4 Advisor Moves That Shouldn't Be Legal

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Throughout the years, I have had investors come to me with statements or reports showing some pretty outstanding performance. That can include anything from “market-beating” portfolio increases to truly satisfying amounts of income, with relatively little risk.

The vast majority of the time, however, this outstanding performance turns out to be a skillful illusion. When I explain the illusions, I often hear something like “Why is that legal?” I don’t have a particularly good answer other than to say, “It shouldn’t be.”

Here are four such practices, as well as some I often see bundled to really confuse the client.


While I’m happy to say this is becoming slightly less common, I still see reports that compare a portfolio to an index — usually the S&P 500.

But that’s a problematic benchmark: The S&P 500 is merely the appreciation of stocks and excludes the dividend reinvestment. It isn’t the total return that, for example, is benchmarked by Morningstar.

Also, the S&P 500 includes only 500 companies; it excludes small and most mid-cap companies, which have outperformed large-caps historically (although not in 2014).

Some advisors make this comparison to create the illusion of alpha — but in truth, they’re only comparing part of the return of part of the stock market to the total return of an equity portfolio, which may have a smaller-cap tilt.

Jonathan Boersma, head of professional standards for the CFA Institute, says this practice is one of his “pet peeves” and is just plain misleading.

To see just how much of an impact this practice can have, consider the “Market-Beating Performance” chart below showing the return of “Fund XYZ” vs. the S&P 500 from Dec. 31, 1999, to Dec. 31, 2014. It looks as though Fund XYZ gained about 90% over the 15-year period, in spite of two 50%-plus plunges since 1999.

Is that alpha? Well, Fund XYZ is simply the total return of the Vanguard Total Stock Market index fund (VTSMX) — which, over the period, followed indexes of the broader U.S. stock market.

Every now and then, I confront an advisor who uses the raw S&P 500 to show market performance. The answer to my tactless question is typically something along the lines of “Everyone does this and that’s what the client wants to see.” The advisor then gives me a look that could kill and walks away in disgust.

Other variants of the indexing game are also common.

S&P Dow Jones Indices now tracks over 1 million indexes. And it is understandably human for advisors to want to cherry-pick indexes to make their own work look good. But even showing the total return of the S&P 500 is still misleading if the client’s equity holdings include small- and mid-cap stocks.


The mutual fund industry must report returns after fees, known as net of fees. Yet many money managers show clients returns gross of fees, or before fees.

In fact, one advisor, a CFA, told me he shows clients their returns gross of fees because the CFA Institute Global Investment Performance Standards call for returns to be stated before fees.

Boersma, however, counters that the CFA Institute’s standard was only meant to apply to clients evaluating managers. Since the client is actually paying the fee and the actual return to the client is reduced by these fees, he agrees, ongoing performance should be shown net of fees.

What matters to the investor, of course, are the actual returns — and any management fee takes from those returns. I don’t typically hold the mutual fund industry up as an example of transparency, but in this case the rules work: Funds must report returns net of fees.


One client came to me with a statement showing hundreds of thousands of dollars annually in “interest income” in his professionally managed muni bond portfolio. In actuality, though, about two-thirds of those returns were an illusion.

Here is an example of how this illusion is constructed. The manager buys a $100 muni bond that has a $4 coupon at a price of $110, or $10 over par. The statement will show annual income of $4 per bond and a yield of 3.64% ($4/$110). The bond is rated AA and callable in four years (at $100) so this income will likely only last for that four-year period.

Note that, as of early February, a low-cost intermediate-term muni bond fund from Vanguard (VWIUX) was yielding only 1.49%.

Why is that portfolio statement misleading? I recently posed this scenario to a group of CPAs I was teaching, challenging them to figure out how this was deceptive. None succeeded.

The illusion here arises because the bond was purchased at a premium and will be called at par. That is to say, the consumer pays $110 for the bond and will get back $10 less, or $100 when the bond is called by the municipality.

In simple terms, roughly $2.50 ($10 divided by four years) of the $4 coupon is return of principal (technically referred to as amortization of premium); only the remaining $1.50 is income. Of course, that $1.50 is gross of fees, so much of it is taken by the bond manager. 

Yet in my experience, rarely does the average investor understand this.

I spoke to Lynnette Kelly, the executive director of the Municipal Securities Rulemaking Board, about the practice of reporting return of principal as income. She was generally more optimistic about investor understanding than I am, although she allowed that there was room for confusion.

“We believe that investors in municipal securities are provided with extensive information and disclosures to help them fully understand this asset class,” she says. “We get regular feedback to help inform our priorities — but we can’t confirm at this point what investors understand.”

Brokerage statements, she notes, “are communications subject to the MSRB’s fair dealing rule.” Yet it seems that the details can be left to the fine print, which may show that income is defined as coupon payments and coupon payments may include amortization of premium.

This is a convoluted way of saying some of investors’ income is the return of their own money.

I asked Kelly if the MSRB would consider an investor survey to determine whether my assertion that investors generally do not realize a portion of “income” is the return of their principal is valid. “The MSRB has never surveyed,” she says, adding that “it is an interesting suggestion that we could consider among our other priorities.”

I gave Kelly and a FINRA spokesman, George Smaragdis, a copy of a client statement showing attractive income that was grossly overstated, but both declined to comment specifically.


The pitch goes something like this. You can only earn about 2.3% on a CD, but you can get an annuity paying 6% that you can never outlive. This is often the pitch for a single premium immediate annuity, which may be an appropriate product under certain circumstances. Yet the pitch is misleading, and the comparison to income from other products, like the CD, is just plain false.

To see why, let’s assume a 65-year-old client buys this annuity paying “6% income.” The client must live another 16 years and eight months just to get her principal back before she gets one penny of income above the amount she handed over.

With even 2% inflation, the client would need to live even longer to get her money back in real inflation-adjusted terms — about 20 years and six months. So a key issue is to make sure her life expectancy is longer than this period.

By contrast, the CD would offer pure income.

There’s another problem with this pitch. Essentially, the clients are buying a bondlike investment with a duration set for the rest of their life. That puts them at risk if inflation were to rise. As the “Spending Power Decline” table below shows, a tame inflation rate of 2% would eat away a third of her real spending power in 20 years; 5% inflation would reduce her real spending power by 62%.


Sometimes these practices are combined. The most common I see are brokerage statements showing the municipal bond total coupon as income gross of fees — essentially showing just the return of the clients’ principal, but carving out the fees they are paying to get their own principal back.

Such an investment might then be compared with a low-cost municipal bond fund — a skewed comparison — which shows true income after fees to give the illusion of alpha.

In one recent case I reviewed, the client’s attractive 3.4% stated income was actually pretty close to zero. The client took 100% of the risk while the broker and the money manager were taking 100% of the profit.
All four of these practices are common; some would even call them industry standards. Even well-meaning advisors may be following these practices blindly, never questioning their fairness to clients, and taking comfort in the knowledge that many other advisors and firms are doing the same. Indeed, we might even convince ourselves that it’s what the client expects. But is it fair?

To be sure, I haven’t revealed anything new. Regulators, from the SEC to FINRA to state divisions of securities and insurance, are also aware of these practices and have chosen to allow them.
Why are they legal? I still don’t have a good answer. 

Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes for The Wall Street Journal and AARP the Magazine, and has taught investing at three universities. Follow him on Twitter at @Dull_Investing.

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