Brent Sheather: Something nice about financial advisers

'Buy the market' rule is less imperfect than most other options - unless you're Warren Buffett. Photo / AP

Critics of this column say it never has anything nice to say about financial advisers which, to be honest, is just about 100 per cent correct. However challenging the consensus view is fun and can be worthwhile. We gave the thumbs down to finance company debentures as early as 2002, warned about CDO's as well and have also forecast five out of the last three recessions.

The "consensus" today is that shares are cheap and bonds are expensive. Maybe, maybe not we will find out soon enough. The "consensus" is also that with the new financial advisers rules, a Code of Conduct, a regulatory authority that is both awake and onto it, things have vastly improved in financial advice land. Better yes, but as we will see (again) some financial advice is less "vastly improved" than others.

But first off let's get back to basics and define what good behaviour looks like. You can criticise any financial advice if you have a mind to but that sort of behaviour is not helpful or productive. It is pretty clear in this business what "best practice" looks like in terms of asset allocation and diversity one only has to look at what balanced super funds with independent trustees and the benefit of actuarial advice do.

For example the average pension fund in New Zealand has had an asset allocation of about 40 per cent in bonds, 10 per cent in property and 50 per cent in shares, more or less for about thirty years. So there is a line in the sand defining what an average risk portfolio looks like a client with a lower risk profile should have more in bonds and a client with a higher risk profile should have less. As an aside some "experts" advocate dynamic asset allocation which means shifting between asset classes. The theory says this doesn't work very well and the reality is that the professionals don't do much of it anyway.

In choosing which bonds, which property and which shares, professional unbiased investors in the form of pension funds generally adhere to the theory that the "market portfolio" is the most efficient in terms of minimizing risk and maximizing return.

What this means, very simply, is that in the investable fixed interest universe for example you should have lots of money invested in Government and SOE bonds and four fifths of five eighths of not much in junk debt. So if you saw a recommendation from a financial adviser opting for a portfolio full of junk debt it is pretty obvious that this isn't good behaviour. Similarly Fletcher Building is the biggest company on the NZX and Xero is a relative minnow so a recommendation for a NZ share portfolio with no Fletcher Building and lots of Xero isn't prudent either. It might be profitable who knows but it definitely isn't a low risk approach. Code Standard 1 of the Code of Conduct says that investments have to be suitable for clients. It is pretty clear what suitable is but this needs to be spelt out more.

That is straightforward enough. The "you should buy the market portfolio" rule is not perfect but it is a lot less imperfect than most of the other options, unless of course you are Warren Buffett, which you probably are not. It is also important to be clear that these aren't just opinions, they are what most professional investors do and that is why they can get so much airtime in this column. However the reality in the world of retail financial advice is that not many advisers adhere to the "buy the market" rule on the basis that:

1. They can earn more money adopting other strategies.

2. They can beat the market (yeah right).

3. They still aren't being taught that the "buy the market" strategy is the best one because this conflicts with just about everybody's business model.

4. The firm they work for has investment banking or other relationships which preclude doing the right thing.

Enough background today's story started with a new client coming in. He had been to see about five different financial advisory firms and they had prepared reports for him. Would I like to see them? I looked at my calendar and was surprised to see it wasn't Christmas! What follows is some of the "highlights" of these reports.

The core of any investment plan is asset allocation and that of course is derived, according to the theory anyway, from the risk profile and objectives of the client. So much for the theory, the reality is that fees, the biases and risk profile of the adviser, just for starters, dominate. Now we get to the good part. Two of the recommendations used the same ostensibly sophisticated risk profiling package perhaps in an attempt to get around the biases highlighted above but more likely in order to give the client a false sense of security and lend some degree of professionalism to the whole sordid process.

The client in question completed detailed questionnaires for both advisers and low and behold the output from the risk profiling package produced the same result he had a low risk profile. Fantastic, but where things went seriously awry was how the financial advisers interpreted the data in terms of asset allocation.

The client was identified as having a low risk profile in both cases and accordingly one adviser came up with a very sensible 65 per cent weighting in bonds and 35 per cent in shares. The other adviser however, using the same risk profile, came up with 35 per cent in bonds and 65 per cent in shares. LOL. One couldn't have come up with a more ridiculous scenario had one tried and I must admit I re-read the recommendations a couple of times to ensure I wasn't dreaming but there it was.

But that was just the start of the silliness.

One of the plans describes itself as adopting an "absolute return strategy" but inexplicably didn't use any absolute return products at all, assuming any actually exist, which is debatable. The annual fee structure of the plan was horrendous which made me suspect there was a typing error in the recommendation and they meant to say an "absolutely no return strategy".