If you’re considering working with a financial advisor, at some point, you’ll probably discuss the advisor’s investment track record. Most advisors aren’t going to offer a public track record of how they’ve done because unlike mutual fund or ETF managers, financial advisors don’t manage a single, uniform portfolio. Instead, they maintain individual client portfolios, and these portfolios are typically based on a model portfolio and then customized to meet client needs.
If an advisor provides information on his or her investment track record, the data is likely based on the model portfolio most appropriate for you. When it comes to reviewing model portfolio returns, there are a couple of questions you should ask as follows:
Is it based on a Hypothetical Portfolio or is it Based on Actual Historical Return?– A “hypothetical” is based on a static portfolio, and any return data is historical data for that portfolio over the period in question. While a hypothetical portfolio can give you some idea of the investment advisor’s approach, it falls short on providing information on the advisor’s track record. The reason is that in managing investments, advisors will typically make changes over time, but the hypo just provides a snapshot of a specific portfolio.
How Has Your Investing Approach Changed Over Time/Has Portfolio Exposure to “x” always been at this level?– This question is particularly relevant if you are presented with a hypothetical. The question can help further illuminate the advisor’s approach, but as important, when it comes to a hypothetical, it can help you determine if the advisor is reporting returns that are better than the advisor’s actual track record.
As an example, U.S. stocks outperformed their foreign counterparts by a wide margin from roughly 2009 through 2016. If an advisor put together a model portfolio and hypothetical with a more substantial weighting to U.S. stocks than he had over the period, model returns would generally be better than actual returns.
One final point this question can help illuminate is whether the advisor is willing to change his investment approach or portfolio exposure. In the latter years of the period in which U.S. stocks outperformed foreign stocks, I met more than one advisor who had done well by overweighting U.S. stocks. When I asked if they planned on upping their international exposure, they said they had no plans to do so as “U.S. stocks had always performed well.” Given market history and the fact that U.S. stocks and foreign stocks have each had periods of outperformance, I think this lack of flexibility will be detrimental to long-term returns.
What Other Assumptions are Made in Producing Model Portfolio Returns – Both hypothetical and model returns generally include several assumptions. The most important is whether returns presented are net of all fees (including the financial advisor’s fee). Some reports may also provide after-tax returns. If a sizable portion of your portfolio is in taxable accounts, check to see how the tax assumptions used to generate the report compare to your tax situation.
Advisors add value for clients in a number of ways, but how well they manage investments is a key component of the relationship. Make sure you understand their approach and have some idea of their investment track record as you consider working with them.
Micah Porter, CFA, CFP is a fee-only financial advisor in Decatur (Atlanta), Georgia.