Products exist because of one of two problems
Most advisors do not possess the expertise to construct, plan and manage portfolios themselves.
The industry does not have the ability to distribute personalised wealth management solutions from the basic portfolio building blocks of cash, fixed interest and equities.
Products are packaged solutions to the problem of distributing investments and to the problem of constructing, planning and managing portfolios of investments.
A share is not a product, cash is not a product, a government of Canada bond is not a product.
A mutual or pooled fund, a wrap account, a principal protected note, a hedge fund, a segregated fund, a GIC are all products.
The difference between a product and an asset is that products do one of the following.
Combine a number of different or similar investments together within a managed structure.
Change the risk/return relationship of the investments held.
Change the normal investment time frame of the investments held or the ability to buy and sell the investments held.
While many products are genuinely needed and have a valid investment rationale, many more are not and, many of those that are valid, are either far too expensive or incorrectly applied.
Basic rules & basic problems
In order to understand products we must first of all understand some basic rules. Furthermore, in order to understand why products are sold we need to understand some basic problems. For further information see rules and problems on the side menu.
Products can solve fundamental "problems"
A mutual/pooled/exchange traded fund solves the problem of insufficient expertise and manpower in the financial services industry to personally manage portfolios of direct shares for individuals.
A mutual fund is a way in which one manager can manage thousands of portfolios or, a way in which investors can diversify into areas that they do not have the time and resources to personally manage. There is nothing wrong in delegating the management of your Japanese small caps, or your Canadian small caps, or your emerging market exposure to a competitively priced firm with the resources and the expertise to do the job properly.
Indeed, mutual funds (if we ignore the costs, the sales practises and the way they are often used to build portfolios) represent one of the most important product developments in investment history.
Most portfolio managers will need to access a pooled fund of some sort to gain exposure to areas they do not possess the expertise or the resources to personally research and manage direct stocks and, their are a number of very good managers who find it more efficient to delegate all the stock selection to experts in a particular area.
Products can solve the wrong problems!
Understand this, in a transaction driven industry remuneration is primarily by commission. The company that produces the product and the salesman that sells the product only earn a return when a sale is made. The interest of the product provider and the salesmen are intertwined.
There is no problem in selling products as long as the client does not think they are being provided with a wealth management solution.
The problem for the salesman is in making sure that "your" capital goes from an asset that does not earn a transaction return or a management return (cash) to one that does.
Naturally many investors are cautious over the risks of stock market investment and may limit their exposure to such assets. If an institution can develop a product that will be attractive to lower risk individuals they will be able to earn either a transaction or a management return on their capital, or both.
These types of products are often typified by their so called ability to earn "stock market returns" while avoiding stock market risks. Unfortunately, in most instances, the negative aspects of the investments are not discussed and the broad marketing claims made are unlikely to be met.
In order to understand why products are not often effective solutions to problems investors need to understand both the basic rules of product use and the difference between portfolio structure and products.
Investors must also understand that the industry is in transition and, that products represent a halfway house in this transition. At some point in the future the industry will finally accept the need to to integrate the management of both financial needs and financial assets. The ability to do this will take away the need, the imperative, the rationale and the distribution network for the vast majority of products we see today.
Products create problems
There are many problems with products
More often than not they represent one off solutions which means they lack a genuine investment rational and are difficult to integrate within your overall portfolio and get in the way of effective portfolio management.
Investors risk ending up with a collection of products/one off solutions, that have bear little or no relationship to each other or the individual’s financial needs.
Those who rely on products to solve every asset allocation or investment dilemma are not likely to possess the necessary expertise needed to construct plan and manage portfolios.
Products are expensive not just because they require incentives to be provided to the seller but also because of the various layers involved in developing and managing them. A large part of the investment industry today exists purely for the return it provides to the companies that produce the products.
Individuals whose portfolio is largely comprised of products face higher costs, lower returns and higher risks.
As discussed in the TAMRIS March 2006 review, higher costs can often take away most if not all of the benefit of a product's underlying investments. At times individuals may be better off with a no cost cash based investment.
A well constructed portfolio should meet all needs and risk preferences
In truth, a well constructed portfolio of cash, fixed interest investments and equities/cost effective mutual funds/ETFs should be more than capable of meeting all your needs and your risk preferences.
If you are lucky to have the amount of capital that can warrant proper portfolio management then you would best avoid most one-off product solutions.
At all times, when being sold a product remember that the person who is selling it may receive a commission for its sale and, if commissions are the only means by which the advisor is remunerated, then beware.
All that most products represents is a costly, complex and awkward combination of investments compared to a portfolio comprised of the basic investment assets.
Note a product is developed without knowledge of your risk preferences, without knowledge of your financial needs, without knowledge of all your investments and without knowledge of the risks and returns of the current market and economic cycle.
The risks are often not pointed out
If a salesman is selling a solution to a problem, it is often counterproductive to point out the negatives. While much of the detail an investor needs to be aware of is provided in the small print of the prospectuses provided, much of the rationale for or against a purchase is not.
Failure to point out the negatives is a misrepresentation of the facts. Yet, misrepresentation is a common practise in the financial services industry.
In reality, in an industry where most earn their return from the sale of products and transactions, there is little or no incentive to draw up arguments against a sale. Why cut your own throat?
A professional advisor on the other hand should not use one sided arguments to induce you into any investment, but should give you a well balanced and clear explanation of the risks and rewards of the investment as it relates to your financial needs, risk preferences, your other investments and the current risks in the market and economy..
You may think that every product simplifies the investment process. It does not. A product more often than not simplifies the sales process but complicates the construction, planning and management of assets to meet financial needs over time.
Most products represent the trappings of a transaction led industry and are far too expensive to represent efficient components of a portfolio in their own right.
While many products do have a rationale, most do not and there is a direct and inverse relationship between product use and investment expertise, product use and financial advice, product use and portfolio returns and product use and financial security.
Given the weaknesses of products in terms of costs and structure, the emphasis on past performance as a strong component in the sales process is of no surprise.
In the present environment it is the individual investor’s responsibility to stand up and to make sure that the advice they are receiving is in their interests and, that they are indeed receiving advice as opposed to a product sale. Only then, will the industry be forced to change.
Demand leads innovation and those who remain happy to pay through the nose for the "advice" they receive will unwittingly reinforce the current status quo.
Products are a sign of an industry in transition and those who principally sell products and their benefits are the servants of an industry that does not have the client’s interests at heart.