implementing similar passive strategies, why pay a premium at a robo-advisor? While there are many legitimate reasons, perhaps centered on a superior user interface or better service, he told me that while the Vanguard fund was something like 16 bps, they were slightly cheaper at at 15 bps. “Ok,” I thought, “Can’t argue with that.” But I did wonder how this startup was able to undercut the operational behemoth of Vanguard. Taking a look at their website, I verified, indeed, the very low management fee. However, this fee did not include the expense ratios of all the underlying funds in which you were invested. The robo-advisor fees essentially doubled the all-in cost. Vanguard had no such extra layer of fees since they were investing in their own ETFs.But now we have a cohort of investment managers falling behind on their Jaguar payments looking for new ways to charge their customers — ways that maybe aren’t so obvious and may go un-noticed. Taking a cue from the retail sector, some financial firms find ways to obfuscate the true costs through a strategy; instead of paying your manager X% per annum, you now pay Tom 50 bps (basis points, or 1/100 of a percentage point) a year who invests in funds managed by Dick who takes another 15 bps a year and executes his trades through Harry who takes a few cents off the top for each time he has to click a button. What the consumer faces is a mess of fees, charged at differing intervals, some expressed in percentages, others in dollar-terms. The investor is unable to effectively comparison shop, hobbled by information asymmetry.

So there it was: a sophisticated investor attempting to buy a simple passive strategy from a startup citing their transparency and he still was completely misinformed as to what he was buying and how much he was paying for it. And not wrong by a little bit. Off by at least a factor of two and in such a manner that he may well have made a different decision with proper information.

What’s the moral here? After your investment advisor shows you the sticker price, don’t simply nod. Ask them if that is your all-in cost. Ask them how much you pay, in dollar terms, for all your investments, all the way down to the last trade clicker charting two cents per trade. The number may surprise you.

Decipher looks across all your accounts, aggregating expense ratios, trading commissions and account fees and puts them all in a single dollar amount: You are paying $X per-year for your investments.

2.) How do you integrate held-away accounts?

Another buzzword keeps coming up: “holistic” asset management. And it makes total sense. The problem, though, is that that the term is not very well defined. Intuitively we can understand that we should want to manage all our finances, not just certain parts. Without going into the mathematical details of how a holistic financial strategy can outperform one that is limited in its purview, we can safely rely on our intuition: we can achieve better results, quantitatively, by managing all our finances in a cohesive manner. If that is not obvious, imagine an advisor (robo- or otherwise) who formulates a risk profile for an investor and then advises that she should have a 20% allocation to high-risk equities. Would the advisor still make the same recommendation if he knew that the investor already had 50% allocation to high-risk stocks in another account? We would think not. So, at the very least, one should inquire as to whether any financial advice considers one’s entire portfolio.

The second question to ask is: How is this information incorporated into an overall financial plan? For instance, If one has a large portion of their portfolio invested in Apple AAPL, would the investment advisor simply reduce exposure to equities? To tech equity in particular? Given that Apple is the biggest component of the S&P 500, any purchase of this broad index only further increases the investor’s exposure to the idiosyncratic risk of iPhone sales.

Decipher not only looks across all your accounts, but is able to intelligently aggregate risk factors across them and control further unnecessary exposure.

3.) How are you managing my tax liability?

One of the most important things to realize is that pre-tax returns mean nothing. And by that I mean the following: Let’s say you bought IBM at $100 and sold it a week later for $110. How much money did you make? Well, if you are in a top end of the income spectrum and are paying 39.6% in short term capital gains, then you just made $6.04 (= 10 x (1-.396)), not $10. the mantra is: you can only spend after-tax dollars. Imagine the same trade was made in a Roth IRA. Now you do make $10 in profit. That’s a 66% increase in your money!

I was speaking with an investment advisor recently and I asked how they managed the effects of taxation in their advice. They told me, “yeah, yeah. We do tax optimization.” “Impressive,” I thought, “that’s a very difficult problem that I’ve spent a lot of time working on.” On further questioning, though, it became obvious that he had a very narrow view of the topic. What he did was “try” to avoid short-term capital gains where possible. To be clear, this is not tax “optimization.” The problem here, as is often the case, is lack of a common vocabulary. Tax optimization encompasses many techniques that, in concert, reduce taxes paid. Avoiding short-term capital gains is certainly a part of the tax problem, but it is just the beginning.

True tax optimization starts with tracking your tax lots to ensure that you are able to minimize taxable gains. It requires, as mentioned, tracking when positions were purchased so that short-term gains can be avoided where possible. But what are the situations in which the higher cost of short-term gains is justified? This is where we arrive at the larger question: How do we construct a portfolio across accounts with different tax treatments in a way that maximizes your after-tax returns? Sure, there are heuristics such as “Put dividend investments in a tax-advantaged account,” but heuristics are vague at best and incorrect at worst. For instance, it was recommended to me to put interest-bearing instruments in a tax-advantaged account due to the unfavorable tax treatment of interest income. This advice rings a bit hollow, though, in the ear of zero interest rates. The truth is that there is no universally accepted methodology or benchmark for tax optimization. Anyone claiming such a feat has a large burden on their shoulders in terms of credible explanation.

At Decipher we’ve dedicated ourselves to constructing an over-arching framework to manage taxes across your entire portfolio. We’ve found that tax management is perhaps the best way to put more investment dollars back in your pocket.

4.) How do you limit my risk?

In just about any discussion of investment or finance, the word “risk” is likely to arise. What may not be obvious is that there is no universal quantifier of this concept of “risk,” though you might not infer this from the popular literature. Why? My guess is that people would think twice about paying for financial advice from someone who admitted to relative ignorance of arguably the most important aspect of investing: risk.

That said, there are some accepted ideas. A common measure of risk is defined as the volatility or variance of returns. What this means is that a person would prefer to get a paycheck of $2000 a week, rather than $4000 some weeks and $0 on others. Planning for life is difficult enough without worrying about whether this is a week that you don’t get paid. But there are other measures as well. For instance, there is something called “drawdown” which, in the context of investment, quantifies the maximum amount I might expect to lose on a given horizon. Looking at my investments in retrospect, my monthly drawdown would be the biggest loss I experienced in any individual month and looking forward, it is the amount I might expect to lose in any particular month over the horizon of my investment. I’d argue that this is closer to what I personally consider to be the “risk” of my investments. As an example, let’s say that during the last big market crash in 2008, my retirement savings went from $200,000 to $120,000 over the course of a month, a 40% loss. Watching that $80,000 disappear from my worth would be incredibly difficult and my actions, whether to start selling during the period or to hold steady, would reverberate across my entire lifetime, drastically changing the money available to me for retirement or my child’s college tuition.

There are ways to control drawdown, but they are not nearly as well understood as the more prevalent concept of variance. But that’s not an excuse for ignoring it. If you care about losses, ask your financial advisor about your possible losses and to quantify them in some way.

At Decipher we consider a measure known as Conditional Value at Risk, which is similar to how large institutions measure their downside risk. Focusing on controlling for this allows a whole new set of portfolios to be constructed that protect the investor during market downturns. Maybe I was forced to sell during that loss — not because I was naive, but maybe because I needed to safeguard that last $120,000 for college tuition. Had I invested in a portfolio that had only lost $60K, I would have been able to push through. The point is that by identifying the type of loss you can tolerate, and by controlling for Conditional Value at Risk, you stand a better chance of not obliterating your long term goals in the next market crash.

So talk to your financial advisor. Ask some of these common sense questions. Remember, you are paying them to know and care about these issues and they owe you more than vague reassurances.