Looking Under the Hood

Daniel YergerFinancial Planning 2 Comments

There’s some age-old wisdom in car buying: “Don’t buy a lemon, look under the hood.” The basic idea here, of course, is that before you buy a car you should look not just at the outside of the car but the interior and the actual mechanical workings. While this is seldom a concern when buying new (and thus the premium price of a new vs. a used car), used cars are popular for the fact that, if you do your homework correctly, you can get a perfectly good car for a fraction of the price of new. Yet, this same wisdom often fails to extend to other realms. The simple fact is that if we tried to “look under the hood” of every purchase, we’d spend our whole lives on due diligence rather than getting anything done! However, in some cases, it’s prudent to return to a due diligence standard. For example, this past week, we had the opportunity to “look under the hood” for someone and found that not only had they been sold a lemon, but a particularly sour one. So this week, we’re sharing the case study and the lessons to be learned therein.

In The Market For Quality, Not Lemons

Let’s set the stage for this particular example. An individual had several million dollars. The money was presently held by a family office (an ultra-high net-worth service institution that typically only works with multi-millionaires), and up to the start of this story, the individual had no say in the management or use of the funds. Newly liberated and given the opportunity to make their own decisions regarding the money, the individual decided they should do their due diligence and shop around. They met with various investment advisers and brokers, along with representatives from the family office. The proposition of the family office was, simply:

  • We are fiduciaries.
  • We will charge you far less than anyone else: 0.15% per year.
  • Remember, we’ve done a great job up to this point. We will keep your money safe.

At face value, that’s a fairly tempting offer when most other firms would ask 1% per year, and may or may not be fiduciaries. Given a track record up to the present of having grown the money, it felt like a safe bet: “We know the quality of the thing and the price is good,” one might say. So, the individual decided to leave their money with the family office, asked to be sent a few thousand dollars a month for supplemental income, and thought nothing more of it. From that point, everything was going great until it wasn’t. The balance of investments grew and the income payments came in, for a time. Yet, after the tumult of 2022, the individual was devastated to realize that by the end of the year, they’d lost almost 13% of their investment.

Now, we’ll pause in the story here to make a note: If you invest for a long enough period of time, you are guaranteed to lose money somewhere along the way. Simply put, there are no long periods of time in which losses do not periodically happen. They might be constrained to a week, a month, or a year or two at a time. But given years and decades, while the long-term results of an investment should be good, losing money from time to time is to be expected. We emphasize this because the investor knew this. It wasn’t to say then that they were shocked to have lost money at all, but that it gave them pause to reconsider: “They said they’d keep my money safe, but it doesn’t feel very safe. I’m going to get a second opinion.” Enter MY Wealth Planners and this case study we have to share with you. We were asked to take a look at their current portfolio to figure out what the matter might be.

Looking Under the Hood of a Portfolio

There are several softwares out there that just about anyone can use to self-evaluate their portfolio. A simple tool anyone might use is Portfolio Visualizer, which for free, will provide basic backtesting and asset analytics. However, professionals will often have access to much more robust tools, so asking for a second opinion from a professional doesn’t hurt if you have someone you trust. You, of course, should beware the conflict of interest inherent in asking someone who can be paid to manage your money how your portfolio that they’re not managing today is doing, but so long as you’re cognizant of that, they might find some things you’re not looking for. That said, here’s what we found in this particular case:

  • The portfolio was invested in almost 100 mutual funds and individual stocks. Of all the investments, four mutual funds made up just shy of 70% of the portfolio, and all four of those mutual funds were proprietary funds of the family office.
  • Those proprietary funds had expense ratios with a weighted average of 1%. This meant that, though the family office told the individual that they would only charge 0.15%, they were in-fact, receiving revenue equal to a 0.84% fee. Thus, while they had competed in part on being “much cheaper than the competition” they were in fact charging just as much, if not more in some cases.
  • The performance and cost of those four proprietary funds was abysmal, and not purely with the benefit of hindsight. In reviewing the numbers below, the 1st percentile would be best and the 100th percentile would be worst in comparing each investment to its peer group.
    • Proprietary Large Cap Fund:
      • Expense Ratio: 64th percentile; meaning 63% of similar investments were cheaper
      • 3 Year Alpha: 95th percentile; meaning 94% of investments outperformed when risk and benchmarks were accounted for over the prior 3 years
      • 3 Year Sharpe Ratio: 94th percentile; meaning that 93% of investments had a better risk-adjusted return over the prior 3 years
      • 12 Month Trailing Return: 69th percentile; meaning 68% of investments had outperformed it for the prior year
      • 36 Month Trailing Return: 97th percentile, meaning 96% of investments had outperformed it for the prior three years
      • 60 Month Trailing Return: 95th percentile; meaning 94% of investments had outperformed it for the prior five years
    • Proprietary Small & Mid-Cap Fund
      • Expense Ratio: 43rd percentile
      • 3 Year Alpha: 75th percentile
      • 3 Year Sharpe Ratio: 75th percentile
      • 12 Month Trailing Return: 88th percentile
      • 36 Month Trailing Return: 85th percentile
      • 60 Month Trailing Return: 87th percentile
    • Proprietary Fixed Income Fund
      • Expense Ratio: 57th percentile
      • 3 Year Alpha: 25th percentile
      • 3 Year Sharpe Ratio: 21st percentile
      • 12 Month Trailing Return: 88th percentile
      • 36 Month Trailing Return: 93rd percentile
      • 60 Month Trailing Return: 94th percentile
    • Proprietary Credit Income Fund (1 year old at the time they invested in it)
      • Expense Ratio: 50th percentile
      • 3 Year Alpha: Incalculable due to the immaturity of the fund
      • 3 Year Sharpe Ratio: Incalculable due to the immaturity of the fund
      • 12 Month Trailing Return: 80th percentile
      • 36 Month Trailing Return: Incalculable due to the immaturity of the fund
      • 60 Month Trailing Return: Incalculable due to the immaturity of the fund
    • All of the other investments were individually held stocks with a handful of mutual funds, with no individual selection making up any more than 1.5% of the portfolio.

To give you a contrast, the Vanguard Total Stock Market Index ETF (VTI) and the Vanguard Total Bond Index ETF (BND) at the same time:


Large Cap Small & Mid Cap

Fixed Income

Credit Fund Vanguard Total Stock Vanguard Total Bond
Expense Ratio 64th 43rd 57th 50th 3rd 5th
3 Year Alpha 95th 75th 25th Not Calculable 38th 58th
3 Year Sharpe 94th 75th 21st Not Calculable 34th 39th
12 Month Return 69th 88th 88th 80th 23rd 73rd
36 Month Return 97th 85th 93rd Not Calculable 24th 47th
60 Month Return 95th 87th 94th Not Calculable 20th 57th

While one might say hindsight is 20/20, the point here is that these supposedly fiduciary investment managers chose proprietary products that not only grossly underperformed comparable and well-known index funds, but that they had done so for years at a time. The argument for selecting more expensive active investment funds over passive funds is often down to the case that if you pay more for active, a decently performing manager can outperform the index they’re competing against. But when investment managers select an actively managed fund that not only hasn’t outperformed its peer product, but that is also paying back the same company as the investment managers, that’s deliberately buying a lemon at a client’s expense.

Looking Under the Hood – Avoiding Lemons Like This

Well, there are a couple of easy things you can do: First, if your investment manager’s name is also the name of the investments they’re recommending to you, that’s a big red flag. While that can create an odd scenario where a Vanguard advisor shouldn’t be recommending a Vanguard fund, that’s a fairly rare exception, not the rule. Secondly, whenever presented with actively managed investments, you should demand a long and thorough history of performance, not only of total return, but of comparison to comparable passive funds. While active funds might outperform in any given year, it is incredibly statistically unlikely that they will continually outperform on a long-term basis, and the net result is that over a decade or longer, only a handful have outperformed a simple benchmark index fund. Third, don’t let your advisor pick individual stocks. That might seem counterintuitive (“isn’t that what I’m paying them for?”) but the fact is that client-facing advisors are not typically trained or qualified as stock pickers, and even the Chartered Financial Analysts that are trained to do so, often underperform basic index investments (as highlighted in point number two!) Fourth, even when a financial planner or advisor says they’re a fiduciary, get that in writing and be sure to read their entire service agreement for any disclaimers or disclosures. In our case study, a glaring disclaimer was that the “Fiduciary Family Office” disclaimed responsibility for picking, managing, or monitoring investments. Essentially, when they invested the client’s money, they had “presented” a portfolio and “let the client choose it,” which is not what the client thought they were doing. Finally, it never hurts to get a second opinion. As we said at the beginning, there can be an obvious conflict of interest between having one investment professional evaluate another professional’s work when they have a chance to win your business, but that also means they’re unlikely to hold back or omit problems they see in the other professional’s work. Much like getting a second opinion from a doctor, when it comes to your life savings, it never hurts to check twice and be sure that you’re looking under the hood.

Comments 2

  1. Well, sigh. My CollegeInvest and IRA money have dropped quite a bit – does that fall under the umbrella of general ups and downs of the market? Or is your point that if it continues to perform poorly while other funds do better, then I had better look for an oil leak? LOL

    BTW, your artistic ability doesn’t seem to be improving with practice. . . . just saying.

    1. Avatar photo Post

      Last year the markets went down; anyone claiming you “would have made money if” last year is just selling a bill of goods. The issue herein for this case study was that they were expecting to “not lose money” which was an unreasonable expectation for their advisor to set for them.

      Oh, I’ve never been an artist, but a little authentic “bad scribbling” just proves I’m human!

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