Go ahead and grill your financial adviser: Questions to ask

First, do no harm. That’s the oath that medical students take on their way to becoming doctors.

Unfortunately, there’s no such oath financial advisers must take before working with clients. And that’s not a good thing for investors.

“Far too often, advisers accept beliefs and practices that are detrimental to the financial well-being of clients,” Scott MacKillop, the CEO of First Ascent Asset Management, wrote recently in an industry trade publication.

Fortunately, there are steps you can take to make sure your adviser does no harm to your nest egg.

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Ask about MPT assumptions. Advisers often rely on modern portfolio theory (MPT) to build an optimal portfolio for investors. And to do that, advisers must know three things, according to MacKillop. Future expected returns, volatilities and correlations of the asset classes in the portfolio. “The problem is no one knows what those numbers are,” MacKillop wrote. “Optimal portfolios are like unicorns — they don’t exist in real life.”

• What to do? “Investors should ask their advisers how they determine the asset allocation of the portfolios they build,” MacKillop said via email. “There are many different ways that advisers might legitimately approach the asset-allocation issue, so there is no one right answer.”

MacKillop suggests looking for the following in the adviser’s response: One, the adviser should have a process for determining a portfolio’s asset allocation; two, the process should be disciplined and repeatable; three, the process should not be overly dependent on complex mathematical calculations based on past patterns in the market; and four, the adviser should be able to explain the process in a way that makes sense.

Rebalancing acts. Many advisers rebalance portfolios periodically back to an established asset allocation. According to MacKillop, rebalancing may be triggered by the passage of time (quarterly, annually and the like) or by bands placed around each asset class (plus or minus 5%, for example).

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“On the surface it makes sense to sell assets that have risen in value and buy assets that are out of favor," he says. "But the research on rebalancing suggests that rebalancing frequently does not add any more value than rebalancing annually and may even be counterproductive because it generates trading costs and can result in unnecessary taxes.”

• What to do? Ask your adviser about his or her rebalancing strategy and look for two things, says MacKillop: One, the adviser should have a disciplined process for rebalancing that can be explained in an understandable way and two, it should not result in frequent and costly trading in the portfolio.

Style-drift. Some advisers monitor active managers for what is known as style drift. “If a manager was put in a portfolio to give the investor exposure to large-cap value stocks, for example, that manager might be accused of ‘style drift’ if the manager bought too many growth stocks,” says MacKillop. “Some advisers view style drift as a sin and may terminate a manager for drifting too much.”

But punishing managers for style drift has a number of shortcomings, says MacKillop. Terminating a manager and hiring a replacement generates costs. And research shows that active managers who drift furthest from their benchmarks are often the ones who add the most value.

• What to do? Ask your adviser how they deal with style drift and avoid those who either don’t monitor it at all or who are overly restrictive, says MacKillop.

The asset-class selection problem. Advisers often promote the benefits of diversification — investing in a mix of assets, stocks, bonds, managed futures, and the like — as a way to reduce volatility and increase risk-adjusted performance.

But reducing volatility might not be the end game. “Why build a conservative portfolio for someone in retirement using the exact same asset classes as a portfolio built for an aggressive investor in their 30s?” asked MacKillop. “In one case, controlling volatility is important. In the other, it gets in the way of fully achieving the client’s long-term goals.”

• What to do? Ask your adviser how they determine the asset classes in their portfolios. “Again, there should be a process in place, and that process should be explainable in simple terms,” MacKillop says.

The data-mining problem. Advisers are starting to rely too much on computers “to mine data in search of winning patterns in the historical tea leaves,” MacKillop wrote. And in doing so, advisers are tilting portfolios based on past performance. And that might not be in the investor’s best interest.

• What to do?   Ask your adviser about their overall philosophy of portfolio management. Make sure you understand why each investment in their portfolio is there. “An investor should be concerned if their adviser’s investment philosophy or investment-selection process relies too much on patterns that have been observed in historical market data,” says MacKillop. “Nothing always wins in the investment world. So investors should be wary of an adviser who purports to have a ‘system,’ ‘academic research’ or a set of indicators that hold the key to investing in the future.”

Robert Powell is editor of Retirement Weekly, contributes regularly to USA TODAY, The Wall Street Journal and MarketWatch. Got questions about money? Email Bob at rpowell@allthingsretirement.com.