Stonegate in The News and Blog Posts

We’ve all seen this on the front pages of magazine’s like Money and Kiplinger’s: “Five funds you need to buy now!”, or “The 50 Best Mutual Funds and ETF’s for 2018.” You may also be familiar with Morningstar’s star rating system where they rate a fund on a scale of 5 stars with 5 the highest. Advisors and consumers have relied on that star system for years to help them choose mutual fund managers. Does it really help? In 2017 the Wall Street Journal investigated the system and analyzed its predictive value; their result: Morningstar’s system is not particularly useful in predicting future performance. When they examined many 5-star funds they also discovered that many of the funds were small when they received a 5-star rating, with their high rating attracting many investors causing the fund to grow dramatically with ratings in future years falling. That might be evidence that many managers cannot invest the same way they did when they were small or that their performance might have been based originally on a few lucky picks.

A case in point is the Fairholme fund, Fairholme invests in US stock independent of size, and they seem to be all over the map over the years, investing in large, midcap and small cap at various times. (Full disclosure we use to use this fund). For years it outperformed its peers by a wide margin (13% per year), then suddenly it experienced a terrible year in 2011. That year the fund lost over 32% while the S&P index gained 2%. (Around the same time Morningstar named Fairholme fund of the year). Now if you compare Fairholme to the S&P 500 index, the Russell Midcap Index and Russell 2000 it has severely underperformed all of them:

Since their focus on company size has been variable we think it is fair to compare them to these three indices.
So how can you tell a manager’s performance is really based on skill? (Something you would have wanted to know about the manager of Fairholme in 2010 when they seemed to be crushing most equity indices). There are ways to analyze their performance using statistics. Comparing a manager’s performance against various indices provides useful information regarding their investment approach (this is called style analysis). You can then compare their performance against a “synthetic” fund that is composed of those indices. Using the composition of the fund and comparing it to a combination of index funds that would match that composition some have concluded that it would take at least 18-20 years to determine if Fairholme’s out performance (before 2011) was manager skill or luck. For some funds with a more volatile track record it might take as long as 100 years before it can be shown with a high degree of certainty that a fund’s performance is based on skill.

Active managers also have some headwinds when compared to an index fund: the low expense ratio and greater tax efficiency of most index funds. Most actively managed funds have expense rations in the .8-1.2% range annually while most index funds are in the .1-.35% range. Just to match an index the fund manager has to automatically outperform it by .7% or more, a high hurdle. That combined with the fact that Index funds tend to be more tax efficient means that at the beginning of every year a fund manager has to beat an index by over 1% on average just to justify their existence.

Over the years we have gradually concluded that it is easy to try to find a fund that seems to have beaten the market but it is hard to find one whose performance can be proven to be skill and not luck. Because of this we mainly use funds and ETF’s that are index based or based on a strategy that is not an attempt by a manager to “beat” the market but is instead based on a mechanistic strategy. A strategy meant to capture a certain risk vs. return component of the market or a particular exposure that fits into our client’s overall asset allocation.

Choosing a financial planner or advisor can be a daunting task, especially if you are faced with trying to determine how they are paid, how competent they are, and what credentials are actually important. Let’s discuss each of those “three C’s.”

Compensation

Advisors may be paid through commissions, fees or a combination of both. When an advisor “sells” you a financial product like a mutual fund or an insurance policy they are paid by the insurance company or brokerage firm that “creates” the product. Some advisors are only paid by you; they may charge you for a detailed analysis of their finances and/or they may charge you a percent of any investments they manage for you. There are also advisors that both receive commissions and also are paid by you (“fee-based”) for a plan or for asset management. Whomever you hire, it is important to understand how they are paid since it might (but not always) affect the types of advice you receive. An advisor that charges for a plan or an asset management fee and cannot receive commissions is generally considered a “fiduciary.” A fiduciary is someone that works for you and must legally act in your best interests not their own. Generally, advisors that are compensated this way and act as “fiduciaries” have the fewest conflicts. They should be diligent in disclosing to you any conflicts that might still exist and how they will either avoid the situation that leads to the conflict or how they will “manage” it.

(CFP® certificants will be required to act in your best interests for financial advice regardless of their method of compensation beginning in October 2019.)

With fee-only advisors you always know the cost of the relationship since you pay them directly, with commission based advisors you may not have a clue since sadly there is no requirement that they disclose how much they earn from products they might sell you.

Competency

How can you tell your advisor is competent? It sure is difficult but there are some things to consider. First do they have a certification? There are plenty of advisors out there who do not, yet they have official sounding titles like “wealth advisor.” We’ll describe the education and certification that real advisors should have below. Besides having a designation or certification you may want to drill in on the advisor’s core competency by asking some pointed questions, including “how many years experience do you have,” and “what are your specialties?” Make sure the advisor has formal training in areas they claim as specialties. You may want to ask to view a sample analysis they did for a client (any advisor should have a sample with names changed or blacked out). When you look at the sample plan make sure it has at least the following sections:

• Planning Assumptions
• Clients goals
• Detailed analysis with backup and discussion
• Detailed recommendations with a discussion of the potential impact of the recommendations and tradeoffs among various recommendations
• Action item list with due dates

That is just a partial list. Not all advisors will have competency in every area so it is important to discover how they deal with that. For example, Fee-Only advisors cannot sell products but they may recommend you purchase more life or disability insurance. Do they have a list of trusted outside experts that they work with? Does that list include attorneys, insurance agents, and possibly accountants?

There is one membership organization that has pretty specific requirements for their members, that is the National Association of Personal Financial Advisors (NAPFA). Their members are required to:

• Submit a financial plan for peer review
• Be CERTIFIED FINANCIAL PLANNER™s (CFP®)
• Take 60 hours of continuing education every 2 years (the highest requirement in the industry).
• Adhere to a strict requirement that they be fee-only and act as fiduciaries in every circumstance. In fact they sign an oath compelling them to act as fiduciaries in every circumstance.

While even those strict requirements are not a guarantee that the advisor is competent it does certainly increase the chances that they are prepared to properly assist you.

Credentials

The financial planning field is saddled with a plethora of titles and supposed certifications. It seems as if this is meant to make things more confusing for the consumer who is trying to get good advice. We suggest you ignore all titles like “wealth manager” or “financial consultant” and instead ask what actual education and certifications the person has. While many certifications exist the most important are the ones that require a broad background in many aspects of financial planning. There are two that fit that bill, CERTIFIED FINANCIAL PLANNER™ (CFP®) and Chartered Financial Consultant (ChFC). The CFP® designation is more widely known and it requires that certificants take a comprehensive exam, and a course that requires them to actually write a financial plan. The CFP® designation is owned and awarded by the CFP® board a non-profit organization that protects the mark and also sets high standards for the behavior of its certificants. The ChFC requires more course work but it’s certificants do not have to take a comprehensive exam, they do have to write a financial plan though.

The CFP® board has adopted a very strong set of ethical requirements for their certificants including a new requirement that they act as Fiduciaries whenever they are providing financial advice (beginning October 2019). That strong requirement does not exist for ChFC certificants.

You may encounter many advisors with both designations. You may also encounter advisors who have continued their education and received an advanced degree in the field including a Masters or PhD. Advisors who have done that should be considered the educational “elite” in the field.

One other designation worth mentioning is the Chartered Financial Analyst (CFA) which is owned and awarded by the CFA Institute. While the designation is only focused on investment analysis and management, advisors who hold the designation have acquired very deep knowledge in that specialty. The designation requires that applicants pass 3 exams that are roughly 6 hours in length and the course material includes statistics, economics, investment analysis, portfolio management, etc. Roughly 8-15% of candidates actually finish and receive the designation. Like the CFP® designation certificants are required to adhere to a very strict set of ethical standards. If you are hiring an advisor to help manage your portfolio this designation is important.

Conclusion

We suggest you consider advisors who are fee-only, act as fiduciaries and hold the CFP® or ChFC designation as a minimum.

Estate planning for families that include children from parents who have been married a couple of times can be complex. Sometimes ensuring that all the children are treated fairly means you may need to take measures to protect their inheritance if you die prematurely. Your current spouse may not have any emotional tie to them so they could disinherit them either innocently or with malice.

Consider the following example of a husband and wife who both have children from prior marriages and have a child together:

Consider the following:

• If John predeceases Mary: Assume Mary has no affection for or relationship with John’s children from his prior marriage. At her death, she leaves them out of her will, and they are left with nothing from John, (who had a simple “I love you” will that left everything to Mary). They are effectively disinherited through a bad sequence of events and poor planning unless their mother Sue (who may or may not have much of an estate) leaves them something. Or if Sue is married and leaves everything to her new husband he could leave everything to someone else effectively leaving no inheritance for John and Sue’s children. This means that things John (and possibly Sue) might have worked hard for never benefit their own children from their marriage.
• If Mary predeceases John: John remarries, he marries a much younger woman who outlives him; since Mary left everything to John, her child from her first marriage could be disinherited if John leaves everything to his new wife who will most likely out live him. Or his younger wife could still care enough about Mary’s son that she does leave him something but John’s young wife may live for many more years meaning any inheritance Mary’s son would have received may be delayed for 20-30 years.

Those are just two of many possible sequences of events. While every scenario cannot be anticipated some estate planning techniques can reduce the risk that someone’s children are not left out in the cold. Here are two.

QTIP Trust (Qualified Terminal Interest Property) – Is a testamentary (created through a will at someone’s death) trust used by married couples to control the disposition of assets in their estate after the death of their spouse. John’s will would create the trust and specify which assets that he owns individually will be in the trust. Assets he leaves to the trust will qualify for the unlimited marital deduction if his executor makes a QTIP election on his estate tax return. A requirement for those assets to qualify for the unlimited marital deduction is that his wife Mary must receive all the income generated by the assets for the remainder of her life. The assets in the trust will also be counted as part of her gross estate at her death. John though has designated who will receive the assets at his wife Mary’s death and that choice is irrevocable. Using this estate planning technique, he can make sure that his children are never disinherited.

Mary can also include this type of trust in her will to protect her the legacy of her son from her first marriage.

Unfortunately, a QTIP trust is not the most appropriate technique if a person has the bulk of their assets in IRA’s, 401K’s, or other qualified types of accounts that will become subject to the Required Minimum Distribution rule. The reason is complex and related to the requirements that all income from the assets in a QTIP trust be distributed to the remaining spouse every year. The definition of income for an IRA may clash with the definition of income under some state’s rules regarding trusts.

Irrevocable Life Insurance Trust (ILIT) – Another and perhaps more appropriate method of protecting children in a mixed family circumstance is life insurance combined with an Irrevocable Life Insurance Trust (ILIT). Here a trust is created while the spouse is living (unlike a QTIP which is typically created at death through a will). The trustee of the ILIT applies for life insurance on the life of the spouse and the trust owns the policy, the spouse pays the policy premium each year by gifting funds to the trust. The trust is created for the benefit of whomever the spouse selects, in this case possibly a child. At the death of the spouse the life insurance is paid to the trust which may then invest the proceeds and pay the income to the child, provide them with rights to the principle under certain conditions (maintenance, education, support, or health) and perhaps gradually pay the corpus out to them at specific ages (25, 30, 35, for example). This type of trust has other benefits including protection of the assets from the child’s creditors. This is a short and simple summary of this type of trust which could accomplish many of a parent’s goals for the protection or creation of a legacy for their children, one not affected by remarriages. It does come at a cost though, the cost of life insurance and the requirement that the spouse be insurable. It is also recommended that the spouse consider setting this trust up when they are younger and the cost of life insurance is less.

Here is a summary of the 2 approaches:

This is a brief non-technical summary of a couple of approaches to consider if you do have children from prior marriages.

Stephen Craffen MS, CFA, ChFC