One More Thing

By N. Russell Wayne

The punch line for Apple presentations hosted by Steve Jobs always began with “One more thing,” which invariably was the event’s key introduction. As a five-decade-plus investment advisor, I’d like to suggest “one more thing” (or a few more things) related to investing that may interest my financial planning colleagues.

What Lies Ahead

As a financial planner, I have always been stunned by the misplaced focus most prospects and clients have on what lies ahead for them. On the numbers side of the equation, the key question was always “Will I have enough?” which most folks seemed to grasp without difficulty. The four pieces of that puzzle were straightforward: assets, liabilities, income, and expenses. The first three were usually easy to come up with; the fourth, however, was a toughie. Some had the data in a few weeks; others took months.

Far more important was the other question: “What do you want to do when you’re retired?” Sad to say, many had no idea. One couple, in fact, smiled and said they wanted to spend time with their grandchildren. When I asked how many they had, they said, “None.” Shocking but quite true.

Although these folks hadn’t focused on how to spend their time, they had handled their finances well. They had recently downsized their home, had saved more than enough to manage their expenses, and had invested in a series of stable value funds with minimal risk of price erosion.

The lesson from this example is that sometimes investing isn’t the most important part of our work as financial advisors. That said, let’s look at how some advisors invest. Clearly, in my opinion, there is room for improvement.

Investing with ETFs

Sometimes I wonder about, and am amused by, the investment approaches some advisors use. One pleasant fellow I’ve known for a while can best be described as a minimalist. He buys the grand total of two ETFs for each account he manages. One is the total U.S. equity market index. The other is the total U.S. bond market index. The only difference is the asset allocation, which depends on the client’s investment horizon. His fee, however, is on a par with the investment industry average. (Maybe I should be horrified instead of amused.)

Equally “interesting” is the diversification approach by a gentleman with a Ph.D. who focuses exclusively on U.S. equities and demonstrates his expertise by buying six ETFs: large-cap growth, large-cap value, mid-cap growth, mid-cap value, small-cap growth, and small-cap value. I have yet to grasp the benefit added by cutting the pie into these slices.

Couldn’t he just buy a total market index? Or could he do that and then add a slice of a specific style or market cap that he thinks is positioned to outperform? Although he could have bought a total market index along with slices of other asset classes that might have appeared promising, the apparent benefit of cutting the pie in slices seemed to have been driven more by his marketing concerns than by improving service to his clients or their investment results.

From my perspective, this advisor’s technique was nothing more than an exercise in accumulating a variety of assets for the purpose of appearing to provide the benefits of Modern Portfolio Theory, i.e., the potential for worthwhile gain while limiting the risk of loss.

Why ETFs?

As investors have learned to appreciate the benefit of reducing costs to improve investment returns, there’s good reason to make greater use of ETFs. Since many ETFs have become close copies of mutual funds, the substantial cost savings they provide along with trading through the market day certainly supports their increased popularity.

Even so, it is essential to have a proper grasp of the underlying holdings of each. That, in turn, requires competence in basic security analysis, which seems to be in short supply among financial advisors I know. One of my colleagues stated that he avoids buying or holding individual stocks because of the effort needed to review income statements and balance sheets. From Day One of my career, I learned that the driving force behind stock price movements was the trend of earnings. And, to assess financial health, you looked at free cash flow. If earnings were rising and free cash flow was consistently positive, you were on the right track.

Simply buying an ETF because it appears to be well positioned in a market cap segment, interesting industry, or region that looks promising is not sufficient. At a minimum, the advisor should check the earnings trends and financial wherewithal of the top 10 holdings of ETFs they are considering. One needs to review these holdings to get a better grasp on what will drive price changes. Although there are ETFs made up of equally weighted underlying holdings in a specific area, there are others in which a few holdings predominate. Rule of thumb: Always look at what’s inside.

Analyzing Stocks

ETFs aren’t the only holdings you should analyze. Unless you work with clients who have no legacy holdings of stocks, especially those with a minimal cost basis, you have to understand the nuts and bolts of stocks.

If you don’t want to do any of this work, you can refer to brokerage reports, especially those prepared by institutional analysts looking to inspire sizable and highly profitable trades. These are often readily available, as are reports from well-known Wall Street sites. What is disturbing is the disproportionate number of buy recommendations, accompanied by a few holds and hardly any sells. These often have numerical stock ratings, which are meaningless. To my knowledge, there is nothing in the literature of investing that suggests that they should be the basis for intelligent stock selection.

Similarly, there is no lack of media promotion for stocks or funds to buy now. If someone really did come up with a worthwhile new wrinkle, you would think they would use it for their own benefit. But tellingly, they don’t.

I recall a conversation I had with the late Sam Eisenstadt, head statistician at Value Line, where I was managing editor of The Value Line Investment Survey. Sam had developed Value Line’s well-known stock ranking system. When asked about the possibility of improved approaches that could be of value, Sam said that minor changes might help. But it rarely took much time before others adopted the new techniques, and the added value faded.

What’s more, as far as I know, even the performance of the Value Line ranking system, which had years of apparent theoretical success in differentiating among the 1,700 stocks followed, was never duplicated in practical application. The original Value Line Fund—which apparently no longer exists in its original form—was supposed to use this approach, but its results did not resemble those of the ranking system.

In any case, there’s always one more thing, but while waiting for that to occur, we need to maintain our focus on providing client comfort by listening to and properly appraising the information presented, making reasonable recommendations, and remaining aware of the need to adjust one’s course as times change.

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N. Russell Wayne, CFP^®, is a member of NAPFA. President of Sound Asset Management, he has appeared on CNN and the Bloomberg Network and been quoted in The Wall Street Journal, The New York Times, Barron’s, and Business Week.

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