Hiring an Investment Manager: What You Need to Know
If you’re reading this, you’re likely considering hiring an investment manager. This might be because one of the following applies to you:
- You’re too busy for a do-it-yourself approach.
- You’re not interested in learning about investments.
- You’re concerned you’ll make errors that could delay your retirement.
Or all the above apply to you. Maybe you’ve asked Google for a list of investment managers available in your area or online, and you’re ready to reach out. Now, what should you ask when you have that first conversation?
While rates of return are probably top of mind for you, your first questions should be about getting to know whom you’re speaking with. You need to understand who has your best interests in mind and what basic money safeguards they’ll utilize. From there, you can move on to the returns.
Safeguards for Your Investments
You might assume that all financial advisors operate with your best interests in mind. However, the reality of the service provider landscape and its two main options may surprise you. Registered investment advisory (RIA) firms and their employees are fiduciaries, which means they are required by law to act in your best interests when providing investment advice.
Some brokerage firms and their employees are held to a different regulatory standard than fiduciaries when it comes to acting in your best interests. We believe it’s important to ask what capacity the investment advisor you’re interviewing will be serving in.
If you choose to work with a registered investment advisor, the next step is to verify the firm is properly registered with the U.S. Securities and Exchange Commission (SEC) or its state’s regulatory authority. You can check that on this website. This website includes data on both the firm and individual advisors who work there, including any disciplinary actions taken against them. Ideally, you’re looking for a strong compliance history, recognizing that disclosures can vary in nature and severity.
If you find disciplinary action, at the very least, ask about it.
Next, review which custodians the investment manager uses. Custodians are responsible for the safekeeping of your assets, and may include well-known firms such as Fidelity Investments, Charles Schwab, BNY Mellon/Pershing, Shareholders Service Group, and others. The custodian’s role is to maintain separate accounts by legal registration (e.g., individual, joint, trust, etc.), hold the title to assets on your behalf, value the assets, settle transactions, collect income (e.g., from dividends), track cost basis, and provide reporting. The custodian is the firm that actually holds your assets; the investment manager should never have possession of your money. Investment firms should only be using an external, third-party custodian.
If you decide to work with a brokerage firm instead of an RIA, you can check the background of the broker you’re interviewing on this site. As part of your review, see if the broker is properly licensed to sell securities.
The Investment Process
Once you’re satisfied with the basic safeguards an advisor provides, you may choose to turn your attention back to returns. What you’re looking for at this point in the conversation is a discussion of the investment process. You need to try to understand what methodology the investment manager uses to generate investment returns and whether that methodology aligns with your long-term goals.
For example, the investment manager might seek to earn investment returns simply by holding large groups of stocks that encompass nearly all the stocks available in a particular category, such as U.S. large company stocks. In this approach, when U.S. large company stocks do well, that part of your investment portfolio will do well. Historically, U.S. large company stocks have earned about 10% per year on average going back to the 1920s, although returns vary significantly year to year and over different time periods, and past performance does not guarantee future results. Other categories, such as U.S. small company stocks, are usually mixed into your investment holdings as well to help create a diversified portfolio.
Historically, U.S. small company stocks have earned higher long-term returns than large company stocks, averaging roughly 11%-12% annually over extended periods, but they also tend to experience greater volatility and risk, including periods of significant underperformance. Past performance does not guarantee future results. The economics behind this approach are straightforward: companies in aggregate must pay investors for the use of their investment capital, and they do that by providing a return on investors’ money. The investment return is there to be earned over time, but investing involves risk, including the potential loss of principal, and returns are never guaranteed.
This approach is commonly known as index investing and is favored by many investors, including large institutional investors. While investment returns are volatile, no matter what methodology is used, index investing tends to be a widely used, long-term investment approach. You should know, will your candidate investment manager use index investing as part or all of their approach?
The other main type of investment methodology involves trying to improve on the average rate of return offered by the market. This is done either through selecting stocks and bonds the investment manager believes will perform better than average, or choosing when to buy and sell securities in the hope of holding them mostly as they rise.
These investment strategies rely on the skill of the investment manager in identifying mispriced securities or timing opportunities and often have high costs to execute, which can drag down investment returns if the investment manager is not successful. Research indicates that most managers using these methodologies do not generate investment returns above the market rate of return on a cost-adjusted basis.
However, occasionally, some investment managers do outperform the market in any given year or over several years. Statistically, that will sometimes happen. Your job is to try to decipher whether a candidate manager’s recent outperformance was based on skill or luck, and if it will continue. Ask for and review long-term performance data (e.g., three-year, five-year, and 10-year returns). Ask for a detailed explanation of the investment process and try to determine how repeatable it is. You’ll need to ask yourself, do I think this manager can consistently discover new information other investors have missed and turn that information into above-market returns?
Once you develop a clear understanding of how candidate investment managers generate investment returns and confirm they have basic money safeguards in place, you’ll have some of the most essential information you need to make your choice. As you think it through, trust your instincts. Take all the time you need. When you do decide on a candidate, you can then move forward with greater confidence, understanding the investment approach and safeguards in place, as you work toward the financial goals you care about.
Savant Wealth Management provides holistic wealth management services including
Bruce R. Barton
Managing Partner / Financial Advisor
CFP®, CFA®, MBA