Fiduciaries v. Certifiers

With President Obama raising the pressure to strengthen enforcement and promotion of the fiduciary standard, now is the time to clarify rules to meet that standard. But as to who should set the rules, there’s a terrible problem.

Leading investment advisors and software designers are focused on guiding investors toward their best interests, dollars for their future needs and goals. And recognizing the great uncertainties, they view those future results in terms of probabilities.

But the organizations that sell investment advisors fiduciary certifications, such as fi360 and the PFP Division of the AICPA, appear stuck in a three-decade-old time warp created by software products introducing modern portfolio theory back in the 1990s, such as Portfolio Strategist designed and marketed by Ibbotson Associates. That approach diverts investment advisors from pursuit of investors’ best interests — in favor of financial industry profits, investment advisors’ fees, and professors’ theoretical interests. That is the opposite of fiduciary.

The problem is that at the Institute for the Fiduciary Standard, it is certification-sellers, rather than leading investment advisors, who are proposing rules for the fiduciary standard. They are proposing rules in line with procedures from 1990s mislabeled misapplication of modern portfolio theory. Those rules avoid pursuit of investors’ best interests in favor of mis-trained investment advisors’ interests.

Investment advisors pursuing investors’ best interests

Even free for investors’ own use on the Web, there’s more and more software that helps us all to focus on investors’ best interests, dollars for an investor’s future needs and goals. For example, FIRECalc, which produces historical simulations of multi-year dollar plans, in dollar value through the years of a plan, like this:


It’s obvious from graphs like this — and also from common sense — that for longer term investment, future dollar results are more and more uncertain.

Recognizing this — that investors’ best interests are meeting dollar goals of future years, and those results are uncertain — leading financial planners and other investment advisors use software products that feature assessments of investment plans and selections in terms of probabilities of meeting future dollar goals.

For example, the most widely used financial planning software product, MoneyGuidePro, features meters that show assessments and comparisons of plans and investments in probabilities of meeting a client’s future dollar goals, like this:


By showing probabilities of meeting goals, this kind of software also shows the client’s real risk: risk of falling short of future dollar goals. For example, the meter at right shows 79% probability of meeting the goals, which means 21% risk of falling short.

Of course, assessments such as these are based on assumptions that should be tested, and should be viewed as only approximations. But these assessments are focused on pursuit of investors’ best interests: dollar results for goals of future years, viewed with uncertainty.

In this way, leading investment advisors and software designers guide investors to see and focus on controlling their real risks — danger of shortfall for their future needs and goals:


This is fiduciary investor guidance, in investors’ best interests.

Certifiers pursuing advisors’ interests

Fi360, which sells the certification of “Accredited Investment Fiduciary (AIF),” tells investment advisors that as the basis for guiding a client toward his goal or objective, the advisor should have done something very different:


This is dreadful misguidance. The term “expected return” is professors’ code for a return that is not expected. That term standardly means there is no such thing as expected return — instead, it means that future returns are uncertain, viewed in probabilities, with no particular return likely enough to be expected.

The leading university investment textbook says — on page 10 in my version — that actual return is almost never “expected return.” So of course anyone who knows what’s going on does not expect return to be “expected return.” Got that?

Worse for investors, as investment years go by, an investment’s actual results are expected to lag further and further behind what that investment’s so-called “expected return” would deliver. With increasing uncertainty as to how far below the investment’s future results may lag.

Of course, fi360 does not intend to train investment advisors to expect investment results that are unexpected. Nor does the PFP Division of the AICPA, which has provided technical review and apparent approval of the fi360 investment advisor teachings. They must think investments’ “expected return” is expected.

But if an investment advisor is trained to guide his client to an investment with the “expected return” to meet the client’s goal, the client will of course expect his investment to meet his goal, while his investment is expected to fall short, maybe by a lot. That is not fiduciary.

This “expected return” misguidance is part of an erroneous view that investments’ longer term future results are known, and the real risk is short-term return-rate variation just ahead, like this:


Of course, this view is refuted by history, mathematics, and common sense. For longer terms, investment results are more uncertain, as illustrated by the FIRECalc graph of actual history.

To guide investment advisors toward the erroneous view of the illustration just above, fi360 software presents them, as the basis for a client’s investment selection, a graph comparing a range of diversified asset-class-mix portfolios — compared in technical measures of percent return-rate probability for the individual year, with labels that make these measures and the comparison mean much more than they actually mean:


In this fi360 graph, the vertical axis actually represents return-rate arithmetic mean, a technical measure of probability that actual return is expected to miss. Yet it is labeled “expected return.”

The horizontal axis represents not the investor’s real risk, danger of shortfall for his future dollar goals, but instead a technical measure of short-term return-rate variation that investors commonly overreact to. Yet it is labeled with the fear-word “risk,” which can inflame those investor overreactions.

Professor Zvi Bodie, lead coauthor of that leading university investment textbook BKM, says with his coauthor of a book for individual investors that for them, this is the wrong definition of risk.

This use of the fear-word “risk” is in stark contrast with its responsible use of that word in other fields affecting people’s well-being, where risk is assessed as probability of an adverse outcome through the well-established methodology of risk assessment. This fi360 use of that word forces good investment advisors into doubletalk, such as “The greatest risk is to take too little ‘risk'” — in which sentence the first risk is the investor’s real risk and the second is the conflicting “risk” in the fi360 training.

Of course, this portfolio comparison is no basis for a client’s portfolio selection. It doesn’t address his best interest, dollar results for his goals of years ahead. It doesn’t even give any consideration to dollars, or years, or effects of compounding along the way.

This diversion of focus from the investor’s best interests to a misleadingly labeled deficient view of the single year has the anti-fiduciary effect of favoring the interest of the investment advisor over that of the investor, in two major ways:

1. From this single-year view the investor has no basis for seeing or judging which portfolios offer best or worst prospects for his future, and thus is left feeling wholly dependent on the advisor.

2. And from this diversion to the single-year view, the investor cannot see the long-term compounded cost to him of the advisor’s fees.

Now the investor is set up for the execution. 

For most investments, grounds for estimating their future return-rate probabilities are too weak to even laugh at. But for this, asset classes defined and measured by indexes have two advantages. One is decades of return-rate history, reported by their indexes, for calculating past return-rate probabilities. The other is widest diversification, to minimize danger from bad future performance of any particular business or investment manager. This is why for portfolio allocation, the investments in the portfolios are asset classes. For the steps outlined above, fi360 uses asset classes with index data representing 40 years of return-rate history. The portfolio thus selected for a client is a mix of those asset classes.

But for the execution, actual placement of the client’s money, fi360 leads investment advisors down a path that makes one gasp. Instead of simply investing the client’s money in his selected asset classes, fi360

leads the advisor to gamble the client’s money on bets in the financial industry casino full of riskier higher-fee gambles on actively managed funds within the asset classes;

sells the advisor oceans of “scores” on these gambles with standards scandalously lower than fi360’s own standards for the client’s asset classes;

leads the advisor to present such gambles of the client’s money with the false appearance of faithful investment in the client’s chosen asset classes.

Of course, most of these gambles are riskier. One of the principal advantages of asset classes is their diversification to minimize danger from bad performance of a business or investment manager. Betting on the manager of an actively managed fund is DEdiversifying. It throws that asset-class advantage away.

Of course, most of these gambles are riskier in another way, concealed by the “scores” that fi360 sells to advisors. Compared to the 40 years of return-rate history for fi360’s asset classes, fi360 “scores” for gambles feature a requirement that to get a perfect “score,” the gamble’s manager must have been on the job for a mere 2 years.

Of course, most of these gambles extract more of the client’s money for fees and expenses, and fi360 “scores” conceal this disadvantage. The fi360 “scores” compare these higher-cost gambles’ fees with fees of other high-cost gambles, instead of with the lower-cost of investment in the client’s selected asset classes via index funds.

Certainly there can be occasions when an investment manager can make a valid case for such a switch from investing in the client’s asset class. But on such occasions, the investment manager should be required to reveal the switch and present the case. It is always simply dishonest to place the client’s money in something other than his selected asset classes under the pretense of investing in his asset classes.

So there we have the training and guidance given to investment advisors by fi360, along with “fiduciary” certifications, after technical review by the PFP Division of the AICPA. Avoid seeking choices that offer best probabilities for the investor’s best interest, dollar results for his future goals. Instead use the misleading term “expected return” to give him false expectation of a goal result his investment is not expected to meet. Use the fear-word “risk” in a misleadingly labeled comparison of asset-class-mix portfolios in technical return-rate probability measures, diverting the client’s focus to the individual year where he has no basis for judging best choices for his future, is left dependent on the investment manager, and cannot see the long-term cost of the investment manager’s fees. Then switch from investment of the client’s money in his selected portfolio’s asset classes to choices from the casino of riskier high-fee gambles within the asset classes.

For the client’s best interest, this guidance is less than ideal. But for the financial industry, it offers fees from those casino choices. And for the investment advisor, it offers an ocean of casino gambles for him to sort through, running up time to justify higher fees.

“Best Practices” for investment fiduciaries

(In this section, paragraphs in italics are recommended best practices or other recommendations to the Institute for the Fiduciary Standard.)

The Institute for the Fiduciary Standard has issued a paper presenting what it calls “Proposed Best Practices” for investment fiduciaries. But the “proposed best practices” appear to be sadly deficient in calling for practices of leading investment fiduciaries summarized at the top of this page, and disappointingly silent on or supportive of not-so-fiduciary practices taught by fi360 and other sellers of investment advisor certifications.

1. While the paper calls for serving the client’s best interest, and in proposed “best practice” #2 calls for documentation including the analysis applied, it says nothing about what those best interests are or what analysis should be applied.  It should be more specific.

While there may be an occasional exception, in almost every case the client investor’s best interest is net purchasing power dollar results for needs and goals of future years, as best they can be foreseen by the advisor and the client. The analysis to be applied should be focused on revealing best choices for those dollar results, and should reveal uncertainties for investments’ future results through probabilities or other indications of ranges of uncertainty.

2. The paper calls for clear communication understood by the client, using such phrases as “understood by Main Street investors” and “plain English.” It references another recent Institute paper criticizing “failure to translate industry jargon into plain language.” Yet it says not a thing about the misleading terms that have mis-shaped investment advisor training and investor guidance since the spread of use of modern portfolio theory in the 1990s.

The term “expected return” or its shortened version “return” should never be used for any future return that is not expected.

The powerful term “risk” should be used to guide the client toward his best interests, dollars for his future needs and goals, by representing danger of lower dollar results for those needs and goals; not to divert his focus toward and inflame his fears of short-term return-rate variations.

3. In its proposed “best practice” #4 the paper calls for detailed reporting of fees and expenses, but only for the individual year. In proposed “best practice” #11 it calls for fee-and-expense comparison of investments, but comparison with other investments in the financial industry casino full of investments with high fees and expenses.

Reports of fees and expenses should include illustrations of their effects on dollar results for the client’s future goals if the same fees and expenses were applied all the way to the final goal, calculated and applied in the same method as currently applied (% AUM, $ amount, etc).

In comparison of investments’ fees and expenses, the standard for each investment should be the index fund for the asset class in which that investment is said to be classified.  

 4. In the paper, proposed “best practice” #10 is “Have access to a broad universe of investment vehicles that provide ample options to meet the desired asset allocation and in consideration of widely accepted criteria.” This is as anti-fiduciary and dishonesty-authorizing as could be, authorizing the malpractice of placing the client’s money for a chosen asset class in any of a casino of less diversified, shorter-history, riskier, higher-fee financial industry gambles within an asset class — and misrepresenting such a gamble as faithful investment in the client’s chosen asset class. It should be removed and replaced.

The way to execute an investment in a client’s asset class is to invest in the asset class — in an index fund or index ETF designed to match the performance of an index for the asset class. Preferably this is the index used for historical analysis and future-performance estimates for that asset class in the client’s portfolio selection.

There may be unusual cases in which, after the investment advisor and the client have selected a portfolio allocation of index-based asset classes, the advisor believes there is valid reason to place the portion of the client’s money allocated to an asset class in something other than the index-based asset class. In each such case, the advisor should present his reasons for doing so, including comparison of the alternative investment with the index fund in length of return-rate history, performance over those histories, and total of fees and expenses on an annual basis and applied through the life of the client’s plan to his final goal. 

5. This whole best practices effort has the appearance of reflecting the sellers of investment advisor training and certifications that have never recovered from the mislabeled misapplication of modern portfolio theory spread to the investor guidance community back in the 1990s, rather than parties best qualified to define investor guidance that pursues investors’ best interests. This appearance is presented by:

a. The proposed best practices

b. The statement in the paper’s page-1 introduction that the proposed best practices are “informed by the good work of others in the professional standards arena; i.e.: fi360, CFP Board, AICPA/ PFS, CFA Institute.”

c. The membership of the Institute’s Best Practices Board that prepared the “proposed best practices”

If the development of “best practices” continues in the current direction, the effect of the fiduciary standard will be to provide benefits not to the investing public but to a growing empire of well-fee’d but mis-trained investment advisors mislabeled as “fiduciaries.”

With the increased scrutiny of the fiduciary standard and its application that lie ahead, and venture-capital-financed entries into the field, such a gross misapplication of the fiduciary standard is likely to be exposed soon, and the exposure may do severe damage to the public image of the entire investment advisor community including the best.

Change the makeup of the group developing fiduciary best practices to dominance by leading practitioners and software developers practicing and providing tools for actual investor guidance in investors’ best interests, and mathematicians who understand probabilistic long-term investment mathematics, instead of dominance by representatives of the organizations that now sell investment advisor training and certifications advocating mislabeled misapplication of modern portfolio theory.

It came from professors

Immediately after Professor Harry Markowitz was given a Nobel Prize in Economics in 1990 for his creation of modern portfolio theory, a paper authored by him was published in which he said that he designed the theory to benefit mutual funds, and for individual investors a different approach involving simulation should be applied.

However, during that decade software products backed by names of professors introduced, enabled, and spread application of that theory to the community of investment advisors providing guidance of individual investors, and to the organizations that sell investment advisors training and certifications.

The theory spread major advances in use of probabilities to reflect investments’ future-return-rate uncertainties and diversification to reduce those uncertainties.

In the professor-backed software, for a list of asset classes with future return rate probability assumption the theory’s mathematics identified a conservative-to-aggressive range of diversified asset-class-mix portfolios presented as points along a curve in a graph called an Efficient Frontier:


As shown by the axis labels above, the graph described and compared the portfolios in two technical measures of return rate probability for the individual year.

Across the range from most-conservative at lower left to most-aggressive at upper right, portfolios along the curve offer vastly different combinations of return-rate potential and uncertainty, so for each investor it is of overwhelming importance to choose a portfolio from the best part of the curve for his particular cash flow investment plan and goals. However, from the comparison presented by this graph the investor has no basis for judging which portfolios are best (or worst) for him. To most investors (and advisors) the mathematical measures of the comparison and their meanings for multi-year investment results are Greek. The graph does not address the investor’s future dollar goals, does not even give any consideration to dollars, years, or effects of compounding along the way..

To assess and compare the portfolios in probabilities of meeting an investor’s future dollar goals, it would be necessary to carry out further analysis: For each portfolio, apply its probabilistic return rate to the investor’s cash flow investment plan year by year from present to his final goal, applying effects of compounding along the way. This could be done with Monte Carlo simulation, another method of mathematical analysis developed at about the same time as modern portfolio theory, back around 1950. Results of this analysis could be shown on a graph comparing the portfolios in probabilities of meeting the investor’s future dollar goals:


From this graph, an investor and an advisor can see right away that the portfolios highest on the graph are best.

However, the designers of the professor-backed software did not incorporate this further analysis. Instead, they stayed with just the single-year efficient frontier graph comparing the portfolios in technical measures for the individual year — and gave those measures new names that made the measures and the graph appear to mean much more than they do mean:


The vertical-axis technical measure was named “expected return” (or just “return”) even though the return it represented was not expected. And the horizontal axis was named “risk” even though an investor’s real risk is very different, danger of shortfall for his future dollar goals.

The professor-backed software led investment advisors to lead investors to chose their portfolios from the comparison on this graph, even though with the new labels it still provided no basis for judging best or worst portfolios for an investor’s dollar plan and goals.

Here is an illustration of this kind of graph, with these labels, presented in one of the software products backed by names of professors as the basis for advisors’ and investors’ portfolio selection:

Ibbot1With no basis for choosing a portfolio for an investor’s best interest, his future dollar goals, the designers decided to exploit the label “risk” to inflame the investor’s short-term fears and base his portfolio selection on those fears.

So called “risk tolerance” questionnaires were developed that directed investors’ attention toward, and further inflamed, their fears of short-term return rate variation.

From investors’ answers to those questionnaires, systems were devised to assign an investor a number called his “coefficient of risk aversion.” Here, as in the questionnaires, “risk” meant short-term return rate variation.

Professors developed mathematical formulations that were said to determine an investor’s portfolio without assessing which were best or worst for his best interest, his future dollar goals — based instead on his coefficient of risk aversion.

Of course this approach was not, and is not, pursuit of the investor’s best interest, best prospects for his future dollar needs and goals, as called for by the fiduciary standard. It does not even address that purpose.

Just the opposite: It certainly favors interests of the advisor over those of the investor, in two major ways.

It leaves the investor with no basis for his own judgment of which portfolios offer best prospects for his future, and thus a feeling of fullest dependence on the advisor.

And with the investor’s focus diverted to the individual year, he cannot see the long-term compounded cost to him of the advisor’s fees.

For the preceding steps, the software backed by names of professors used asset classes as the portfolio components, because compared to other investments asset classes have far longer return rate histories and wider diversification, and thus less future-performance uncertainty and risk.

But for actual placement of an investor’s money, the software backed by names of professors led advisors to consider, for each asset class, any less-diversified, shorter-history, riskier gamble said to be within the asset class. And to do so while presenting the false appearance that such a switch from asset class to gamble was faithful investment of the investor’s money in his chosen asset class.

Here is an illustration of a window for that switch in one of the software products marketed under the name of a professor:


Across the top were letters for the various asset classes that might be included in an investor’s portfolio. Down the left was a scrollable list of hundreds or thousands of actively managed mutual funds and other gambles said to be within one or another of the asset classes. for each asset class, the advisor could select any gamble said to be within that asset class for placement of the investor’s money.

Thus essentially everything that’s most anti-fiduciary about the investment advisor training provided by fi360 and the other certification sellers was introduced by software backed by professors back in the 1990s.

I’m sure you can see why Professor Markowitz wrote that his theory was designed to benefit mutual funds instead of individual investors — that is did, and still does.

I’m sure you can see why Wharton Professor Kent Smetters wrote not long ago that for guiding individual investors, the approach of modern portfolio theory based on answers to a risk tolerance questionnaire is a “simpleton procedure” that is “terribly naive.”

But obviously, the folks at fi360, the PFP Division of the AICPA, and the others concerned with selling investment advisor training and certifications who are still teaching this stuff intend to have investors guided in their best interests as called for by the fiduciary standard. They must believe this stuff — that “expected return” is expected and all the rest.

Well, it may not be best for investors, but it sure can lead to lots of fees for lots of mis-trained advisors, and we’re now in the third decade of training investors this way, and nobody’s stopped us yet. Think we can go with the Institute’s best practices and hope it will not be exposed for another decade?

I’d rather we stop this training and certification for investor misguidance now, and adopt best practices for real fiduciarity.



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