Old Big Red sprung a leak a while back. Many of you are familiar with Big Red, but there are a few of you who might need an introduction. Big Red is my 18-year-old Chevy Silverado 2500 HD. I realize this may not be the type of vehicle driven by the majority of bankers, money managers, financial advisors, or brokers, but for me he is comfortable, and for the most part very reliable. Besides, I grew up in farm country and quickly learned the value of a pickup.
Big Red has only had a few problems over the years that were all easily fixed with a little minor surgery. The surgery needed to fix this particular leak was the replacement of a valve cover gasket. So I took him to the closest auto parts store to buy a new gasket. The store belongs to one of the nation’s largest retailers of automotive parts. I approached the gentleman at the counter and let him know what I wanted.
“Sure” he said, as he straightened his keyboard in front of him, “we’ll find what you need. Can I start by getting your telephone number?” As soon as he entered my number, up popped my name, address, and countless other bits of my data, probably produced from some hidden box on the other side of the country.
“What was the year and make of the truck again?” Each question he asked was prompted in the form of a drop down box of choices on his computer screen. Next was, “What Model?” which led to, “Which engine?” Each answer prompted another set of choices that the man at the computer quickly selected from.
The final question was which gasket I was looking for, and after I replied, the screen filled up with a list of gaskets, one of which was in bold letters and highlighted green. The gentleman said, “It will be $27.99 plus tax. Do you want me to grab it for you?”
Personally, I thought this was a bit high for a gasket. So I looked at the list that appeared on the screen and found out that his recommendation was for a gasket kit. The kit included some additional parts that I did not need. So I selected the option without the extra parts for $16.97.
I want you to consider this transaction in light of benefits to the auto parts company. First of all, the gentleman behind the counter needed zero knowledge of mechanics, automotive theory, engineering, mechanical design, business management or anything else having to do with me, my truck or the operations of the business. The only skill needed was his ability to type information into a computer and be nice to me. A company has to pay dearly for higher levels of skill, knowledge and experience. Armed with the computer, this auto parts salesman could be anyone. Being able to use low-skilled, and thus low-paid individuals to fulfill the majority of their jobs, the organization can produce excess profits.
Profitability to the parts company is also directly related to the markup on each individual part sold. I may be wrong, but it would seem to me that the part originally recommended to me probably had a little higher profit margin than the alternatives. There is nothing wrong with this, as maximizing profits is the goal of most businesses. If the pricing is out of line, too high or too low, the business will be harmed by lower sales or no profit.
The title of this letter emphasizes the future, but for many individual investors, the future is already here. Take your 401(k). A few of the largest 401(k) programs are owned and operated by mutual fund companies. They include TIAA, T. Rowe Price, Fidelity and Vanguard. Other large providers include Wells Fargo and Bank of America/Merrill Lynch. For the most part your interaction with these providers is online or by phone. When you communicate with them, what is the process? Is it similar to our auto parts salesman? A few questions and boom, a screen pops up either on your computer or on the screen of the person you are talking with. Recommendations, if requested, will be based on some model that, at least in theory, will provide you with want you want.
It is easy to forget that the person you are talking with, or for that matter, the computer you are providing information to, is an employee of the 401(k) provider. Their primary duty is to the company they work for, not to you. The probability is that any recommended portfolio will include only mutual funds managed by that provider.
In recent years more and more of these providers are pushing you to hire them as your manager. For this they charge a small fee without referencing the additional fees they receive for the management of the mutual funds or ETFs that are the primary investments made on your behalf. You, the investor, will never know what the profit margin is to the company. Like our auto parts retailer, the fund company may make a little more profit by using their own products.
This by itself is not necessarily bad for you. Competition for your money has reduced overall cost. In addition, the model portfolios provided are designed by someone at each company who, at least we will assume, has a proven level of skill. You will never have the opportunity, however, to discuss your portfolio with these skilled individuals.
The 401(k) providers have been a leader in this move towards computer driven recommendations. But the discount brokerage firms are close behind. The two largest, Charles Schwab and TD Ameritrade, both provide managed portfolios. They may be able to use a broader group of investment products than the big mutual fund companies, but the fees and profit margins are probably the same. As with the mutual fund companies, the model creator is off limits to you.
Next in line will be investment advisors and full service brokerage firms, all of whom have access to these model providers and slowly are accepting this outsourced approach. It does free up their time to solicit new customers, with the added benefit of being able to share the blame for underperformance with someone else.
This model approach has some benefits. You can be assured of a diversified portfolio that will minimize the risk of any one or two securities dominating the total returns of the portfolio. It also will reduce the chance of earning extraordinarily high returns. Because of that, results cannot be judged against a standard index, like the S&P 500 or the Dow Jones Industrial Average. A better way would be to judge results against similar portfolios. Luckily, Morningstar, the great compiler of mutual fund returns, gives us a good place to start the review. They provide average returns for allocation funds with various objectives. We pay attention to the very simple groupings based on the amount of the portfolio invested in equities. Here is their reported average returns for a select group on the data provided to them through 11/16/2018. Returns include reinvestment and are annualized:
Normally we would not pay much attention to 3 month returns, but the changes in market valuation have been quite extreme over these past few months. The positive returns in September, followed by large declines in October and November (so far) has stirred up a lot of worry for all of us. It is hard to remember that in January of this year we had a very fast appreciation in prices, giving it all back in the next couple of months. Twice in a single year is not what any of us want.
I can only hope that these rapid changes in market prices, both positive and negative, end quickly, as they have so often in the past. Until then, we will look for opportunities that can increase the quality of our holdings and the cash flow those holdings can produce, and make changes when appropriate.
Until next time,
Kendall J. Anderson, CFA
Kendall J. Anderson, CFA, Founder
Justin T. Anderson, President