5 signs your adviser is taking big risks
Most risk managers had a difficult time last year. Global hedge funds posted a modest 3.5%-4.5% return, according to Eurekahedge data, falling just short of the 5.5% that the MSCI world index returned and well below the 13.7% return posted by the top-performing U.S. equity market.
Not surprisingly, investors are slowing the pace of injections into the alternative market and reallocating them to long-only managers with assets concentrated in the U.S.
That said, it’s important to remember the merits of managing risk alongside return targets. Hedge funds over the past 20 years have been able to achieve respectable annual returns in excess of 8% with less risk than the broader market.
By contrast, the average investor, due to poor market timing and risk chasing, has achieved a disappointing annualized return of just over 2% during the same period, according to a recent analysis by Richard Bernstein Advisers LLC.
We believe such poor performance can be attributed to a financial industry that is more focused on asset gathering than asset management.
It is much easier to grow a firm’s assets by selling financial products than it is by growing organically through prudent management. Consequently,
excessive risk is often taken as human emotion is allowed to dictate the investment decision process.
Here are a few warning signs that can indicate whether your financial adviser is taking excessive risk with your portfolio. Commission-based compensation structures Unless you are very comfortable directing the investment decisions on your portfolio based on your advisers’ recommendations, commission-based selling structures can encourage the selling of a certain financial product because of its higher associated fee.
Fortunately, the Canadian Securities Administrators’ new Client Relationship Model 2 rules will take effect this summer that force the full disclosure of such fees, which were previously difficult to determine in many cases.
The expert recommendation It isn’t uncommon for advisers to tout a certain investment because of their firm’s expertise and/or analyst recommendation.
There was a great study undertaken by Marketwatch that showed that going back to the start of 2008, investors who bought the 10 worst-rated U.S. stocks by Wall Street analysts would have earned more than twice as much as the S&P 500. Buying based on recent performance Past performance provides no indication of future performance. However, all of us in the industry know it’s much easier to sell a financial product with a very high recent return. Just look at the massive inflows into U.S. equity funds at the moment.
Consequently, market tops are bought for fear of missing out and/or losing clients (known as career risk), while market lows are sold as clients capitulate and sell their once top-performing funds to avoid the pain of further loses.
Offering of predictions Recent studies have shown that weathermen actually have the best track record for predictions (and that’s not saying much), perhaps because they aren’t shy about forecasting storms on the horizon.
But it is impossible to consistently time the market, so don’t do it.
The buy-and-hold pitch Many advisers will say “Buy and hold over 10 years and you will be OK” and claim that is a riskmanagement tool.
However, what does an arbitrary time period have to do with your own financial goals? And what happens if a large crash like 2008 happens right at the end of your investment time horizon?
In conclusion, it’s important that investors also do their due diligence before investing in hedge funds in order to separate those who are truly risk managers from those who are long-only managers in disguise or, worse, speculators and levered longs.