How to assess your financial advisor's performance

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Finance careers are made and lost on investment performance.

Fidelity's legendary fund manager Peter Lynch is considered one of the investing world's all-time greats thanks to the fact that the Magellan fund returned a mind-blowing 29% per year between 1977 and 1990. George Soros is one of the world's richest men because his hedge fund returned roughly 20% per year over more than three decades. And while beating the S&P 500 for 15 straight years put Legg Mason's Bill Miller on nearly every investor's radar, lagging it for a few led to his unceremonious exit from Legg Mason's Value Trust fund.

And yet, when we turn to the brokerage and financial advisory industry, most upstanding practitioners back away from marketing themselves based on investment returns. Why?

The elephant in the room
Josh Brown is a financial advisor and the author of Backstage Wall Street: An Insider's Guide to Knowing Who to Trust, Who to Run From, and How to Maximize Your Investments. "If you're focused primarily on performance," he said, "you're asking the wrong question."

He went on to describe how a shifty broker could easily construct a portfolio based almost entirely on the SPDR Gold ETF, back-test it over 10 years, and — because gold has performed so well over that stretch — show clients how amazing their returns could be. Past performance, as they say, is no guarantee of future results, and actually constructing a portfolio like that could be disastrous.

For Brown, rather than focusing on the returns themselves, the spotlight should be on the investment process and how an advisor formulates his portfolios. "If an advisor can't articulate his process," Brown said, "it's much more worrisome than if they don't show a track record."

Behavioural finance expert Terrance Odean has a similar view. He told us that looking at returns to measure advisor performance is "just the wrong thing to look at." In fact, Odean went as far as to say that "your advisor should not be trying to beat the market."

Even US industry watchdog FINRA nudges investors away from using returns as a measuring stick. On its website, FINRA provides investors with a guide for interviewing a broker, and the only place where returns come up is to warn against brokers that tout high returns:

"Be cautious of any investment professional who promises you above-average account performance or says you'll be making risk-free investments. Nobody can guarantee that your investments will grow at a particular rate or that you won't lose money."

When we spoke with FINRA's vice president of investor education, Gerri Walsh, she echoed that sentiment, saying that "focusing on past performance can get you into a danger zone."

And they all have a point. One of the primary tools in the financial huckster's toolbox is promising huge returns, or at least comfortable, risk-free returns. It was the case with the multi-billion-dollar scams of Bernie Madoff and Allen Stanford, and they're the same techniques used by the run-of-the-mill, everyday penny-stock pusher.

On the other hand, though, it'd be silly to ignore the importance of returns. The best-laid financial plans of mice and men go astray much faster if an adequate rate of return isn't achieved.

How do advisors stack up?
Unfortunately, many brokers and advisors simply don't earn market-beating returns. Research from Goethe University's business school dean Andreas Hackethal suggests that returns from advisor-assisted accounts badly lag the results from customers who handle their accounts on their own. Studying data from a large German brokerage house and a major German bank, Hackethal and his co-authors found that investors in their dataset who used advisors earned annual returns that were 5 percentage points less than investors doing it on their own. Even when adjusting for the riskiness of portfolios — that is, a lower-risk portfolio should be expected to produce lower returns — the advisor-led accounts still notably underperformed self-managed accounts.

This is just a single study, but it shouldn't come as much of a shock that broker- and advisor-managed accounts would underperform. Brokers and advisors tend to use mutual funds with their clients, and research has shown that somewhere in the neighborhood of three-quarters of mutual funds fail to beat their benchmarks.

It's worth noting that successful investment returns don't always mean beating a particular benchmark. As Josh Brown put it, "A big misconception is that clients need to beat the S&P 500." Rather, he emphasised that it's about knowing the client's goals and getting the returns necessary to meet those goals.

A question of transparency
Professor Hackethal has written extensively on the subject of financial advice and is part of a group that's been advising the German government on how to deal with the industry. And if you were to boil down Hackethal's scholarship on the subject to a single word, it'd be "transparency."

Hackethal is quick to point out that you have to be careful when talking about investment returns without considering the risk that's taken to earn those returns. It's a "double-edged sword," he said, noting that "if advisors compete on performance defined as returns on their portfolios then it … gives incentives to ignore risk."

Instead, he has suggested showing investors not only their returns but also how much risk they're taking. Hackethal noted that people tend to get confused with too much data, so communication has to be "simple, clear, and relevant" — but a uniform system would drastically increase transparency and get everyone in the industry to speak the same language, allowing clients to see and evaluate their risk-return profile and their advisor's performance.

An interesting twist is that Hackethal believes that individuals who manage their own investments should get the same data. For Hackethal, who calls himself "a big supporter of financial advice," this could help sober up this group and encourage them to seek some outside help. Or, as he put it, "Some people are overconfident — you need to show [them] that their own performance doesn't stack up."

Hackethal admits that major brokerage and advisory companies have no incentive to provide this information. While regulation is certainly a possibility, he concedes that "the lobby is too strong." Instead, he suggests that the change will come about as customers increasingly demand more transparency and new entrants rise up to meet that demand.

New entrants like Ibis Capital
Neal McNeil is no newcomer to the industry — he's been managing money for well over a decade. But he's recognised that there's a lot that needs to be done differently.

A former broker with Morgan Stanley, McNeil was struck by how clients struggled to figure out how their portfolio was stacking up. "All they'd see is a bottom line number," he said. "There's no standard deviation, no beta, no performance against a benchmark."

McNeil calls performance transparency "hyper-critical" and quipped that without knowing how their investments are performing, "How is a client supposed to know whether you're doing a good job for them?" At Ibis, which he started after leaving Morgan Stanley, McNeil has sought out performance-reporting technology that lets clients put an X-ray to their portfolio, allowing them to "go online any time and compare over any time period, any benchmark, and get an idea of not only their performance, but the risk they're taking."

McNeil recognises that if the investment performance isn't getting his clients where they need to be, then something's wrong. "If a client is paying those fees, they need to be able to judge you." Yet he adds, "Advisors are afraid to be judged by their performance."

McNeil and Ibis base this approach around a simple way of looking at the business. "At the end of the day we ask ourselves, 'How would I want my money run? How would I want to be treated, and how would I want my assets to be treated?'"

The entire industry won't follow Ibis' example until customers push for change. But if brokers and advisors see clients walking out when they don't provide adequate transparency, that change will take place much faster.

In the end, it's on you
For many brokers and advisors, lack of investment performance may not make them lose much sleep. Josh Brown said the internal review process for brokers at big firms is focused on how much money they make for the company, not the client. "When you're a registered rep at a big firm," he said, "They look at how profitable you are. The more profitable, the more likelihood they keep you and the better bonus you'll get."

Nicole Seghetti, a writer who spent eight years as a financial advisor before leaving the industry, echoed that view: "At a big brokerage firm, a performance review really boils down to 'How much money did you make us last year?,' 'How much will you make us next year?,' and 'How many extra phone calls will you make to get there? '"

So it falls on clients' shoulders to keep a report card of their own and be ready to either push advice providers to deliver what's needed or go shopping for a new relationship. I've ranked some of the key questions clients should ask about their advisors' investment performance:

  1. Are the returns in my portfolio clearly displayed and easy to understand?
  2. Are my returns compared to applicable benchmarks?
  3. Is my broker or advisor willing to walk me through any aspect of the performance that I don't understand?
  4. Are my returns beating their benchmarks? There are many reasons an advisory relationship can deliver value outside of investment returns, so if the advisor isn't measuring up on the returns front, there's a simple solution: Tell your advisor to switch from actively managed funds or individual stocks to market-matching, low-cost index funds.

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The Motley Fool's purpose is to help the world invest, better. Take Stock is The Motley Fool's free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. Click here now to request your free subscription, whilst it's still available. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

A version of this article, written by Matt Koppenheffer, originally appeared on

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