How to spot craftsmanship in quality investment management
If you or someone you love needed surgery, you’d want to go to the best doctor. But how would you know who’s the best?
You could check patient reviews.
Unfortunately, those are often riddled with complaints about a doctor’s gruff chairside manner or the unnecessarily long waiting room times. So, all those reviews really prove is how overworked that doctor is.
You could look at the doctor’s pedigree.
But even the best colleges and medical schools use non-merit-based criteria that don’t correlate with actual skill.
Rankings of technical ability don’t seem to exist, and learning more about patient complaints or malpractice lawsuits is not an easy process – which makes it hard for people to know who is truly an expert instead of who is simply good at appearing to be an expert.
The same is true in almost every industry.
Did your car really need new brake calipers? Or just rotors and pads?
Did your roofer put ice and water shield all the way up the sheathing? Or just along the edges?
Are those open-ended mutual funds best for you? Or should you invest in exchange-traded funds?
Since you can’t be an expert in everything, you need to educate yourself with trusted resources and identify craftsmanship when you see it – which applies to everything from your surgeon to quality investment management.
Salesmanship versus craftsmanship
Salesmanship seems to have become the name of the game in many parts of the investment industry.
Selling “products” such as annuities, insurance policies, certain private real estate funds, and high-cost mutual funds often generate large commissions that benefit the “advisor,” but aren’t necessarily in the client’s best interest.
One of our competing firms has even confided in me over the years that they don’t truly believe in their investment approach.
They chose it because it was a salable and scalable business model, not because it made the most sense for their investors. And this is a firm that is considered a fiduciary. There are far worse in our industry.
There is a wide spectrum of quality (and ethics) that exists on a scale from “salesmanship” to “craftsmanship,” which unfortunately are often at odds with one another.
For example
We recently helped start a new investment management advisory business, which involved moving clients from their former broker/dealer to a new Registered Investment Advisor (RIA) structure.
All I will say is that we revealed a lot of poor practices that are widespread in the brokerage world that would never be contemplated in our RIA world where we are held to a fiduciary standard.
We were relieved to have moved all of those clients along the quality spectrum from salesmanship to craftsmanship.
Holding the investment industry to higher standards
So, how do you avoid finding yourself on the “salesmanship” side of the quality wealth management spectrum?
You look for firms that hold themselves to higher standards and engage in things like:
Internal Research
We do our own internal research to sniff out the best funds at the lowest cost because we’re penny pinchers when it comes to fees and hidden costs on our client’s assets.
Tax Minimization Strategies
Low turnover funds, ETFs that don’t pay annual capital gains distributions, asset location, tax-loss harvesting.
These are all strategies we use to minimize taxes (and it turns out these strategies are often ignored by others in our industry).
Professional Integrity
Not every higher-standard strategy will be obvious to our clients, and most will not even be aware that we’re taking these actions.
They take a lot of extra work and time, but striving for the highest possible quality in wealth management is the right thing to do.
Many years ago, I had the privilege of having dinner with Vanguard founder Jack Bogle. He told me that the investment industry was a “profession” when he started 50 years earlier.
He reflected that it’s more recently morphed into a business in that shift toward the salesmanship side of the quality spectrum.
Investment advisors used to be true stewards of their client’s money who worked to always do their best and that’s how we believe it should still be.
Craftsmanship in portfolio management
I don’t know what year your house was built, but our first house, built in 1906, was far better than every house we’ve lived in since with its hasty new construction.
Every house is made of wood, nails, glass windows, and so on, but the details determine the quality.
Your investment portfolio can also be slapped together hastily, or it can be made to last.
As with houses, the difference is in the craftsmanship.
But with so many possible ways to build and manage a portfolio, it helps if you know what craftsmanship and quality in the investment management industry actually look like.
Consistent Tax Loss Harvesting
It’s common practice to look for portfolio losses only at the end of the year to offset taxes on capital gains that have been realized throughout the year.
We tax-loss harvest throughout the year.
This involves selling a stock or fund when it goes down in value and then buying something very similar.
For example
We might sell a large-cap US stock fund for a 10% loss and immediately buy a different but similar fund. (You can’t repurchase the same investment and claim a loss, as that would violate tax law).
This practice keeps the portfolio exposure but allows you to use the loss to offset taxes on capital gains and a little income now and in the future.
A real world example was during the COVID downturn. Stocks fell around 35% early in the year.
If you’d waited until December, like most investment advisors, to harvest your tax losses, you would have missed out on the opportunity since stocks were back in positive territory by year end.
Because we harvest all year long, we realized a ton of losses in the first quarter. That allowed us to end the year with positive performance as the market recovered, but huge losses for tax purposes – the ideal combination.
Asset Location
By using “asset location,” we can also minimize the tax bite.
Most advisors will say that if your asset allocation target is 60% stocks and 40% bonds, each of your various accounts – brokerage, IRA, spouse IRA, Roth, etc. – should be set up to be 60/40
But bonds generally pay interest that’s taxed as ordinary income (ie. high), so we try to hold bonds in retirement accounts, like IRAs and 401(k)s.
Stocks are more tax-efficient since they don’t usually pay a lot of income. (Because dividends tend to be smaller and because they’re often taxed at more favorable “qualified dividend” tax rates.)
We can more easily control the timing of taxes from stocks since we usually only have larger tax liabilities when stocks are sold and capital gains are “realized.” And those long-term capital gains are taxed at a more favorable rate, so it generally makes sense to hold stocks in taxable brokerage accounts.
Also, when you draw money out of your retirement accounts, which you’re required to do starting at age 73, the money you withdraw is taxed at ordinary income rates (again, high).
If you’re holding stocks in retirement accounts, your favorable capital gains treatment turns into unfavorable ordinary income tax treatment.
You can see how many different considerations are involved in asset location, but we believe it’s worth the extra effort on our part to ensure you’re holding the right investments in the right accounts so that you keep most of your return instead of paying it out in taxes and unnecessary costs.
Alternative Investments
If you Google “alternative investments,” you’ll find articles on private equity and hedge funds – which probably don’t make sense for most investors.
That’s why we’ve done deep research to create a portfolio of investments that aren’t traditional stocks or bonds. Instead, they offer an independent and uncorrelated return stream that can complement the returns of a more traditional stock and bond portfolio.
They may hedge the risk of the stock market but can also boost returns beyond what bonds provide.
The funds we use have low correlation with stocks and bonds but also low cross-correlation with one another, giving the portfolio a risk profile similar to the bond market, even though the components are all moderately risky.
Factor-based Investing
Traditional active or passive approaches to stock portfolio construction have flaws that may make them less appetizing for most investors.
Using academic research studies, we developed our own approach that relies on “factor-based” strategies, which are common in large institutional portfolios but still fairly rare in the private wealth management space.
Some firms dabble with these exposures, but we build entire portfolios around them in an effort to achieve market-beating long-term performance.
Implementing these strategies is more time-consuming (and often more expensive for us).
But by focusing on the craftsmanship of building and managing your portfolio, we can create something stronger that will serve you longer.
Undoing portfolio damage
A client came to us many years ago and said he wasn’t sure why, but he had a sense his portfolio wasn’t performing that well. (And he felt like he was writing big checks to the IRS every year.)
He showed me his statements, and it took about 15 seconds to conclude that he was right on both points because his portfolio consisted of open-ended mutual funds held in taxable accounts.
He looked at me funny, and I explained that the exact same portfolio built with ETFs (exchange-traded funds) would likely perform better because they’re indexed rather than actively managed.
Also, open-ended mutual funds have to pay out their capital gains each year in a taxable form, whereas ETFs generally do not pay capital gains distributions.
He hired us on the spot, and we fixed both the performance and tax issues.
Unfortunately, we see brokers doing things like this all too often:
- Selling high-cost annuities that put large commissions in their pockets but could harm the client in the form of higher costs and lower long-run performance.
- Not focusing on tax minimization and the many strategies to accomplish this, which results in clients paying too much in taxes.
- Building portfolios by selecting “off-the-shelf” products (model portfolios) that are generically managed for gazillions* of clients who likely all have very different needs.
*Nerdy number speak for “way too many”
Lately, we’re undoing a number of brokerage portfolios with problems like this that persist in our industry.
The good news?
Smarter methods are known – they’re just not being used as often as they should be.
Quality wealth management still exists
When you understand a bit about the signs that point to a high-quality firm, finding a solid investment advisor becomes a lot less complicated than figuring out which surgeon has the technical skills to perform your surgery.
Craftsmanship in quality wealth management isn’t dead.
It’s just more difficult – and time-consuming – to do it right. Which is why you’ll likely need an RIA (Registered Investment Advisor) to ensure things are done properly.
Rather than default to cookie-cutter investment advice and productized portfolios, we custom-build portfolios for each client to meet their unique return, risk, and tax circumstances.
You can think of it as the difference between the chair you buy from IKEA and the one you get from a carpenter working out of his big red barn in Vermont.
If you’re tired of questioning the value of the mass-produced option, it may be time to explore a more personalized investment management solution.
**Notice:
Armbruster Capital Management’s views, as portrayed in this post, are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector. Investing involves risks, and the value of your investment will fluctuate over time, and you may gain or lose money.
Past performance is no guarantee of future results.
Third-party sites and materials are available for access at your own risk.