Red-flag financial advice

Questionable strategies for watch for

Despite improving financial literacy and a growing regulatory environment, questionable investment strategies are still being used by some advisors, and some investors keep falling into the trap. Keep in mind that 95% of financial advisors are putting their client’s interests before their own and are acting in a very professional manner. Here, I want to look at some financial strategies that should raise big red warning flags.

Leveraging

Leveraging is the practice of borrowing money to invest. Financial advisors propose this to clients because the interest is normally tax deductible and it adds assets to their practice in a very quick way. The problem is that this is one of the most abused practices, because too many people who enter into it aren’t fully aware of the downside risk, which can be considerable.

Risks are magnified by leveraging. I think a number of basic conditions should be met before you even think about using leverage for investment: You should have paid off a good portion of your home; you should have a good employment situation and stable income; you should already be maximizing RRSPs. Why enter into a sophisticated investing strategy if you haven’t taken care of the basics first.

Churning

In the world of mutual funds, “churning” is the practice selling a client a mutual fund with a deferred sales charge (DSC) option, which typically carries a vary good commission for the advisor, and then moving the 10% fee-free units that are available each year to front-end load (FE) units. At some point in the future, the FE units are moved back to DSC units, while the advisor earns a second commission on the same money.

At other times, an advisor will wait six or seven years until the entire amount is fee free and then give the clients a proposal to move the investment back to DSC units. The sneaky thing here is that the client may not be aware that the funds are locked then into the DSC units of the fund for another six to seven years.

DSC option

The deferred sales charge (DSC) option pays the advisor the largest commission (usually 5%), but the funds are effectively “locked” into that fund company for six to seven years. If redeemed before then, management fees will be charged to the client.

Most financial advisors have shifted to zero front-end load units, so clients can move to another investment company or redeem units with no fees or penalties, giving them much more flexibility. The DSC does nothing positive for a client. Why would you want to be locked into one investment company when you have many other options where this isn’t the case?

A newly-licensed financial advisor might use this option to pay some bills while the business grows. That is reasonable, allowing the advisor to stay in business. But be aware that this is what the advisor is doing. Some advisors who have an asset threshold (for example, $500,000 in household assets) will put clients with less than that amount into the DSC option to meet their income requirements per client. If you don’t like it, you are free to move to another advisor with a business model that is more aligned with your goals.

Using DSC funds also may be a necessary as a tool if a client has DSC mutual funds at an institution which is a closed shop (for example, Investor’s Group) and wants to move them out of that firm to the new advisor. The new advisor would be able to sell DSC funds to earn enough commission to rebate the fees at that closed shop, so the client doesn’t have to pay the fees and lose money as a result of the changing his advisor.

Most companies allow you to transfer assets in kind which allows you to transfer DSC funds and simply wait for the fee schedule to mature, which is the case for most transfers.

Long bull market

When the markets have been going through a prolonged bullish phase, be wary of investing lump sums in equity investments. If a major correction occurs shortly after your investment, you may find your portfolio down 30%-40% in a very short period of time.

In this situation, you can invest in more balanced assets that include more fixed income and some investments that don’t correlate too closely with the stock market, for example, real estate or infrastructure to mention two.

If your advisor suggests investing a big lump sum during a stale bull market, be careful. One strategy to reduce risk is to avoid large lump-sum exposures. For instance, rather than investing $300,000 into a stale bull market, invest $15,000-$20,000 a month. This may allow you to buy low if the market corrects in two to three months after you invest, which may substantially reduce your downside risk.

Why invest a large lump sum when prices may be close to their peak and a correction is overdue from a historical perspective. That is when risk is at highest.

Alternative investments

Alternative investments (if you have any at all) should be perhaps only 10%-20% of your total portfolio, and you should buy only if you are a sophisticated investor and totally understand the nature of the investment. Most alternative strategies are not easy to liquidate and may take as long as two to three years to sell. Advisors need to have what is known as an exempt market license to offer these types of investments to their client. These are still sometimes highly risky investment strategies that could go belly up very fast, which is why they are not financed through the traditional channels.

Fortunately, most financial advisors are doing what’s right for their clients. And by doing that, the business side of their practice will usually thrive, because the client will see that the advisor cares about you as a person.

If your financial advisor is employing one or a few of the tactics I’ve mentioned here, I would ask an objective, unrelated professional advisor to give a second unbiased opinion just to be safe. You worked very hard to build your retirement nest egg, and it’s crucial that you don’t make it vulnerable to the schemes of an unscrupulous financial advisor.

Bruce Loeppky is based in Surrey, B.C. and is registered with Portfolio Strategies Corporation as a mutual funds person. He is a regular contributor to the Fund Library. He can be reached at sloeppky-1@shaw.ca.

Notes and Disclaimers

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The foregoing is for general information purposes only and is the opinion of the writer. No guarantee of performance is made or implied. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice. However, please contact the author to discuss your particular circumstances.