Probability, disclosure and client choice

Many advisors I know recommend picking stocks or picking actively-managed mutual funds as their specialty and their exclusive way of building a responsible portfolio. While I respect their decision and acknowledge advisors should be able to recommend whatever products or strategies they think are best for their clients, I also believe a substantial element of professional advice-giving is the notion of informed consent.

In other words, irrespective of what products or strategies an advisor recommends and what the rationale is for those recommendations, does the client understand the rationale behind those recommendations on a balance of probabilities basis?

In terms of probabilities, the advice to only consider active security selection (either through direct securities or through mutual funds) I postulate is not compelling from what I have heard and I question whether this ought to be the sole paradigm for investors to consider. From my perspective, that’s especially true in the context of taking a long-term view.

This article, however, is only nominally about which of the two options is superior. To me, the more fundamental question is one of informed consent based on disclosure related to the balance of probabilities. Everyone – advisors, consumers, the media, product manufacturers- are entitled to an opinion or preference. My interest is to request that investors be given the facts on a fully disclosed basis that fairly depicts options so a decision based on an investor’s own values, perceptions of risk, and objectives for reward will be facilitated.

This is not a novel concept.

It’s actually the mandate from Regulators known as KYC (Know Your Client) suitability.

The long view

Although there are many definitions of “long term view”, let’s use 25 years as a proxy to depict that timeframe. Over that time horizon, what percent of actively managed funds end up beating the return of a tracking product? Various studies have been done on this subject and the ones I gravitate to seem to indicate “less than 10%”. There is also an argument that those that do provide superior performance do so on a random basis that may be explained by chance.

This also means the 90% of actively managed funds will underperform over that timeframe. Back to the original thesis: on a balance of probabilities basis and on a fully informed basis, which option should a client choose and are advisors making those disclosures?

The obvious answer is clients should choose whichever option best meets their own views of risk and return with the balance of probabilities being a risk issue to consider. My recommendation is to take the passive and low cost approach to portfolio construction, but I respect the choice of clients who choose the 10% probability option.

Why is that?

For those who are statically inclined, the answers are obvious. The likely reason for the collective underperformance of active strategies over long timeframes is they cost more. My simple point is cost is likely the most reliable long-term indicator of long-term relative performance- and that it is a negative indicator. The adage could be you get what you don’t pay for. The less you pay; the more you keep. The more you keep; the better you do and that becomes truer as the time horizon extends.

William F. Sharpe’s paper ‘The Arithmetic of Active Management’ articulates this argument well and for a copy please drop me an e-mail The Nobel Laureate explains his reasoning of why the average passively managed dollar must out perform the average actively managed dollar.

This concept can be graphically depicted. Using the assumption of a normally-distributed after-cost collective investment experience for active managers as a benchmarked and taking out costs that constitute leakages to overall performance to reduce returns, the normal distribution shifts left for the impact of costs, thus decreasing investor returns “on average”.

In this illustration, a market return might be the high point of the chart, but actual investor experience will be uncertain. However, passive (market-tracking) products have costs and therefore will have a return that will be below the market return by the amount of those costs. The illustration then assumes active product costs are 1% higher in aggregate, causing a further 1% shift that one might expect over time. The noteworthy graphic observations are consistent with the balance of probabilities approach:

• The shaded area of the normal distribution to the left of the average return of the market returns represents the actively managed funds that underperform before considering costs. After costs, the entire bell curve shifts to the left.

• The “average active” option underperforms the “passive market” option (see the line that dissects the original bell curve) over time and on a balance of probabilities.

• The unshaded area to the right of the centre of the grey distribution represents the outperformance compared to the investable benchmark after costs are taken into account.

While not depicted here, it should be intuitively obvious that in short time horizons, dispersions of outcomes can be massive, while the impact of costs is nominal. Over time, the dispersion of outcomes tends to ‘revert to the mean’, but the impact of costs becomes increasingly material.

Once this type of disclosure is made and clients understand the balance of probabilities, an informed choice can be made. A client who wants to choose on the basis of statistical probability should choose passive products that fit their other objectives and risk tolerance. Clients who are chasing returns and are properly informed will know what they are giving up when they “chase returns” and choose lower probability options. These approaches are not mutually exclusive and can be mixed in a variety of fashions.

Now for the advice

In light of the above points, what should conscientious advisors say to their clients when discussing the relative merits of both active and passive strategies and products? My point is the real decision here is not only about whether or not someone might be able to “win” as a result of a particular course of action, but the reasonable probability that one might expect to be successful. Of course, it ispossible one might do better as a result of pursuing an active approach…. but is it probable? As importantly, has this probability disclosure been made?

Given we already know it is improbable that one would have a superior investment experience as a result of pursuing an active strategy,is it advisable to counsel someone to pursue a strategy that is more likely than not to be unsuccessful without disclosure about balance of probability?

Call for reflection

For those readers who work directly with financial advisors, please give your advisor a copy of this article. Through you, I’d like to ask your advisor to reflect on one question:

“Would anyone who recommends actively managed products and strategies while simultaneously failing to disclose the balance of probabilities issues and the availability and potential applicability of passive options please offer a clear, rational, research-supported basis for failing to do so?”

In my book, The Professional Financial Advisor II , I distinguish between types of advisors. One type, STANDUP (Scientific Testing And Necessary Disclosure Underpin Professionalism) Advisors, attempts to work using full, true and plain disclosure of all material facts that might impact on a client’s decision-making. The other, SPANDEX (Sales Pitches And Non-Disclosure Eliminate eXcellence) Advisors seems prepared to avoid conversations like these. Which type of advisor would you rather work with?

John De Goey, CFP, is the vice president of Burgeonvest Bick Securities Limited (BBSL) and author of The Professional Financial Advisor II. The views expressed are not necessarily shared by BBSL. You can learn more about John at his Web site: www.johndegoey.com.