In recent years investors have increasingly turned to fee-only investment management relationships. This trend has been driven, to a large degree, by the desire among both investment professionals and their clients to better align advisor compensation with the work advisors do to help clients grow their portfolios and reach their investment objectives.
Commission-based investment advice, which for many years was the standard method of compensating financial professionals, has lost ground as a result. The problem with this method is that it can present a conflict of interest, as it enables a stockbroker or financial advisor to boost his or her compensation by making more trades, whether or not those trades make the client money.
The potential to abuse commission-based compensation by engaging in what is known as “churning,” or making trades solely to earn compensation, has resulted in a move in the financial services industry to compensation methods which are less likely to present conflicts of interest, such as the fee-only investment management approach.
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Advisors who manage investment portfolios on a fee-only basis receive no per-trade, or commission, compensation. This means that the only compensation they receive from the assets they manage is in the form of fees, typically based on a percentage of total assets under management (AUM) or flat retainer. At Financial Freedom Fee-Only Wealth Management, our only method of compensation is a fully-disclosed, hourly or retainer-based fee. We do not receive any compensation from third parties or anyone other than you the client.
The increased utilization of the fee-only investment management approach makes sense when considered from this standpoint. By removing the incentive for advisors to take actions that are not in the best interests of their clients, a more equitable framework for a productive client-advisor relationship is maintained.
This type of compensation arrangement also frees an advisor to make as many, or few, trades as are needed in a client’s account to help the client meet their investment objectives. Because the advisor doesn’t make any more – or less – money based on the number of trades they make, they can focus strictly on doing what is best for the client. This makes it easier for advisors to work with clients on sophisticated strategies such as those that involve portfolio rebalancing or tax optimization.
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Strategic asset allocation calls for an investor to establish targets for allocating funds to various asset classes within their portfolio. As those allocations change over time due to performance differences among the different assets, the portfolio is rebalanced to the original allocation on a regular basis.
Strategic asset allocation can use various approaches to determine the original allocation targets. Typically, the initial step in drawing up an allocation strategy involves taking into account the following three major factors:
- Time horizon: This factor is important for determining the type of investments in a portfolio. Generally speaking, the longer you have until you need to use the funds in your investment portfolio, the more volatility you can withstand in your portfolio’s performance.
- Risk tolerance: The amount of volatility you can accept in an investment is the primary determinant of your risk tolerance. In general, the investments with the highest potential return are the most volatile, so considering your tolerance for up and down moves in a potential investment is an important factor in determining how much risk you are willing to take on.
- Investment objectives: The goals you are aiming to achieve with your investments play an important part in determining the type of investment strategy which will work best for you. If your goal is to retire early, for example, you may have to set aggressive investment objectives which could conflict with your risk tolerance. An advisor can help you in analyzing such a scenario and determining whether to push back your retirement timeline or decide to invest more aggressively than you might normally be inclined to in order to attempt to achieve your dream of an early retirement.
As these factors change, for instance, as an investor gets closer to retirement, the asset allocation of the portfolio would change accordingly. Thus, a typical use of strategic asset allocation might involve an investor investing aggressively for growth when they have many years until retirement, then taking a more conservative approach when retirement is just a few years away.
Given differing investment objectives and financial situations, investors in similar age brackets will not necessarily pursue identical asset allocations. For example, an investor who is comfortable with high levels of volatility would be more likely to invest a significant portion of their portfolio in growth stocks, while a more conservative investor with a similar time horizon might feel more comfortable with a higher level of fixed income, or bond, investments to help reduce portfolio volatility.
Strategic asset allocation is based on the principles of Modern Portfolio Theory, which stresses the benefits of diversification among different types of assets and asset classes to reduce portfolio volatility and optimize a portfolio’s potential return for a given level of risk.
This approach is designed to take the emotion out of investing. Investors often hurt their investment performance by making emotional decisions. For instance, chasing a hot stock or sector only to find that by the time you invest in it the magic is gone and the investment’s performance turns from positive to negative. By reallocating funds from hot performing sectors to keep them in balance, this approach ensures that your portfolio doesn’t become unbalanced to the point where it is excessively dependent on any one sector.
This type of disciplined approach is key to maximizing the ability of strategic asset allocation to help investors achieve their objectives.
Strategic diversification refers to the concept of investing in a variety of assets with different performance characteristics to reduce risk while still positioning a portfolio for growth. The idea is to give up some of the potential upside of investing in an undiversified portfolio while avoiding the potential downside that goes along with such an approach.
Strategic diversification allows investors to minimize firm or asset-specific risk, which is known as unsystematic risk. For instance, if you invest a significant portion of your portfolio in a single stock, bad news about the stock could prove devastating to your portfolio’s performance. On the other hand, if you diversify into many stocks, a steep decline in the price of one of them wouldn’t be so bad.
The same holds true with regard to individual asset classes. For example, if your portfolio contains only oil stocks and the price of oil plummets, the portfolio’s performance will suffer significantly more than would be the case if oil stocks only composed a modest portion of your portfolio’s overall investment mix.
Strategic diversification focuses on including assets with low correlation inside a portfolio to help reduce volatility. Correlation refers to the rate at which an asset moves in conjunction with another asset. If an asset moves up at the same rate as another asset, it would have a 100% correlation, whereas it if it moved down when the other asset moved up, it would be said to be negatively correlated. By diversifying into assets that are not all closely correlated to each other, investors can significantly reduce portfolio volatility and risk.
Strategic diversification complements strategic asset allocation in a managed investment account. While strategic asset allocation helps an investor identify a mix of asset classes that have historically offered returns that can enable the investor to meet their long-term objectives, strategic diversification assists the investor to optimize their distribution of funds among assets and asset classes to reduce portfolio volatility.
For instance, if you decide to invest in U.S. growth stocks, or international value stocks as an asset class, rather than place your entire investment in either of those sectors into a single mutual fund or ETF (exchange-traded fund), an advisor familiar with strategic diversification would likely suggest diversifying among asset managers by buying several mutual funds or ETFs.
The goal of strategic diversification is to retain the return potential of investing in an asset class or mix of asset classes while lowering the volatility involved with an investment. Doing so helps optimize a portfolio, with the goal of realizing the returns necessary to achieve an investor’s investment objectives while minimizing volatility levels.
Strategic diversification typically involves investments in the following asset categories:
- Investment type: stocks, bonds, cash, ETFs, mutual funds, etc.
- Risk level: high, medium and low-risk investments can be included.
- Sectors: this includes broad sectors such as growth stocks, blue-chip stocks, corporate bonds, government bonds, etc. and more specialized sectors such as technology stocks, oil stocks, etc.
- Geographies: U.S. and international stocks and bonds.
The vast majority of fee-only investment advisors are considered to be fiduciaries. This subjects these advisors to fiduciary standards, which are considered more stringent than the “suitability” standards which have traditionally applied to commission-based brokers and advisors.
When subject to a fiduciary standard, an advisor is required to place the best interests of their clients ahead of their own when offering investment advice. Under suitability standards, an advisor or stockbroker is only required to consider whether a trade they are recommending is “suitable” for a client, not whether it is in their best interest. This can create a conflict of interest due to the fact that the suitability standard is not as clearly defined as the fiduciary standard. As a result, the fiduciary standard is considered to be the more stringent standard.
Fiduciary standards often go hand in hand with fee-only investment advice. This is because a fiduciary advisor, whether charging fees as a percentage of AUM, flat retainer or on an hourly basis, will generally find it easier to meet the best interests standard using a compensation approach which does not raise concerns about whether the trades being made for a client are motivated by the desire to earn greater commissions.
Fee-only investment management continues to grow in popularity as advisors and clients turn away from commission-based compensation due to the conflict of interest this method can present. In addition to helping foster a mutually beneficial advisor/client relationship from the standpoint of advisor incentives, fee-only investment management often involves strategic asset allocation. Taking such an approach enables investors to create a portfolio tailored to help them achieve their investment objectives in a manner consistent with their time horizon, risk tolerance, and financial situation.
Strategic diversification is often used in conjunction with strategic asset allocation as a means of reducing the risk of investing in growth-oriented investments such as stocks and mutual funds. By investing in a variety of investment vehicles by asset class, investors can reduce portfolio volatility while maintaining the potential for growth offered by the asset class.
Finally, working with an advisor who is subject to fiduciary standards can provide investors with the peace of mind that comes from knowing that their advisor must put their best interests first when providing them with investment advice. Working with an advisor who is covered by the rigorous standards associated with fiduciaries, accompanied by investment management approaches such as strategic asset allocation and strategic diversification, enables investors to take advantage of comprehensive, time-tested strategies with an advisor who puts their best interests first.
At Financial Freedom Fee-Only Wealth Management, we have over 30 years of experience working with high-net-worth individuals and couples. We are a fee-only, fiduciary, wealth management firm dedicated to helping our clients protect, grow, and maximize their wealth.
Contact us today for a complimentary consultation, and find out if we are the right fit for your needs.