Convincing clients to stay invested is a major challenge for advisors

By Reynaldo Marquez | September 13 2008 08:25PM

In down markets, financial advisors face one of the toughest challenges of their careers: convincing their clients to remain invested in long-term equity mutual funds or have them miss an eventual market recovery, experts warn.

Equity funds offer the greatest potential for long-term growth. But they usually experience greater volatility than income or money market funds. And even if they are a good choice for longer term goals, investors have a hard time accepting possible declines in the short-term value of their investments.

The ongoing market volatility has frightened many investors away from long-term equity funds, with most new sales going into more conservative investments such as short-term money market funds.

Data from the Investment Funds Institute of Canada (IFIC) tells the tale. In its July analytical report, IFIC states, "The split between long-term fund sales and money market fund sales has reversed itself from previous periods. Canadian investors, in response to increased volatility in capital markets and uncertainty in the U.S. housing and financial markets have chosen to park their money. Over the last 12 months, $20.3 billion of the $20.8 billion in total industry sales went to money market funds."

The problem is that investors who choose to park their money in these funds, awaiting better market conditions, may be making a costly mistake. They run the risk of missing out on an eventual market recovery. Such recoveries historically boost yields by up to 20%, experts say.

That downward trend has even hit the more niche players of the Canadian mutual funds industry. "There is definitely more pressure by clients to be more conservative," says Andy MacLean, director, private client research, of Toronto-based, Richardson Partners Financial. "Clients, especially if they are left on their own, tend to become very reactive to the latest bit of economic news," he says.

With twelve offices nation-wide, and with eight billion dollars under management, Richardson Partners caters to wealthy clients. And while more affluent investors tend to be less panicky than the average ones, in times of down markets, their nervousness has nonetheless been felt by his firm, says Mr. MacLean.

"We have not seen, inside our firm, an increase in net redemptions from our equity funds. But what we have seen is that our present and our new clients choose to sit on the sidelines, because they now prefer to buy fixed income or money market funds."

With clients pressing to be more conservative, some advisors may experience a drop in their commissions, says Dennis Yanchus manager, statistics and research at the Investment Funds Institute of Canada (IFIC). While advisors selling fee-based investment solutions are more likely to keep their head out of the water, those selling stand-alone mutual funds may indeed experience a drop in their sales and trailer commissions, he says.

John Lutrin, Vancouver-based vice-president at Hub Financial, agrees. "Trailer commissions are down because [equity mutual funds] asset values are down," he says. "Either way, brokers always pay the price of negative markets," Mr. Lutrin adds.

On the one hand, if the clients chose to stay invested in equity markets, advisors' commissions declined because they are based on the waning asset values of equity funds. On the other hand, if clients choose to invest in more conservative vehicles, advisors' commissions also decline. "Money market and fixed-income mutual funds pay less commissions," Mr. Lutrin explains.

But things need to be put into perspective warns Mr. Yanchus. "If drops are occurring, they are not as significant as they were when the technology bubble burst in 2000."

Perhaps surprisingly, even in an advisor-driven industry like mutual funds, clients with an advisor guiding them don't seem to behave much differently than clients without advisors in difficult markets.

The reason is that only a minority of clients give their advisors full discretion over their portfolio, says Donald Reed, president and chief executive officer of Toronto-based Franklin Templeton Investments. "Most clients will only take recommendations from their advisors. It is up to the clients to see if she or he will agree with the recommendations and act accordingly, because at the end of the day, it is the clients' money," Mr. Reed says.

"Different advisors cause their clients different degrees of comfort. There are some advisors out there that make their clients feel very at ease with their recommendations. Others do not. It is often a matter of chemistry between the two."

However, all advisors should educate their clients about the necessity of sticking to their equity holdings, especially in times of down markets, he says. "What happens in a quarter or in a year should not be too material to investors. It's the long term that counts," Mr. Reed adds. "The consideration to remain invested in equity markets should focus on the suitable need of the clients in a long-term perspective," he says.

Armed with the right arguments, advisors may succeed in convincing their panicky clients to remain invested in equity markets, experts say.

The following five tips may help:

1. Don't miss the recovery

One of the first things advisors should do is to warn their clients about the risks of reducing or completely liquidating their equity holdings. "It can be a costly mistake," says Mr. MacLean from Richardson Partners.
"Investors who withdraw from the market and choose to sit on the sidelines, waiting for a confirmation that the economy has improved, will typically miss the bulk of the returns coming out of recessionary or bear market environments," he explains.

The problem is that no one knows when markets will go up. When they do, it tends to be very sudden, and the returns at the very beginning of it can be very dramatic.

"Historically, once investors get a confirmation that the recession is over, the market has already generated a 20% return on average," says Mr. MacLean citing data from the S&P500 and the American Bureau of Economical Research compiled by his firm.

According to Denis Dion, product specialist with Quebec-based Desjardins Group, someone who invested $10,000 in the Canadian equity market on June 30, 1991, would have seen his money grow to $55,729 by December 31, 2007, an annual increase of 10.97% over that 16-year period.

On the other hand, if that same person withdrew from the market during the 10 most profitable days of that period, the $10,000 would have generated $37,358 at a composite annual rate of 8.35%.

In addition, that same amount would have grown to only $27,191 if the investor had withdrawn his equity holdings from the market during the 20 most profitable days of that same period (see inset table). "The tip is: over the long run, markets eventually recover. So yes, there is a financial consequence if you choose to sit on the sidelines," he says.

2. Use analogies

To efficiently educate clients about risk and how it impacts the performance of their investments, advisors should use analogies, says Mr. Lutrin of Hub Financial.

He says that when talking to clients, analogies paint a clearer picture for clients.

"For example, if you bought a house to live in and the housing market crashes or dips, do you suddenly sell your house and go live elsewhere? No you don't. You keep living there," he says.

"What we mean by that is that the equity markets are no different than other markets in the world. It is a matter of buying and selling, except that you are using the fund as a vehicle to get into the equity markets," Mr. Lutrin explains. "It comes down to buying when costs are low, and selling high to capitalize on the gain."

Unfortunately, in equity markets, investors tend to do the reverse. "People seem to buy when it is expensive and sell when it is cheap," he deplores.

"Those are the analogies we get the brokers and their clients to understand. If investors are in for the long-run, they should expect the bumps along the way."

3. Rethink good returns

In down markets, advisor should help their clients rethink their definition of what a good return should be. That should increase investors' sense of confidence in financial markets. For example, while a four or five per cent return might look weak when stocks are moving up 15%, that same return may look more interesting to clients when markets are down by 15%.

"In an up market, clients tend to focus on the relative return of their investments," says Dave Richardson from RBC Wealth Management. "If they get 30%, they will wonder why they are not getting 40%," he explains. That is why in up markets investors will often be moving their holdings around in the hopes of generating better returns."

"But in a down market, investors turn their focus only on real returns. Pretty much any investment is going to be down in a down market. Clients will then start to think about absolute returns. So while the market is down 10% they could be comforted if their portfolio is only down by 5%," he says.

Another way to restore your clients' confidence in the markets is to review with them their initial investment goals. By giving your clients' investments a good once-over, you will increase their confidence that these investments are worth sticking with, despite the weak recent performance, says Mr. MacLean.

Investors need also to be reminded that investing is a long-term proposition, he adds.

"But before advising your clients to stick with their initial investment plan, advisors may want to make sure that it is still the appropriate recommendation. And if it is, their risk tolerance and their income requirements should back that up."

Normally, when clients' portfolios are put together, they are meant to handle periods of buoyancy in the markets as well as periods of volatility, he adds.

4. Dollar cost averaging

Also, advisors should make their clients think of volatility as an opportunity in order to position their portfolio favourably, says Mr. Reed from Franklin Templeton. "Wealth is created in down markets not in up markets", he explains. Clients can accomplish this by a technique called dollar cost averaging.

This technique consists of investing regularly by putting the same amount into mutual funds or stocks every month or quarter. Although it does not eliminate risk, dollar cost averaging reduces average cost per share in fluctuating markets.

"So the tip would be: use market volatility to your clients' advantage," Mr. Reed says. Essentially, market volatility is pacing the rate at which clients enter their funds.

"Dollar cost averaging is a smoothing strategy that allows clients to buy more when units are cheaper and to buy fewer when more expensive. That works in the investor's favour."

5. Diversify, diversify and diversify

Informing clients why diversification is important, but also assuring them their portfolios are well diversified is another very basic message that should help to convince them to stick to their equity holdings.

Maintaining exposure in a variety of areas, including stocks and bonds, international funds, real estate funds, certificates, money market savings accounts and stocks issued by large and small companies in different industries, is a good way to reduce risk, says Mr. Richardson of RBC Wealth Management.

"In a very weak equity market, a diversified portfolio with fixed income and cash in it will cushion the fall of equity markets in your portfolio. But a diversified portfolio is a good idea at any point in the cycle because you want to have a mix of different types of assets so that you build a portfolio that matches your risk tolerance," he adds.

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