Hiring a financial advisor is a deeply personal decision. You are letting a stranger see the intimate details of your financial life, something that is usually unthinkable even if it’s your parents, siblings, or best friends. Most relationships with an advisor are exactly that — relationships. Some might be short term, like a one-time estate planning session, or advice on how to invest a 401(k).
The true benefits of hiring an advisor are only visible over long periods: keeping savings and investing on track; periodic portfolio rebalancing; help with taxes every year; setting up 529 plans for children; and so on. The list is long. But they all require years, even decades, before they bear fruit. Studies done by Morningstar indicate that the value of this advice, if allowed to compound over time (just like an investment), can drastically improve outcomes in retirement.
So, when you hire an advisor, keep in mind that you might be working with them for another 10 or 20 years. If that’s the case, then you should collect as much information as possible so you can make an informed decision, and feel comfortable with that decision. That involves asking a lot of questions, even ones that would be awkward or inappropriate in a different setting.
How do you get paid?
The first, and most important, question is to ask the advisor how they make their money. As noted in previous posts, the majority of RIAs are paid through a fee on percentage of assets, a flat fee, or a combination of the two. But don’t stop with that question. The financial industry loves to pack extra fees wherever it can fit them. Ask them to walk you through the all-in costs and how you will be charged.
Ask the advisor if they use funds with sales loads. If they do, ask if they accept the kickbacks. It’s OK to use this word. Many RIAs will use funds with sales loads, but will have a deal with their broker/dealer to waive the load. There are many good funds that have loads. Ask if they accept compensation from broker/dealers for using funds on the b/d’s platform.
Ask if they mostly use mutual funds, exchange-traded funds (ETFs), or stocks (or a combination of all three) in their investment plans. If they are using ETFs or stocks, then each trade might be charged a sales commission, which will come out of your account. Ask them if they refund these commissions. Many advisors will keep track of the dollar amount of commissions you paid over the year, and then rebate your annual fee by that amount. Doing this comes at a cost to the advisors, since they aren’t receiving those commissions but are still paying them back to you, and is often a sign of their commitment to clients. Alternatively, many broker/dealers offer a lineup of commission-free ETFs, which is a simple way to cut costs.
San Francisco.
What do you invest in?
If you are turning over management of your money to an advisor (rather than just getting periodic advice), then you need to know what they will be doing with it. Will they be managing that money themselves or letting an automated service handle it? These automated services (called “robo-advisors”) will be the subject of my next post. If the advisor is handling it themselves, most will curate a specific lineup of investments that allows them to understand those investments well and to easily scale their business. Ask them what those investments are.
Most of the time, it will be mutual funds and ETFs — or a combination of the two. ETFs are similar to mutual funds, except they trade on exchanges like stocks. They are often significantly cheaper than mutual funds and are very popular among advisors.
Occasionally, advisors will use stocks, but this is getting rarer as it has become clear that stock-picking is extremely difficult to do well. The most common way advisors use stocks is keeping a list of stable, dividend-paying stocks that can generate income for their clients. If the advisor is regularly pitching get-rich-quick stocks, that’s a sign to walk away.
A smaller subset of advisors will use master-limited partnerships (MLPs), business development companies (BDCs), or even real-estate investment trusts (REITs) that are private or non-traded. Publicly traded REITs are a long-established part of an investor’s toolkit, but the private and non-traded versions carry significantly more risk. FINRA released a handy review/criticism of them last year.
They also used to pay fat commissions to advisors, but this practice has been curtailed in recent months and it shouldn’t be a surprise that many advisors have stopped using them as a result. Any advisor still offering them should be treated with caution.
MLPs often form part of any dividend-paying stock lineup. The income paid by MLPs is treated as return of capital, which means that only a small portion of the distributions are taxed. This is a major benefit. However, owners of MLPs don’t get a normal 1099-DIV form during tax time. Instead, they get a Schedule K-1, which usually doesn’t arrive until March or April (sometimes after the tax deadline). So, you and the advisor better be prepared to handle this every year. It is OK to press them for specifics on this.
You should also beware of advisors who use BDCs. These often have juicy yields that advisors will use to justify them, but are very murky investments. Treat them with caution.
What is your investment philosophy?
This was a question that I recommended asking yourself in a previous post, and it’s worth asking the same of the advisor. It’s OK if they don’t match exactly — that’s an opportunity for further discussion and learning on both sides. Also, it’s OK if you don’t have a philosophy. As long as you are open to learning, it’s OK to tell the advisor, “I don’t know.”
I have less to say on this question, simply because there are so many valid answers. The goal isn’t to find the “best” philosophy or strategy. The goal is to find the best one for you, so that you are willing and able to stick with it over time. Some other questions to consider asking:
· What is the rationale behind your philosophy?
· What will cause you to buy or sell?
· How do you determine when to make changes to my portfolio (and why)?
· When and how will you notify me of any changes to my portfolio?
Conclusion
This isn’t an exhaustive review, but hopefully it will help you feel confident walking into a meeting with an advisor. The most important thing to remember is that here, maybe more than anywhere else, there are no stupid questions. A good advisor will be excited by your level of engagement and be happy to answer your questions (in fact, many RIAs go out of their way to be as transparent as possible). The reasoning is simple: You should never give up understanding what is happening to your money.
Special thanks to Ben Carlson and his book “Organizational Alpha,” which was one of the inspirations for this post.