I’m writing today to illuminate a problem I’ve encountered when it comes to financial advisors and active investment management strategies. I call it “Investment Theater”.
For those of you who have read my writing, you might say to yourself, “Here we go again, he’s gonna write about how terrible active investing is!” However, nothing could be further from the truth.
Many everyday investors and/or their financial advisors often use active investment strategies. And that’s ok! I admit that I generally try to dissuade people from using active investment strategies (the odds are not in their favor after all). However, I can respect the notion that some people want to seek above-market rates of return. And I realize that there are some active investment managers that do a great job and deliver tremendous value for their clients.
Or maybe you just want a little more excitement in your investment portfolio. Low-cost, passive investing is often quite boring after all. And it certainly won’t spark much interesting conversation at a dinner party. Talking about buying the next Google or Tesla makes for much more interesting conversation than buying a total stock market fund.
Bare minimum threshold
However, today I’m focused on those investors and financial advisors that choose to use active investment strategies, but muck it up.
In my opinion, there is a bare minimum threshold of research and due diligence required to be successful in active investing. Without reaching this bare minimum threshold, any potential success will be driven purely by luck, not skill. And that’s akin to heading over to the casino with your retirement nest egg.
Let me give you an example of a typical situation I’ve encountered in my career. An advisory firm (I’ll refer to them as XYZ Financial) decided they want to pick individual stocks and bonds for their clients. Nothing wrong with that per se. But when it comes to the execution of their strategy, the folks at XYZ failed to meet that bare minimum threshold. What do I mean by that?
Well, common sense dictates that if you want to actively invest in individual stocks or bonds, then your bare minimum threshold for research and due diligence includes the following items:
- Read through all recent SEC filings including 10-K, 10-Q, and prospectus
- Locate and review any filings with other regulators (e.g. local, state, federal, and international)
- Conduct a deep dive into the company’s financial statements (as well as any footnotes)
- Develop an encyclopedic knowledge of the company’s lines of business and sources of revenue and expenses
- Understand the company’s corporate structure and shareholder mix
- Analyze the company’s tax situation
- Review any trade publications that mention the target company or competitors
- Review all recent earnings calls
- Investigate all major suppliers, competitors, and customers
- Review the background of every member of the company’s management team and board of directors
- Develop an understanding of the major investors in the company
- Create an estimate of intrinsic value for the company’s stock or bonds
- Create a framework to avoid cognitive bias when it comes to making decisions
- Formulate a strategy for trading the stock/bond with a focus on low-cost
- Have a plan B for when things go wrong
Needless to say, meeting this bare minimum threshold requires a huge investment of time, energy, and cost. A person could spend 10-20 hours or more reading and learning about just a single security. Now multiply that by 50 or even 100 securities and the time really starts to add up.
At a minimum, any financial advisory firm hoping to pick stocks for clients would need at least one or two highly paid professionals dedicated full-time to investment and security research.
Much like Warren Buffett and his investment colleagues sit in their offices and read for 8-10 hours every day, any firm engaging in active stock picking should have a laser focus on research and due diligence. In fact, here’s a good quote from Mr. Buffett:
“I just sit in my office and read all day.”
-Warren Buffett
Investment Theater
In the end, most of the firms like XYZ Financial decide not to invest the time, energy, and cost required. They rarely check off even a single item on the list mentioned above. After all, to be successful they don’t need to be great at investment management, they only need to be great at gathering assets.
And who can blame them? Financial advisors have a lot of demands on their time. They need to network and socialize (to gather those assets), create financial plans, meet with existing clients, review tax returns and estate planning documents, process paperwork, handle the day-to-day challenges of their business, manage a host of compliance concerns, perform continuing education, play golf, etc.
As a result, clients of firms like XYZ end up receiving the aforementioned “investment theater.” Clients get sold a fiction of sorts. They are swayed by their advisor talking about finding the highest quality investments. But in reality, the clients are just receiving repackaged talking points from the talking heads on CNBC or investment bank research departments.
What about active investment funds?
Most financial advisors will readily admit that picking stocks takes too much time. “But we can still use the best active investment managers in the world by using active investment funds,” they might say. “And due diligence for investment funds takes much less time and effort.”
Ok, then let’s take a look at the bare minimum threshold for active investment funds:
- Review the entire fund prospectus as well as any recent commentary by the fund’s managers
- Tabulate all fund related costs (including any sales, 12b-1, or other hidden charges)
- Calculate any overlap in securities across different funds and correct accordingly
- Review the background and qualifications of the fund’s manager(s)
- Review the background and financial solvency of the investment company offering the fund
- Develop a comprehensive understanding of the fund’s investment strategy
- Figure out whether the fund’s investment strategy will scale with future growth
- Understand the fund’s risk management policies and investment mandate/restrictions
- Understand the drivers of the fund’s historical performance and track record
- Review the tax implications of investing in the fund
- Analyze the fund’s performance benchmark for appropriateness
- Analyze the fund’s active share to avoid “closet indexing”
- Research comparable funds available in the market
For a point of reference, in 2021 there were about 6,680 active mutual funds in the market. I guess you could say the due diligence requirements for mutual funds are lower than individual stocks, but not by much. I would hazard a guess that most financial advisors are not doing this work. And again we arrive at more investment theater.
What can you do about it?
In a nutshell, start asking questions.
If your financial advisor has stuffed your portfolio with a bunch of individual stocks, ask them about their due diligence process. Pick a few of your holdings and really grill your advisor about why they chose to include that particular stock instead of an alternative. Don’t give them any time to prepare either. The more you can surprise them, the better. After all, if your financial advisor is truly doing what they are supposed to be doing, they should have no trouble answering some basic questions about your portfolio.
Some good questions you can ask:
- What do the quarterly earnings look like for the past year?
- What’s the trend in earnings? What’s driving any changes?
- What are the major challenges faced by the business?
- Can you explain all of the company’s lines of business to me?
- How much debt does the company carry? Can you walk me through the capital structure?
- Who is the company’s Chief Financial Officer (CFO) and Chief Technology Officer (CTO)?1
- Tell me about the major competitors.
- What’s your plan B in case your analysis is wrong?
If your advisor uses active mutual funds or ETFs instead, then you can these questions:
- Has the fund’s benchmark changed in the past 10 years?
- What is the R-Squared figure for the fund vs the benchmark?
- Does the fund use a top-down or bottom-up approach to portfolio construction? Why?
- Tell me about all of the members of the fund’s management team?
- What are the fund’s net inflow/outflow amounts for the past 5 years?
- What are the fund’s taxable distribution amounts for the past 5 years?
In many cases, your financial advisor will spit out some gobbledygook answers. And if they do, then it’s a sure sign that they are not qualified to pick stocks or active mutual funds for your portfolio. Tell them you’d prefer a passive approach or go find another advisor.
In the rare event that your advisor is able to answer your questions in a cogent, satisfactory manner, then you still might not be out of the woods. Remember that we are talking about doing the bare minimum here. There is no guarantee of success in active management. And as I have said before, the odds are not in your favor.
One more question you might ask, “Why, in the face of mountains of academic research, do you choose to employ active investment strategies instead of passive ones?” Or more succinctly, “What makes you so special when it comes to investments?”
1 – Many financial advisors know who the Chief Executive Officer (CEO) is, but it’s rare that they are well versed on the CFO/CTO. Feel free to ask about other obscure members of the management team as well.
