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Investing in financial markets

In Part 1 of this new series on financial management basis, Andrew Allentuck explains how to choose a manager for your money

Warren Buffett, the tycoon from Omaha who became America’s second richest billionaire after Bill Gates, quipped that investing is simple but not necessarily easy. The simplicity is understanding relatively few things very, very well. The job entails both researching each business he buys and having the guts to stick to rules he traces back to Ben Graham, a professor of classics at Columbia University who invented securities analysis. He was Buffet’s teacher and mentor and also a man who got rich following principles of understanding balance sheets and income statements.

Anyone can do what Buffet and Graham do, but it does take a lot of study. The alternative is to hire fund managers or portfolio managers who, presumably, have studied Graham or other investment principles and let them invest for you.

At this point, the path to money management comes to a fork in the road. There are many varieties of financial planner, each with a few letters of designation, many with useful skills and some with motivations that are harmful to their clients’ wealth. You can go down that road or take the other branch of the fork, which is to study accounting, economics, math, some financial history and perhaps financial or engineering specialties for sectors which attract you — say banking or energy. This is labour-intensive, but it will give you the tools not just to invest, but to judge the work of those you hire to handle your money.

You might ask, “Why bother?” If your farm is profitable and produces a return on your equity in the business of, say, eight or 10 per cent a year or more, you are probably beating the long-term average returns from financial assets. For retirement purposes, building up a farm and making use of the complex but flexible accounting rules for productive and profitable farms and the ability to make use of up to $800,000 of capital gains on qualified small business corporation shares provides both tax shelter and inventive to stick to the business you know and stay out of the ups and downs of financial markets.

The problem with sticking with farming is that, of course, there are good and bad years. Farmers have almost no control over the prices they receive, weather is unpredictable and bugs, vermin and government rule changes can wreck the best laid plans.

Reducing the risk of exposure to the whims of weather, the markets, the odds of exposure to transient diseases like BSE and more requires diversification. And there is no diversification as broad as what financial markets offer.

Financial markets

The government wants you to invest in financial markets. Registered Retirement Income Funds must be invested in financial products. You can’t put real estate directly into an RRSP, though you can borrow from an RRSP to buy a home — many do it to get a down payment. The home, if it is your principal residence, can be sold with no tax on capital gains. It’s an easy and entirely legal way to invest and get a tax break.

The trouble with financial markets is their complexity. It takes a lot of knowledge to understand stocks and bonds, mutual funds, exchange traded funds, options, tax rules and international currency markets. Financial advisors are available to help you invest your money at banks, mutual fund vendors like Investors Group, accounting companies and life insurance and annuity brokers. Most of these advisors take a slice of your money and in many cases, it is hard to know what you are paying. There are few grading systems for advisors, so it is hard not just to find one who is good at picking stocks or funds, but also to find one who is worth what they charge.

You can find advisors at banks, investment firms, insurance brokerages, independent mutual fund dealers, or through professional associations such as the Institute of Advanced Financial Planners (visit www.iafp.ca). Many of these people earn their living from commissions and fees paid by the companies whose products they sell. Finding fee-only financial planers is harder. See this directory of fee only planners at moneysense.ca for their fees and specialties.

Let’s consider fees. The average management fee for an equity mutual fund in Canada is 2.6 per cent of net asset value of the portfolio or fund per year. For 10 years, you will pay 26 per cent, for 20 years of management, 52 per cent. If you add compounding of what the advisor gets and what you lose, the numbers are even higher.

Fees are usually charged invisibly. They are deducted each month from the fund. What the advisor gets, you lose. In some cases, the advisor is worth the fee. In many cases, the advisor offers relatively little beyond hand holding and guidance through a menu of mutual funds. There is change in progress, for regulators and the mutual fund industry are preparing to make the fee structure more visible. Trailer fees paid to advisors out of funds will be more visible. They will show that the more you have under management in a fund, the more you pay. But the labour of advising a client for a $100,000 portfolio is not substantially different from advising for a $150,000 fund, though the advisor’s remuneration is 50 per cent higher.

You can pay lower fees by hiring an independent investment advisor. These people usually want to get $500,000 under management. They charge an average of one to 1.5 per cent of assets under management. They get no sales commissions and most of these people have far more demanding qualifications than mutual fund sales people, such as being Chartered Financial Analysts.

There are also questions of honesty, both in the strict sense of accounting for money and not pocketing client funds for personal use and the more subtle sense of providing value for the client. Large mutual fund companies and chartered banks, credit unions and trust companies will not steal your money. But they can lose it in unfortunate investments or fritter it away with excessive fees.

The history of client losses through theft are littered with names of big thieves — Ponzi and Madoff, for example. Today, if you choose to use an independent money manager, it is vital that you understand who is the custodian of your money. Most money managers have a trust company act as custodian of your cash, stocks , bonds, funds or other assets. The advisor tells the custodian what to do. Cheques are written to the custodian and the custodian pays the client when he or she wants money. The advisor never gets his hands on client money directly. If an advisor asks for a big cheque made out to him personally, head out the door.

Understanding the rules of investing and the economics and accounting of money management provide comparable protection. It is far harder for an advisor to bamboozle a client well versed in financial markets than a naïve client who comes with money, trust and a lack of understanding.

About the author

Columnist

Andrew Allentuck’s book, “Cherished Fortune: Build Your Portfolio Like Your Own Business,” written with co-author Benoit Poliquin, was recently published by Dundurn Press.

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