When evaluating financial advisors, understand how they make money
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Today’s economic environment and market volatility have caused many DIY investors to reconsider working with professional financial advisors. Those who work with advisors also may be evaluating their advisor and investigating alternatives.
First, we should address if it even makes sense to hire a professional advisor to manage your portfolio. After all, no one has a greater interest than you in protecting and looking after your investments. Further, paying someone else to handle this crucial area of wealth management will mean there is some “fee drag” to your overall investment performance (ie, it will always be more cost efficient to do it all yourself).
Why do so many physicians use professionals? Most importantly, the data shows that it is wise to do so.
Several large studies quantify the value professional advisors bring to their clients. Two such studies, from Vanguard and Morningstar, examined the financial management of clients with and without professional advice and looked at a myriad of planning factors. The Vanguard study estimated advisors can potentially add 3% in net returns, calculated retroactively on an annual basis. The Morningstar study concluded an investor could expect an annual return increase of 1.59% by using an advisor.
Beyond these studies, the important point for physicians to consider is advisors do not exist strictly to pick the best stock, mutual fund or exchange traded fund or to simply forecast economic conditions and make tactical decisions in a portfolio. Although those activities and others are important components of investment advice, an advisor should also act as a buffer who puts space between you and your investments to take some of the emotion out of investment decisions. For most physicians, this component alone will prove valuable over a lifetime of investing, especially in the most stressful times.
Types of financial advisors
If we assume that a physician is going to use a financial advisor at some point in their financial life, the key question they should ask emanates directly from an understanding of one fundamental difference between two types of financial advisors that exist in the marketplace — those who have a fiduciary duty to their clients and those who do not. For physicians, understanding this difference is fundamental to making good decisions with their investments and will lead to the key question highlighted below. The earlier they learn this difference, the better, because compounding assets at a higher rate, even if fractional, could result in a substantially higher net worth when physicians reach retirement age.
Fiduciary vs. suitability standards
The distinction between a fiduciary and suitability standard revolves around the requirements for professional ethics and loyalty an advisor is held to when working with a client. Unfortunately, investors often rely on an advisor without understanding how the advisor is obligated to work with them.
The largest and most popular financial firms are broker-dealers. These are primarily regulated by the Financial Industry Regulatory Authority under standards that require them to make suitable recommendations to their clients. Instead of having to place his or her interests below that of the client, the broker-dealer’s suitability standard requires a broker-dealer reasonably believe that any recommendations he or she makes are suitable for the client. There is a key distinction to understand about loyalty. It is also important because a broker’s duty is to the broker-dealer for which he or she works and not necessarily to the client.
Try not to focus on the term “broker.” Many firms have realized the negative implications this term has and have begun referring to members of their sales force as financial advisors, a term that may be encountered in advertisements and marketing materials.
In contrast to large broker-dealers, a registered investment advisor (RIA) is an advisor or firm engaged in the investment advisory business and registered either with the Securities and Exchange Commission or state securities authorities. An investment advisor under the RIA model has a fiduciary duty — a fundamental obligation — to his or her clients to provide suitable investment advice and always act in the clients’ best interests.
RIAs are the most popular, but not the only, subset of advisors who adhere to the fiduciary standard. When choosing a financial advisor, research your options carefully and ask at least one simple question, as discussed later in this article. Additionally, it is critical that a physician ensures that the advisor is working based on the investment time horizon, risk tolerance and financial goals of the physician and his or her family.
Example
Doctor A contacts his broker and expresses an interest in investing $50,000 in U.S. growth stocks. The broker invests the client assets in Fund XYZ, which charges a sales load of 5.75% with operating expenses of 0.68% annually. The client (physician) will immediately pay a one-time fee of $2,875 on the trade on top of the recurring fund management fee. In this case, the suitability standard has been met.
Doctor B contacts her RIA with the same request. The investment advisor purchases an exchange-traded fund with a gross expense ratio of 0.18% and pays $8.95 commission on the trade. This physician pays her RIA a management fee of 1% of the assets, which equates to $500 per year on $50,000. The advisor has met the fiduciary standard.
In this example, the front-loaded fees paid by Doctor A are significant enough to require a commitment of about 9 years to this fund family before the commission that was paid equals the sum of the advisory fees that Doctor B paid.
Key question to ask
Given this situation, the most important question a physician can ask a current or prospective financial advisor: Do you have a fiduciary duty to me, to put my best interests before yours? The question seems simple, but often investors never ask this question and continue to work with advisors who would fail this test of their fiduciary duty. Furthermore, even if an advisor states they have a fiduciary duty to you, a physician should confirm the advisor is working based on the investment time horizon, risk tolerance and financial goals of the physician and his or her family.
Understanding how advisors make money and whether they owe their duty to their clients or to their firms is paramount in finding the right professional to help you achieve your long-term financial goals. Equally essential is ensuring your advisor understands you and your family’s financial goals.
For more information:
Wealth Planning for the Modern Physician and Wealth Management Made Simple are available free in print or by ebook download by texting HEALIO to 844-418-1212 or at www.ojmbookstore.com. Enter code HEALIO at checkout.
David B. Mandell, JD, MBA, is an attorney and founder of the wealth management firm OJM Group www.ojmgroup.com, where Bob Peelman is a partner and director of wealth advisors. The authors can be reached at mandell@ojmgroup.com or 877-656-4362. You should seek professional tax and legal advice before implementing any strategy discussed herein.
References:
- Bhatia S, et al. Where does your financial advisor’s duty lie? Available at: www.healio.com/news/primary-care/20200116/where-does-your-financial-advisors-duty-lie. Published Jan. 16, 2020. Accessed April 3, 2023.
- Bhatia S, et al. How to decide which type of investment advisor works for you. Available at: www.healio.com/news/primary-care/20191216/how-to-decide-which-type-of-investment-advisor-works-for-you. Published Dec. 16, 2019. Accessed April 3, 2023.
- Bhatia S, et al. An advisor can help take the emotion out of investing. Available at: www.healio.com/news/primary-care/20191015/an-advisor-can-help-take-the-emotion-out-of-investing. Published Oct. 15, 2019. Accessed April 3, 2023.
- Blanchett D, et al. Alpha, Beta, and now ... Gamma. Available at: https://www.morningstar.com/content/dam/marketing/shared/research/foundational/677796-AlphaBetaGamma.pdf. Published Aug. 28, 2013. Accessed April 3, 2023.
- Kinniry Jr. FM, et al. Putting a value of your value: quantifying Vanguard Advisor’s Alpha. Available at: https://advisors.vanguard.com/insights/article/IWE_ResPuttingAValueOnValue. Published Aug. 12, 2022. Accessed April 3, 2023.
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