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A Simple Way To Gauge Your Investment Advisor's Competence

February 26th, 2014

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This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

How good is your investment advisor?

If you're like most people, you'll have trouble answering the question. Unlike with some other professionals, measuring your advisor's performance is tricky.

For example, I'm willing to bet that many pepole are happy with their advisors right now, even if their advisors have done a mediocre job. If you have a portfolio with even a moderate amount of risk, then unless your advisor is very incompetent, you'll have realized double digit returns on your portfolio last year. Many people will look at their results and think, "well, it sure beats earning interest at a savings account". However, as I've pointed outbefore, this is an illusion.

Instead, in theory, you should always measure your advisor's performance against a relevant benchmark. A good benchmark may consist of a basket containing U.S. stocks, Canadian stocks, bonds, etc, and you should measure it over a number of years. However, while this sounds good in theory, most people don't actually measure their performance this way, for the simple reason that it's complicated. Most people don't have the skill and the knowledge to construct such meaningful benchmarks.

That's why perhaps more so than in any other industry, the financial advice industry runs on trust. Absent any meaningfully simple way to gauge an advisor's competence, many people instead rely on word of mouth recommendations. However, this method is far from perfect as well. If the person recommending the advisor doesn't know how to gauge the advisor's competence either, then it becomes a case of the blind leading the blind. I think it's the main reason why so many bad advisors manage to stay in business.

Introducing The MoneyGeek Measure

That got me thinking - is there really no better way to tell whether an advisor is good or not? Having a good advisor can make a huge difference - often by hundreds of thousands of dollars - to your wealth over time. After some thinking, I believe I have come up with a simple way, which though far from perfect, should serve its purpose. I'm going to call it the MoneyGeek Measure.

The MoneyGeek Measure is very simple. It involves asking your advisor just one simple question:

"How big is your TFSA account?"

The advisor's answer shouldn't contain his/her spouse's account as well, but only the advisor's. Once you have the answer, compare it against the following table.

GradeTFSA Size
A Over $45,000
B $42,000 to $45,000
C $39,000 to $42,000
D $36,000 to $39,000
E $33,000 to $36,000
F Under $33,000

Here's why this measure works. Unlike with an RRSP, everyone in Canada gets the same TFSA contribution room. That means unless your advisor is under 23 years of age, he/she will have been able to contribute a maximum of $31,000.

Also, since the TFSA is a such great investment vehicle, it would have probably made sense for the advisor to contribute the maximum possible. For someone who is facing higher income tax rates in the future (which is most people who are far from retirement), it makes sense to contribute to his/her TFSA first, before contributing to the RRSP.

Therefore, the size of an advisor's TFSA should correspond directly to the advisor's investment performance over the past 5 years. With that in mind, let me explain how I came up with the thresholds.

What The Grades Mean

The best class of advisors (i.e. Grade As) would have a TFSA containing over $45,000. That's because with $45,000 or more, that means the advisor beat a hypothetical portfolio containing 50% Canadian stocks and 50% U.S. stocks. Beating this benchmark implies two things: 1. The advisor had the wisdom and the guts to bet on stocks in 2009, and 2. The advisor did better than the market by successfully picking stocks. I expect that very few advisors will belong in this category.

To make it into Grade B category, the advisor would have either had to invest most of his/her money into a stock market index fund, or pick stocks that ended up doing about as well as the market. Either way, it shows that the advisor recognized that stocks had been undervalued for much of the past 5 years.

Making it into Grade C would have required to advisor to either invest in a "balanced" 60% stocks, 40% bond mix of index funds, or invest heavily in stock market mutual funds that cost 2.5%. Although a grade of 'C' doesn't sound very high for those who grew up in a North American educational system that hands out As liberally, I believe those who belong to Grade Cs in the MoneyGeek Measure are good advisors, and are worthy of attention.

To make it into Grade D, the advisor would have had to either invest in a "balanced" 60% stocks, 40% bond mix of mutual funds that charge heavy fees. On the plus side, if they sell mutual funds, these advisors should be commended for practicing what they preach. However, it may also show that they haven't clued into the damaging effect of fees.

Advisors that make it in to grades E and F are essentially those who have a habit of making bad decisions. Perhaps they invested in gold, or perhaps they bought overvalued stocks. I believe these advisors should be avoided.

Caveats

The MoneyGeek Measure isn't fool proof, mainly because it operates on one big assumption - that your advisor has contributed the maximum possible into his/her TFSA account. If they hadn't done so, you can't use the measure. But if your advisor didn't make the full contribution, it may be worth asking why. There are good and bad explanations.

A good explanation might be that the advisor is busy filling up his/her RRSP contribution first. This is especially legitimate if the advisor is nearing retirement, so it really is tax advantageous to do what he/she is doing. However, I would get a little suspicious if the advisor is young, as the TFSA is a better tax vehicle than RRSPs for people who expect to see higher tax rates because of rising income in the future.

Another possible explanation is that the advisor just doesn't have enough savings to fill up his/her TFSA. But if the advisor doesn't have much in RRSPs nor TFSAs, then you should ask yourself whether you feel comfortable taking advice from someone with little experience.

Lastly, some might object to the MoneyGeek Measure, because advisors wouldn't have achieved grades A or B without taking on a lot of risk in the form of heavy stock allocation. While I think this objection has merit, I don't think it's critical.

Advisors who belong to grades A and B are great advisors. These advisors would have been in agreement with great investors such as Buffett, who had maintained that stocks were cheap, but bonds aren't (not necessarily true today!). I believe that great advisors know when an asset class is under or over valued, which lends itself to a certain degree of market timing. I know that many will disagree with me on this point, but I believe it's part of an advisor's job to know these things.

In short, the MoneyGeek Measure isn't perfect - no simple method is. However, I would argue it's better than nothing. I realize that it's awkward to ask an advisor, particularly one referred to you by a friend, for their TFSA account size. But on the other hand, if you have $100,000 in investible savings, even a low cost advisor may charge you 1% of your assets, equating to $1,000 a year. If you're going to spend that much, it may be worth asking awkward questions.

This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

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