News
Call for more prescriptive adviser regulation
Friday 14th of December 2012
Brent Sheather, an Authorised Financial Adviser for Private Asset Management, said the financial adviser regulatory regime is very focused on compliance issues but has little to say on how advisers actually go about aspects of their business including building a portfolio.
He said New Zealand should follow Britain, where the Financial Services Authority (FSA) plays a greater role in telling advisers what they can and can’t do, including on return forecasts.
“Under the FSA’s rules you can’t say your portfolio is going to do 10% and they tell you to forecast 3.5-4% returns for bonds and about 5% for equities. In New Zealand you can have idiots saying ‘we’ll aim for 20%’,” he said.
Sheather said to improve the quality of advice in New Zealand commission should be abolished and the Financial Markets Authority should broadly define “good advice” and publicise examples of bad advice.
He said to get an idea of what “best practice” investment looks like the FMA should look at the asset allocation of pension plans.
“There’s no question what it [best practice] is… those who disagree often do it because they have vested interests; they’ve got a corporate department who want to flog Moa Brewing to people.”
Goldman Henry director Brian Henry, who is also a corporate lawyer, has proposed advisers and other financial services sector participants get once-yearly audits like lawyers do.
“The FMA should visit everyone registered to provide financial services and check your books. The Law Society has audited lawyers like that for years,” he said.
Regulation had made it more difficult and expensive for honest advisers but “you can’t legislate honesty” and the focus needed to be on making it harder for the dishonest practitioners to slip through the net, he said.
Comments (36)
Austin Fisher
Britain's record isn't that great. The regulator in the 80's (LAUTRO) said that it was OK to project annual returns of up to 10.5% p.a. on endowment policies. That's an *average* return of 10.5% p.a. over, say, 30 years.
And here's the kicker, most people at the time thought that was too cautious!
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12 years ago
Kevin Kevin
Everybody knows what Best Practice is, because everybody operates using Best Practice. Just like you never see anyone saying "I AM wrong" (as opposed to I was wrong), you wont find many people every saying "I use second best practice!"
We should be open to discussing Best Practice though, if only to challenge our existing ideas. Would be good if Brent jumped on and provided specific details on what he considers are universal best practices in portfolio construction.
Wouldn't expect many items would cause great disagreement. But a few might spark interesting discussion.
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12 years ago
Mike Naylor
When the debate around 'principle vs prescriptive' approaches to regulation took place in the committees around adviser regulation it was pointed out to the various committees that international evidence pointed clearly to the principle approach being far superior.It was also pointed out that once regulation has been introduced there is always a very strong pressure on regulators to become more prescriptive, and this always leads to disaster. International evidence has not changed. Australia is now moving from prescriptive to principle.
The main reason why prescriptive methods do not work is that the financial world is always changing, and regulation tends to be fixed for a long time -so a gap opens up between what is regulated and real life. This leads to irrelevant regulation, to financial wizards making complex arguments why their particular product/ method skirts the rules, to advisers staying with the 'conventional wisdom' (which is often wrong & and never innovative), and to ever more complex rules which nobody understands (books of rules).
Advisers should know what best practice in building portfolios is - and should be regularly audited on that. Those who can not demonstrate such understanding (the idiots) should be expelled from the profession. However we cannot have FMA public servants trying to tell advisers how to do their job. This is not a matter of ideology - there is clear evidence that it leads to a worse outcome.
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12 years ago
Brent Sheather
Maybe, maybe not. Here's an idea. Mystery shop 15 financial advisers randomly selected. Look at the portfolios closely and having regard to what pension funds do then see if you change your views.
My guess is you will.
Let me know the outcome.
Rgds Brent
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12 years ago
Brent Sheather
Hi Kimble, I just look at what pension funds do and it seems that an average risk profile is 40 per cent bonds, 10 per cent property and 50 per cent shares. All the bonds are investment grade with some short, some medium and some long and some inflation indexed. Also have a bit overseas but not much. In property pension funds invest in local listed. In shares pension funds seem to be about one third Australasia and 67 per cent international with 50 per cent of exposure indexed and 50 per cent in low cost, actively managed funds. So it is pretty simple and will generate an after cost cash yield of around 4.5 per cent which beats the bank. For more detail check out this week's Herald article What is suitable advice really.
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12 years ago
Kevin Kevin
So 20 percent bonds, no property, 40 percent domestic shares and 40 percent foreign shares is wrong? How about 50 percent bonds, 30 percent shares, and 20 percent property? Or how about...
Why is a 50:50 split between active and indexed the right proportion? If someone believes active management adds value, why cant they be 100% active. Or if they dont, 100% indexed?
The principle of diversification is fine. Saying "this is how you should all diversify" is not. It implies a great number of assumptions are absolutely true. For instance, saying all bonds should be investment grade assumes there is no price for sub-investment grade bonds that would make them a worthwhile investment; that the return would never justify the risk, no matter how good it is. So whats the point in asset allocation?
As for taking the average pension fund as ideal, well, you wouldnt advocate all clothes be the average size, would you?
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12 years ago
Brent Sheather
Answers to your questions/comments:
40/10/50 is the average for about 30 years.
A person who had a lower tolerance for risk would have more bonds but 40/10/50 is a line in the sand.
Someone who believes active can add value should read the literature and change his/her adviser.
Sub-investment grade bonds have little diversification benefit if you also own shares..ie when shares tank so does junk debt.
And no I don't think all clothes should be the same size but I do think advice standards could be vastly improved.
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12 years ago
Kevin Kevin
So active management can't add value? Then by all rights your portfolio using 50% active management is definitely not best practice. Right?
You have a lot of opinions, and no doubt reasons for those opinions. But it seems like you are incapable of seeing those opinions as anything other than established fact. And the only reason you prefer the prescriptive over the principled approach, is that you cant imagine a world where the prescriptions wouldnt match your opinions.
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12 years ago
Mike Naylor
The job of financial advisers is not to construct portfolios - that is far too much for the knowledge/ education level of the average AFA. The job of financial advisers is to work with clients on how to rearrange their finances so they maximise cashflow and savings and minimise risk. Anyone who has had advise from a quality adviser knows they are well worth their fee.
Part of that is assessing a client's attitude to and ability to cope with risk in investment portfolios and then using selecting a mix of products which suits the particular client. It is very hard to say that any set mix of products is superior unless that is compared to the clients needs (including currency), to source of income stream, to liquidity, to existing assets etc etc. For example, property can add to returns, but a number of clients will already be over-exposed in that area. For younger clients a small allocation to junk bonds can add useful returns.
The big failures in NZ advice occur when advisers decide what they want to sell before they assess client needs. This is a question of adviser skill levels and ethics.
The overall international evidience is that selecting a diversified range of low-cost passive funds will generally give superior long-term performance when compared to high cost active funds. However - not in all years or in all financial environments. Passive funds will not suit all clients.
The key questions have to be - has the adviser expertly assessed client needs, do they have very good reasons for the advice they have given, and have they given the client clearly explained alternatives. This should pass any FMA audit - and yes, FMA checks will weed out some of the the idiots and crooks.
It cannot be about whether the adviser has a strong opinions of the worth of active management etc, it can only be about the worth of the combined portfolio attributes to that client.
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12 years ago
Kevin Kevin
Thanks for the reply Brent. I disagree that everyone has a responsibility to employ active managers; does everyone have a responsibility to sell good stocks, or buy bad ones?
How should we compare the big pension funds to advisers? Should we compare the specific allocations to specific asset classes? Cant really do that given the fact that their portfolios should be different due to the differences between the goals of an individual and a pension fund. Or should we compare based on principles like diversification and cost effectiveness?
You can determine whether a portfolio is decently diversified without having to specify what the asset allocation must be. The benefit of this principle-based approach is that it allows for justification by the portfolio constructor.
Its the difference between "you have too much invested in commodities" and "your justification for investing that much in commodities does not stack up".
The one advantage of the prescriptive approach is that it is easy to administer.
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12 years ago
Brent Sheather
Hi Barrington, Yes, perhaps we should just agree to disagree. However if I was a financial adviser with a zero weighting in bonds I think I would be prepared for a change in job pretty quickly subsequent to any visit from the FMA. Let’s look at your point about asset allocation – if the average pension fund has a 30 year time horizon (your figures) and has 40% in bonds whereas a typical retail client has a 10 year time horizon (your figures again), shouldn’t they have more in bonds!!
Also aren’t you afraid that you are in a very crowded trade in that everybody thinks bonds are overvalued. In addition as you know we can buy long dated bonds from “too big to fail” institutions here at 4.8% with no fees and no FDR tax. Compare that with a 6% prospective return from international equities less say 2% in fees (if you are an average client of a financial planning firm) less another 1.5% for FDR. Equities aren’t so compelling are they! Regards Brent
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12 years ago
Kevin Kevin
1. An average isnt a consensus.
2. Please define average risk.
3. What Barry Smith said.
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12 years ago
Kevin Kevin
If the average pension fund has 40% bonds, then that makes no difference to whether an individual investor has more or less. It only matters if you the 40% is justifiable as a benchmark. The weight of the average Pension fund managers portfolio is central to YOUR position. You cant just say "GIVEN fund managers have X in bonds".. you have to explain why the comparison is appropriate. There is no agreeing to disagree on a point so fundamental to your position.
Modern Portfolio theory is a structured way to deal with uncertainty. The prescriptive approach as you described it, is effectively asserting that the uncertainty is known, and it is X, and given the return is Y and the correlations are A:B, the correct allocation must be F(X, Y, A:B). Of course, if Y was known there is no need for F(~).
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12 years ago
Brent Sheather
Like I said..a prescriptive approach is a huge threat to the std industry business model. High fees are not compatible with 40% bond weightings unless they are junk.
Over and out !!
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12 years ago
Kevin Kevin
Wow. Sorry but that's pathetic. At best, you have just shown that the prescriptive approach cannot be intelligently defended.
Instead of explaining WHY you think the average pension fund asset allocation is an appropriate benchmark, you accuse everyone who has asked for an explanation of only disagreeing with you because you are so right it will put them out of business!
If that is the best defense a vocal advocate of the prescriptive approach can muster in the face of thoughtful and justified reasoning, then advocates of a principle-based approach shouldn't be losing any sleep.
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12 years ago
Alan Schofield
I would have thought that the rationale for adopting the asset allocation of the average pension fund as a reference point for setting up a portfolio wouldn't require much explanation as it simply reflects the consensus view of non-conflicted experts; 'investment 101'. Would be interested to know what Kimble and others use as their reference point.
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12 years ago
John Berry
Brent, I agree the prescriptive vs principled approach is a great debate for advisers to have. I expect that if you advocate adopting pension fund asset allocations as the base assumption, you'd also adopt their base assumption on currency hedging? Like many pension funds the NZ Super Fund maintains a minimum 50% currency hedge at all times for international equities (in fact their mandate allows hedging up to 120%). For consistency, shouldn't your prescriptive approach also adopt the currency hedging of pension funds?
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12 years ago
Kevin Kevin
Firstly, an average isn't a consensus. A consensus is where everyone agrees on the outcome. Using the asset allocation of a certain group of individuals implies that they have special insight; that they are right. The further implication is that if you deviate from their allocation, you are wrong. This isn't about peer group analysis, or analysing your own portfolio. The prescriptive approach means legislating that one group of people is right and that all others must follow them.
It is no different than advocating all equity portfolios mustn't deviate too much from the index. Too high a tracking error and you must be doing something wrong.
So if you want everyone to be judged by the opinions and decisions (and individual funding positions, how much in equities does an over funded pension fund need?) of a certain group of people, then the onus is on you to provide justification for selecting that group. Why are they right, and everyone else is wrong? Why is their selection "right"?
Its no coincidence that the people who advocate the prescriptive approach are also the ones with the highest opinion of their own abilities.
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12 years ago
Alan Schofield
I will float the question again Kimble. What is your reference point(s) for defining suitable asset allocations for moderate risk investors? And some supplementary questions: What is the allocation you use and how much to investment grade bonds? On what basis can you justify the the asset allocation you decide/agree with your client? Would the FMA consider this approach reasonable and in the client's best interests?
I read Brent's article and he's saying the reasons "everyone else is wrong" include commissions, investment banking, higher fees for equities, etc., etc. Does that make sense to you? It does to me.
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12 years ago
Kevin Kevin
On what basis can I justify my asset allocation? That's my point! I should have to justify my portfolio positioning. What about someone who just says "its what the pension funds do, on average, sometimes."?
Commissions and higher fees are not an argument for the prescriptive approach. That is simply Brent saying that everyone who disagrees with his prescription is just greedy and corrupt; its lazy and you shouldn't admire him for it. Its not clear what investment banking has to do with anything, but commissions definitely have nothing to do with asset allocation. Fees only relate in as much as they reduce the expected return of some vehicles used to get asset class exposure. Those are product selection issues, not asset allocation.
My view on sub-investment grade bonds is this; there is a price at which the return would justify the risk. That's not controversial; its fundamental to portfolio construction.
Notice how I am not saying how much should be in bonds, or investment grade bonds specifically? That's because I am humble enough to know that my position in those assets is based on my opinion, and my opinion can be wrong while others can be correct. So I think it would be wrong for me to say people not matching my weights are incorrect for no reason other than they don't match my weights.
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12 years ago
Graeme Tee
I am surprised that in the rush to criticize Brent Sheather's research on asset allocation no-one has picked up on Dr Mike Naylor's comment that "the average AFA isn't qualified to construct portfolios. It appears he is saying the "average AFA" is no more than a glorified budget adviser and risk assessor. He would know because I see from the Massey website this is what he teaches. I agree and if this true then most AFAs should be their giving advice free at the local Citizens Advice Bureau because that is about all its worth judging from the egos, speculation and illogical reasoning displayed on this thread. Furthermore how many AFAs when fully meeting their Code of Compliance obligations to provide meaning alternatives are saying "you can have this high cost product on this high cost wrap platform or you can leave the money in the bank and earn the same after fee, after tax return for the next five years"?
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12 years ago
Brent Sheather
Hi again Kimball. First up your comment that “commissions definitely have nothing to do with asset allocation” is ridiculous. The fact is finance company debentures paid high commissions that is why all those poor mums and dads had huge allocations to junk bonds. CDO’s paid high commissions that is why people owned CDO’s like Credit Sails. Equities pay higher commissions than bonds and can, theoretically anyway, sustain higher annual monitoring fees that is why retail portfolios are underweight bonds. Shall I go on – I might as well – exchange traded funds don’t pay trailing fees that is why institutions have more money in passive funds than retail. That is probably enough. The point of my article was that external factors drive asset allocation decisions in many cases for retail clients, not what is best for the client and we can observe the difference by comparing pension fund portfolios which are relatively free of these biases with those of retail. By following the asset allocation of the average pension fund you can free yourself from those naughty biases. Let yourself go! Regards Brent
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12 years ago
Brent Sheather
Hi Barrington, in my view you are saying “I, Barrington Smythe, think that bonds are expensive so I am going to ignore what the average pension fund does because I am right”. My clients are mainly retired, need regular income, can’t afford to speculate and can’t afford to make big mistakes so that is why I have a balance of bonds and shares. In addition I can’t afford to make big mistakes either.
The more I think about it the more I believe that the average pension fund data is absolutely appropriate as a benchmark for asset allocation because the average person in a pension fund in NZ is probably around 40 years old and if, in the absence of commission, fees, etc the trustees come up with 40% bonds then I think at least 40% bonds is right for retired people. We only have to look at the disasters wrought on retail investor portfolios when advisers have adopted alternative models and I am thinking finance company debentures, Feltex, CDO’s etc. I would also be surprised if the average portfolio of Australian pension funds weighted by assets had only 18% in bonds because that would make them very different from every other pension fund around the world and to have 25% in high cost alternatives like hedge funds and infrastructure is nothing short of ridiculous but certainly would suit the purposes of any adviser trying to maximize fees from his or her clients. Finally I didn’t think there were hardly any defined benefit pension funds left in the world – certainly reading the Financial Times suggest that they are almost all closed. In any case that is irrelevant because I follow the asset allocation of NZ pension funds. Regards Brent
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12 years ago
Kevin Kevin
Finance company debentures, Feltex, CDO funds... those are products. They do not relate to asset allocation which deals with asset classes. Asset classes don't pay commission.
We know you think that advisers just follow the commission when selecting products, but that's a different issue. A ban on commissions would solve it, right? So in no way do commissions mean that asset allocation should be prescribed.
So far your only justification for using the pension fund average is that the average member is probably 40 years old. Have another read of your last comment. That's the only thing you said related to average pension fund appropriateness. You allude to many other things you thought about in the past, but you haven't written any of those things here.
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12 years ago
Graeme Tee
Kimble, you should re-read Mike Naylor's comment above. I believe Brent Sheather is saying here is a benchmark that can be used as a starting point point for asset allocation that is free from the bias of commissions. You can deviate from that benchmark as much as you like and then you can explain to your clients why their return is so different to that of their friends.
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12 years ago
Brent Sheather
Hi Barrington, good point about the NZ super fund..so when the FMA visit and see your clients have 9% in bonds you can tell them its because you are benchmarking against the NZ superfund which has a multi generation investment horizon and isn't allowed to invest in local bonds. Dont be surprised if the FMA suggests that that isn't appropriate because yr clients have much shorter horizons,a need for income and a lower tolerance for risk. Merry Xmas and good luck !!
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12 years ago
Kevin Kevin
Graeme, you should have to explain your clients return regardless. Are you saying that the benchmark just gives you an excuse not to explain client returns? (And that is ignoring the fact that even portfolios that match the pension average asset allocation will have very different returns due to product selection).
And Brent what are you going to say when the FMA turns up and asks why the pension fund average was used? That the average member is probably 40 years old?
Or will you be telling them that the pension fund managers are smarter than you, so you used their allocation without considering any other factors?
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12 years ago
Brent Sheather
Barrington my boy, just looked at the Towers Watson study and see that the average allocation to bonds is 37%..with cash another 2%.. That's getting close to 40, but..there is another 20% in "other"...other isnt defined in full but in other studies I've seen "other" includes other bond-type products and I'm sure you will know more hedge funds pursue fixed interest strategies today than equity ones.
All im saying is I dont know what's around the corner so I have a $ each way. My clients can afford to have low yielding, low risk bonds because their annual fees are low.
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12 years ago
Brent Sheather
Kimble, Kimble, Kimble...What I said is that the average pension funds asset allocation is a good basis to start to determine the right asset allocation. Most of my clients are retired so I generally have more in bonds than the average pension fund, and yes i think the consensus view of what's right as demonstrated by the asset allocation of pension funds is much smarter than anything i could dream up..that's why I'm happy to use it.
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12 years ago
Kevin Kevin
Wait, are you saying that hedge funds pursuing fixed interest strategies is the same as having a fixed income exposure in your portfolio? Otherwise, what was the point of that sentence?
Anyway, now that you have embraced the TW survey as supporting your point, I can say that the average exposure to bonds is around 40%, but that doesnt mean consensus is around 40%. Australian exposure to bonds is below 20%, for the US it is down around 30%, while for Japan and the Netherlands it is up around 60%.
Your demand that the benchmark exposure to bonds be 40% is shared by Switzerland and the UK only. What is it about the pension managers in those countries that makes you think they have such a great insight into the allocation of NZ retail investors? On the other hand, what is it about pension managers in the US, Australia, Japan, and the Netherlands that makes their opinions worthless?
(And none of this is me conceding that you have provided sufficient reason to follow the pension fund average.)
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12 years ago
Michael Donovan
Hey "ADVISORS",
If you place "bonds" into any portfolio, are you taking into account the risk (in the event your client needs to cash up prior to maturity for an unforeseen reason) of investing in the current low interest rate environment, where (as you would ALL know as financial planners) the only effective way for interest rates to 'move' is UP, and as you ALL know, when bond rates rise and you sell prior to maturity, you (ACTUALLY YOUR CLIENT'S)lose money..!?
So, you are telling your client to accept obscenely low comparative interest rate returns, PLUS sit there with the risk as alluded to above?
Now, with all this money being printed, remember that this fact has the effect of increasing what some of you still refer to as "INFLATION" which most of you now know does not exist (except as a word) and never has, and if what you perceive as "inflation" happens at say 3% (or a bit more based on the rate of money-printing) then surely the "poor" old clients are going to get their calculator out and ask you the question "you have put me into a bond yielding 3-4% but there is 3%-4% "inflation?"
Then you have to re-explain to the clients that when a house doubles in value(inflates) over each 10 years, that the truth is that in that 10 years the printers just printed and released approx twice the amount of money, so ALL the money has now halved in it's buying power.?
Where you used to carry a dollar in your pocket....you now need to carry $2..to buy the same stuff.!
Bonds can be scary,,, when interest rates are in the low bracket.
1st mortgages are the BEST security in the world....and 12% leaves some TRUE WEALTH CREATED, (someone even copywrote that!) even after what some of you still appear to call "inflation."
eg: 12% minus 4% "inflation = 8% NET..!
It's going to be one of the "biggies" how you all are going to try and prove how you can sit down for hours designing your own interpretation of balanced portfolios, and all just to offer your clients an effectively NIL "True Wealth Creation".
ie: a balanced portfolio return of 4%pa with an "inflation" rate to match...!
Is that just giving advice on how to lose the buying-power of your clients money in one easy step?
To be 'fair' to your clients and yourselves, now that you have some holiday time,get onto a site like that one I mentioned in my previous comment, and at least have a read, then let's see if there are any changes in the ensuing comments.
Michael Donovan
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12 years ago
Brent Sheather
Michael this is meant to be a serious discussion.
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12 years ago
alan clarke
TRUE If you place "bonds" into any portfolio, are you taking into account the risk (in the event your client needs to cash up prior to maturity for an unforeseen reason) of investing in the current low interest rate environment, where (as you would ALL know as financial planners) the only effective way for interest rates to 'move' is UP, and as you ALL know, when bond rates rise and you sell prior to maturity, you (ACTUALLY YOUR CLIENT'S)lose money..!?
NOT NEW BUT BIG a lot of retired people are actually decumulating , and so will sell before maturity
GOOD QUESTION So, you are telling your client to accept obscenely low comparative interest rate returns, PLUS sit there with the risk as alluded to above?
EXTREMELY WORRYING - 12% mortgages, dear oh dear !!!
BRETT IS A WORRY How can anyone "manage" $600 million with 1.5 advisers ? perhaps we need to examine what "managing client portfolios" means?
WE HAVE paid for asset allocations from a large global researcher, and these have worked well for us for many years. They include recommended minimum time frames e.g. balanced is pretty much 50/50 and 5 years minimum
DIY asset allocations - why ? Do we as advisers have the nous to design our own ? Is that our role ?
WE KNOW and accept active management does not work consistently enough to be of any use. Accepting this has something to do with being humble
DECUMULATION is not new but growing - asset allocations for these clients are challenging
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12 years ago
Alan Schofield
I can hear Michael's clients signing on for the ride of their life (with great hope and expectations) and the results of their nightmares. I prefer to be completey honest and know that I do not know what the future holds and that it is simply gambling to think you can second guess the market and say that some particular asset or class of asset is under or over-valued.
Right now the world is in unchartered and very uncertain times and any of a myriad of events could switch asset values one way or the other. For my clients I am happy to stay with using pension fund asset allocations as a benchmark for beginning the process of agreeing an asset allocation with a client in the full knowledge that we are trying to manage risks while achieving their expectations (provided they are realistic - otherwise they are asked to go elsewhere). Anything else to my mind is a pretension to know better than the truely independent researchers; delusions of grandeur are I think the root of many of the financial systems woes, from overpaid bankers gambling with other people's money and peddlers of hope to the unknowing doing similar things.
Thanks Barrington Smythe for your insight into your approach and the rational debate you and Brent Sheather have been prepared to conduct in this forum. Kimble, I think you use many words to avoid the tough questions; I'm still waiting for straight answers to straight questions of many days ago.
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12 years ago
Anthony Edmonds
Please tell me that Michael Donovan is not a real person and that this (as Brent eludes to) is simply someone taking the micky.
Brent. When a client buys an exchange traded fund off you do you get any of the brokerage on this?
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12 years ago
Brent Sheather
It's on our website. We charge a flat % fee to implement a recommendation..usually about 0.8% depending on size. We pay the broker's fees out of this. The fee we get is the same for all instruments and asset classes thus we aren't tempted to favour one asset class over another. No products we use pay commission or trailing fees.
Lots of comments on this story !!
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12 years ago
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