Managed Accounts

In legal terms, a broker is any person engaged in the business of effecting transactions in securities for the account of others. A dealer is any person regularly engaged in the business of buying and selling securities for his or her own account.

In layman’s terms, broker-dealers are salespeople. Like sales staff in any non-financial industry, broker-dealers are compensated through the commissions or markups they receive for effecting transactions.

Broker-dealers often do business as “financial advisors.” Unfortunately, there is no legal definition for this term; anyone can call themselves such. Broker-dealers like to use it because it sounds almost like investment adviser, which they are not.

In contrast to “financial advisor,” the term investment adviser has a precise definition. We identify these people with a three-prong test. By law, an investment adviser is anyone who:

1. provides investment advice, reports, or analyses with respect to securities;
2. is in the business of providing advice or analyses; and
3. receives compensation, directly or indirectly, for these services.

In layman’s terms, investment advisers are consultants, paid for providing investment advice and held to the fiduciary standard. A fiduciary is a person legally appointed and authorized to hold assets in trust for another person. The fiduciary manages the assets for the benefit of the other person rather than for his or her own profit, and must exercise a standard of care imposed by law.

Besides their fiduciary duty, investment advisers have to meet numerous further requirements regarding their fee structure, ethical standards, record keeping, and more. That’s why it seems more attractive to some professionals to appear to be an investment adviser than to actually be one.

To further complicate things, many financial professionals choose dual registration: they act as broker-dealers and investment advisers simultaneously. Doing so makes sense in some situations, but it potentially blurs the line between the two further, leaving clients unclear about the obligations of their counterparts.

I have seen brochures offering clients multiple plans side by side, seemingly interchangeable:

• plans charging commissions per trade, but no fees
• plans charging a fee for assets under management, but no trade commissions

The fee structure has important implications: one plan is with a broker-dealer, the other with an investment adviser. Salesperson versus consultant: they are far from the same, and investors should make a conscious decision.

When working with an investment adviser, you can expect to receive advice in your best interest. Further, investment advisers are required to disclose their potential conflicts of interest, especially compensation and benefits received from third parties.

In contrast, broker-dealers are held to a lower standard. Their main obligation is to ensure the general suitability of the products recommended to a client. And even though Regulation Best Interest has raised this bar somewhat, it remains distinct from the fiduciary standard.

This is not to say that broker-dealers cannot provide valuable advice. Unfortunately, it is impossible for a client to determine the real motivation behind the advice: is it attractive commissions, or a genuine interest in providing sound advice?

Luckily, for our type of tactical investments, the difference might not matter much. After all, we use quantitative methods to eliminate the human factor. That, of course, includes am ulterior motives.

Financial Regulation vs. Tactical Investments

Most financial professionals are rather hesitant to recommend any quantitative investment strategies. The reason for this hesitation is rooted more in financial regulation than in a general dislike for this investment style.

Typical quantitative strategies are developed and optimized using historical data. Unfortunately, financial regulation makes it very difficult to share backtested or hypothetical results with investors. Doing so is typically considered misleading, which puts the financial professional at risk.

At the same time, not sharing the knowledge gained from these simulations could be considered withholding relevant material information, which again puts the financial professional at risk. It is understandable, that financial professionals try to avoid being wedged between these two.

So the only information a financial professional could freely share with a retail investor would be a certified track record of the investment performance. Unfortunately, this information most often does not exist, at least not to the extent the investor would like to see. The reason is that quantitative strategies are essentially software, and software is updated on a regular basis.

Whenever a quant developer has an idea for an improvement and rolls it into the strategy, the track record is reset. As a result, these track records most often span only a couple of years, which is far too short for an investor to make a sound decision. Investors would be especially interested in seeing performance through multiple recessions – but track records reaching that far back are rarely available.

So the investor is ultimately alone in finding a suitable investment strategy. The financial professional will have a hard time recommending any strategy, or even commenting on strategies an investor is actively considering. Instead, the investor will have to approach the financial professional and ask them to trade a strategy on their behalf as an unsolicited order.

Such an unsolicited order is a decision made by the investor, without the financial professional intervening. Consequently, the financial professional carries no responsibility for this decision, which cuts this Gordian knot. At the same time, the financial professional is still fully accountable for the flawless execution of the order, which is exactly what we want.

The Mechanics

For the financial professional to trade a tactical strategy on our behalf, they will need access to the strategy signals. I strongly advise investors against providing the signals to the professional. Instead, the professional should hold the required subscription to the signal service of choice.

Nonetheless, it is important for investors to understand the complexity of the whole system and the multitude of possible points of failure:

• Signal provider
  • Issues receiving quotes, indicators, and economic data
  • Software failures or human error
  • Issues distributing the signals
• Financial professional
  • Issues receiving the signals
  • Errors and omissions in signal interpretation and order placement
  • Issues placing orders with the brokerage
• Brokerage
  • Errors executing the orders correctly or in a timely manner

In other words: don’t be surprised when, once in a while, things are not perfect. Luckily, for the types of strategies proposed in this book, such errors should not have drastic consequences.

However, some other strategies marketed to retail investors are timing-sensitive and require intra-day trading. In my opinion, such strategies should only be traded in a fully automated fashion. Unfortunately, such systems are rarely available to retail investors.

Here is an incomplete list of financial professionals able to trade tactical strategies in separately managed client accounts. I am not receiving any compensation for linking them here. Nonetheless, if you contact them, please mention that you found their info on Invest-Like-a-Pro.com:

• Ridgeline Asset Management
• Porter Investments