When his career as a financial advisor ended in May, Norman Pappous took up a new line of work — evaluating the investment performance of his former peers. Pappous transformed himself from a retail financial advisor into something like a classic pension plan consultant — but aimed at retail investors instead of institutions. In essence, he's switched sides and now sits on the other side of the table.
The switch may seem surprising. But the 15-year veteran, let go by Merrill Lynch, reckons he has a righteous job to do. On his 50-mile drive to Houston each day to work — crossing the bridge to the mainland from his home on laid-back Galveston Island on the Gulf Coast — he had plenty of time to think.
“There's not a single wirehouse that rewards an advisor for portfolio performance,” says Pappous, 45. “They simply reward their advisors for sales performance.” (Firms deny this, stating that the client always comes first.)
Propelled by this rather bold opinion, Pappous and three partners launched Investment Performance Evaluation, a company to help retail clients evaluate the skill of retail financial advisors. (The software is licensed from institutional money analyzer Markov Processes International.) The product was several years in development, albeit, on again and off again, as Pappous' advisory career was his primary focus. But it launched, finally, within weeks of his unceremonious Merrill departure earlier this year. The name of his website, Evaluate My Advisor, pretty much tells the story.
Pappous' inspiration has a familiar ring to it: “The thing is,” Pappous asks, “Why hire an advisor if he is just going to be a one-and-half-percent drag on your portfolio each year?”
His new business is winning some attention. In his first few weeks, Pappous says about two-dozen subscribers each paid $500 for individualized 12-page reports (securely posted online but also shipped via UPS if the client prefers) that purport to “grade” their advisors' performance. His web-based service requires each investor to download from his portfolio what can best be described as a “ton” of data, generated over a minimum of 37 consecutive months, with the same advisor. The data include time-weighted monthly returns, or month-end balances, dates and amounts of deposits, withdrawals, interest payments, dividends, commissions and the like.
Why Are You Good?
What Pappous is offering is simply performance-attribution software, which has been around for decades. Indeed, for many years, institutions of all kinds have hired pension plan consultants to analyze money managers, to figure out how asset managers add value (if they do at all). Pension consulting is a big business and the backbone of it is high-powered, performance-attribution software. Well-known players include, Advent, Markov Processes International, SunGard, ThomsonReuters Wilshire Associates and Zephyr Associates.
Performance attribution is rooted in Modern Portfolio Theory and can be very complicated. But with the growing sophistication of retail investors and rise in computing power, the software is making its way — slowly — into the retail space. Broker/dealers, RIAs and financial planners have begun using the tools to evaluate clients' portfolios and share them with clients.
“Much of what before was technology that someone needed a Ph.D. in applied math to even turn on is now being packaged in a way that makes it easier for everyone to use,” says Phillip Silitschanu, an analyst at Aite Group. “I think it is still a step or two removed from being usable by ‘mom and pop,’ but it is slowly moving there.”
Pappous says his product stands out from the other retail games in town, including Telemet's and John Hancock's recently announced Portfolio Insight. Unlike other providers, Pappous' mom-and-pop subscribers can directly enter their own account data, and it contains their asset allocation information. In many cases, this information is a “blended benchmark” of various indices. That's not necessarily the way it works with other providers, says Pappous. He also says many investment advisors and wirehouses compare a client's portfolio to a single index, such as the S&P 500 or Lehman Aggregate Bond Index. “Our report gives you an apples-to-apples comparison by taking riskiness into account, using math formulas based on Nobel Laureate William Sharpe's Returns-Based Style Analysis,” Pappous' website says.
Pappous' software compares a client's portfolio performance with his benchmark asset allocations. The computer processing results in a series of “mini” evaluations in one single report, including any annualized excess returns, as well as a “batting average.” This is the number of months your returns beat the benchmark's monthly returns, divided by the total months in the study. A batting average of 0.50, for example, is considered good. These various subsets aim to measure the advisor's skills on market timing, security selection and portfolio re-balancing.
No doubt you have been using “up capture” and “down capture” when choosing mutual funds; obviously, it is another important statistical tool, in use for many years, that his software offers. Your clients will use it like you do when analyzing mutual funds: “Good upside/downside capture ratios, such as 120/80, would be the result of good security selection for the advisor and/or market timing,” explains Pappous. “A bad ratio, such as 90/110, could be the result of high fees and poor returns, including bad security selection and market timing.”?
Pappous is unimpressed with how the people in the advisory business are compensated. “At a minimum,” he says, “the advisor should make back his fees [with his investment performance]. If not, the client is clearly better off investing through passive ETFs or indexed mutual funds. It kills me that advisors' bonus checks and commission splits are tied to sales numbers. But no one gives a bonus for good portfolio management.”
Big Firms' Offering
Wirehouses offer an array of portfolio analysis, too, of course. Since the silicon revolution lowered the cost of entry, there are any number of software options available to analyze performance. Not to be outdone, Pappous' former employer says it recently upgraded its own in-house Client Review Center, an online tool used by advisors to generate, at no extra charge, free time-weighted performance analysis on clients' portfolios, including relative to blended benchmarks. (The package will eventually be available company-wide to all customers of its Bank of America parent.)
“If you have a negative alpha, not only are you not adding value but you are hurting the client,” says Andrew Heiges, director of wealth management tools at Merrill Lynch,
However, Pappous' product does have unique twists — not the least being its status as an independent, third-party provider, and as a sort of upstart, do-it-yourself alternative. “I like the concept,” says Heiges of Pappous product. A spokeswoman for fund and stock analyzer Morningstar, commenting on Pappous' product, said via e-mail: “While we have similar capabilities in our offerings for institutions and financial advisors — including Morningstar Direct, Advisor Workstation, and Principia — we don't have [the same] level of analysis available to individual investors on Morningstar.com.”
A spokeswoman for Morgan Stanley Smith Barney says clients are provided, “extensive reporting, [including] year-to-date, month-to-date, one-year returns, five-year returns, as well as returns that are measured against benchmarks and blended indexes on a client's allocations.” (There is no charge.)
Pappous and his partners' timing is good. “Retail investors are disappointed by their results, and they are firing their advisors,” says Jack Waymire, author of Who's Watching Your Money? (John Wiley & Sons, 2004). “Studies have shown that 40 percent to 50 percent of investors are planning this.”
Michael Pirrello, a partner and investment advisor at Mill Ridge Wealth Management in Chester, N.J., says Pappous has the concept right. “It is long overdue, especially from an independent third party,” he says. “Advisors are famous for sitting down with their clients and convincing them they are doing well, using all types of charts and analysis, so having an outside agency to evaluate is the best way to go.”
Still, folks like Waymire are not entirely convinced about the benefits of the do-it-yourself software. Investors who select to enter their own data may run into trouble, he thinks. “It is kind of like the old saying, ‘Garbage in, garbage out,’” he says. Waymire is co-owner and co-founder of Paladin Registry, a website that matches up investors with advisors compatible with the investor's financial profile. It's free to the investors; advisors pay for inclusion. Paladin claims a database of 38,000 investors. “Our traffic is up between 50 to 60 percent in the past twelve months,” he says. One Merrill advisor, who declined to be named, had a so-so reaction when he reviewed a sample report from Pappous.
Pirrello says that while Pappous' product might demonstrate broadly the advisor's added value, but it can't account for missed market opportunities, even as the advisor beats the client's benchmark. “The adviser could potentially miss a major market move of say, 30 percent, if the client is in cash,” he says. “In that case, he is not doing right for the client.”
Pappous is not deterred. “In these recent tough markets clients are upset anyway, because they have lost money,” he says. “Our third-party report can vindicate an FAs decisions if it comes back with good numbers. The FA can look the client in the eye, and say he is still adding value.”
