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Send  Share  RSS  Twitter  22 Jan 2009

FINANCE: Beware Some 'Financial Advice'


Recent Western Cape Business News

With the current global economic turbulence and recent financial market turmoil, investors may tend to seek guidance and comfort from many sources. In times of crisis the average investor is inclined to turn to their financial advisor. 

“Difficult circumstances often present the ideal opportunity to evaluate the status quo,” says Darron West of Cape Town-based Foord Asset Management.  “The role of the financial advisor cannot be excluded from this process.”

According to West the real value of professional financial advisors is in assisting investors with the requisite planning of their financial affairs and to give guidance for the maintenance of financial discipline.

“To this end, a financial advisor should spend time with a client, soliciting relevant information in order to conduct a thorough financial needs analysis, which takes matters such as the investor’s age, current income or income requirements, the adequacy of insurance, the extent of debt and the investor’s current portfolio of assets into account.

“On the basis of the needs analysis, the financial advisor should compile and present a long term financial plan for the client.  The long-term perspective is critical because it sets a basis for making pragmatic, rational decisions that are not unduly influenced by short-term market circumstances.  Also, such a decision-making basis makes the maintenance of financial discipline more likely.”

However, West warns that the preparation of a long term plan does not preclude the need for a periodic review, in much the same way as receiving a clean bill of health from a doctor does not absolve the patient from having subsequent annual check ups.  “Since a client’s circumstances and needs may evolve, so the long term plan may require review and revision.

“In an investment environment characterized by overwhelming and sometimes unnecessary choice, the financial advisor has a responsibility to carefully and diligently limit the number of choices that an investor should make, specifically in terms of fund and fund manager selection,” says West.

“For these services, the professional financial advisor deserves to be paid a fee that is fair and reasonable.  However, Foord Asset Management’s view is that there are two key problems that make the reality of financial advice somewhat different from the described ideal.”

First, consider the problem of asset allocation, product and fund manager selection.

West advises that financial advisors are not fund managers, and as such, they should not be making tactical asset allocation decisions.  “Stated differently, financial advisors should not be deciding whether investors should be exposed to specific sectors in the equity market.  The proliferation of sector- and style-specific funds may induce some advisors to take on an active role in asset and sector allocation, which might be detrimental to the client’s best interests.

“At best, financial advisors should consider how much of a client’s portfolio should be invested in cash, but then only in an effort to service continuing income requirements, rather than in an effort to manage risk and returns.

“In general, we would consider a client to be well advised by a financial advisor if presented with a recommended allocation of cash to fund income requirements, and a shortlist of flexible asset allocation unit trust funds managed by fund managers who have proven, consistent, long term track records of performance excellence,” says West.  “Of course, a younger client with a long investment horizon may find an equity fund (which has higher volatility) more appropriate than a flexible fund.  Equally, a much older client with a short investment horizon might be better suited to a stable fund with lower volatility.  In our experience, though, the flexible fund default option is a good one.

“But at Foord, we take particular issue with ‘broker funds’.  These are unit trusts offered directly by brokers or financial advisors, the underlying investments of which are typically other unit trusts managed by fund managers.  This kind of fund requires additional fees to be recouped from the client, which erodes returns.  Furthermore, a ‘broker fund’ presupposes that the broker or financial advisor is better equipped to make tactical asset allocation decisions than a fund manager, which may not be true necessarily.”

The second key problem of financial advice, says West, is initial or upfront fees of any kind that are levied against the investment as well as excessive ongoing fees, which should be avoided.

“One of the first rules of investment success is to minimize ’friction’ or costs, since these serve only to reduce wealth.  Presently, financial advisors typically charge an upfront fee or commission of between 1% and 5% of the amount invested.  Furthermore, financial advisors also earn ongoing fees or trail commissions of between 0.5% and 1.5% of the value of the investment per annum.

“The percentages seem paltry, and it is exactly this notion that leads investors to accept such a fee structure.  However, the ultimate costs involved can be substantial:  Consider a R100 000 investment made with Foord 20 years ago.  Over that period, Foord has returned some 20% per annum.  Without the advisory upfront and ongoing fees, this investment would have been worth R3.8m today.  After the deduction of an upfront fee of 5.7% (5% plus VAT) and the payment of an ongoing fee of 1.14% per annum, the investment would have been worth only R2.9m today.  The difference of R900 000 is the effective cost of the advisory fees!”

West states that the fraternity of financial advisors has itself begun to question the remuneration model for its services.  “Many have argued that it is more appropriate for investors to pay a time-based fee to a financial advisor for services rendered, in much the same way as one would pay other professionals such as doctors, lawyers and accountants.”

“Foord doesn’t dispute the valuable role that financial advisors can play for investors.  However, we encourage investors to engage with their professional advisors, determine precisely the services being rendered and negotiate a fee, in absolute terms, for those services.”

“In the management of one’s investments, it is fair to say that the financial advisor can provide useful involvement, but the risks and rewards of investing are the investor’s alone. Understanding that costs erode returns, investors would do well to consider implementing the recommendations of the advisor themselves by investing directly in an appropriate fund with a suitable fund manager,” concludes West.

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