If you’re reading this, you’re likely considering hiring an investment manager. This might be because you’re (1) too busy for a do-it-yourself approach, (2) not interested in learning about investments, (3) concerned you’ll make errors that will delay your retirement, or (4) all of the above. Maybe you’ve asked Google for a list of investment managers available in your area or online, and you’re ready to reach out. Now, what should you ask about when you have that first conversation?

While rates of return are probably top of mind for you, your first questions should be about getting to know whom you’re speaking with. You need to understand who’s looking out for you and what basic money safeguards they’ll utilize. From there, you can move on to the returns.

Safeguards for Your Investments

You might assume that all financial advisors operate with your best interests in mind. However, the reality of the service provider landscape and its two main options may surprise you. The lesser-known registered investment advisory (RIA) firms and their employees are fiduciaries, which means they are required by law to act in your best interest. The large TV-commercial brokerage firms and their employees are not fiduciaries and are not required by law to act in your best interest. Many people opt to work with an RIA for this reason. Be sure to find out whether the investment advisor you’re interviewing will be acting as a fiduciary.

If you choose to work with an RIA, the next step is to verify the firm is properly registered with the US Securities and Exchange Commission (SEC) or their state’s regulatory authority. You can check that here: https://adviserinfo.sec.gov/. This website includes data on both the firm and individual advisors who work there, including any disciplinary actions taken against them. Ideally, you’re looking for a spotless record. If you find a disciplinary action, at the very least ask about it. However, your best option in that case may be to simply move on. There are plenty of firms and individuals with clean compliance records.

Next, make sure the investment manager uses a reputable custodian. Custodians are fiduciaries responsible for the safekeeping of your assets, and include well-known firms such as Fidelity Investments, Charles Schwab, TD Ameritrade (recently acquired by Charles Schwab), BNY Mellon/Pershing, Shareholders Service Group, and others. The custodian’s role is to maintain separate accounts by legal registration (e.g., individual, joint, trust, etc.), hold the title to assets on your behalf, value the assets, settle transactions, collect income (e.g., from dividends), track cost basis, and provide reporting. The custodian is the firm that actually holds your assets—the investment manager should never have possession of your money. If an investment firm doesn’t use an external, third-party custodian, it’s a serious red flag.

If you decide to work with a brokerage firm instead of an RIA, you can check out the background of the broker you’re interviewing here: https://brokercheck.finra.org/. As part of your review, see if the broker is properly licensed to sell securities—this is important.

The Investment Process

Once you’re satisfied with the basic safeguards an advisor provides, you can turn your attention back to returns. What you’re looking for at this point in the conversation is a discussion of the investment process. You need to try and understand what methodology the investment manager uses to generate investment returns, and whether that methodology can generate the rates of return you need over the long term. (How much your investments need to earn for you is often best determined by a separate financial planning exercise.)

For example, the investment manager might seek to earn investment returns simply by holding large groups of stocks that encompass nearly all the stocks available in a particular category, such as US large company stocks. In this approach, when US large company stocks do well, that part of your investment portfolio will do well. US large company stocks have earned about 10% per year on average going back to the 1920s. Other categories, such as US small company stocks, are usually mixed into your investment holdings as well to create a diversified portfolio. US small company stocks have earned more than large stocks—about 12% per year on average. The economics behind this approach are straightforward: companies in aggregate must pay investors for the use of their investment capital, and they do that by providing a return on investors’ money. The investment return is there to be earned simply by investing. This approach is commonly known as index investing and is favored by many investors, including large institutional investors. While investment returns are volatile no matter what methodology is used, index investing tends to be a reliable approach to generating returns over time and can be a good default methodology. You need to know, will your candidate investment manager use index investing as part or all of their approach?

The other main type of investment methodology involves trying to improve on the average rate of return offered by the market. This is done either through (1) selecting stocks and bonds the investment manager believes will perform better than average, or (2) choosing when to buy and sell securities in the hope of holding them mostly as they rise. These investment strategies rely on the skill of the investment manager in identifying mispriced securities or timing opportunities and often have significant costs to execute, which can drag down investment returns if the investment manager is not successful. Research indicates that most managers using these methodologies do not generate investment returns above the market rate of return on a cost-adjusted basis. However, some investment managers do outperform the market in any given year or over several years—statistically, that will sometimes happen. Your job is to try and decipher whether a candidate manager’s recent outperformance was based on skill or luck, and if it will continue. Ask for, and review, long-term performance data (e.g., three-year, five-year, and ten-year returns). Ask for a detailed explanation of the investment process and try to determine how repeatable it is. You’ll need to ask yourself, do I think this manager can consistently discover new information other investors have missed and turn that information into above-market returns?

Once you develop a clear understanding of how candidate investment managers generate investment returns and confirm they have basic money safeguards in place, you’ll have some of the most essential information you need to make your choice. As you think it through, trust your instincts. Take all the time you need. When you do decide on a candidate, you can then rest easier with the support you need to meet the financial goals you care about.

Parkworth Wealth Management provides holistic wealth management services including financial planning, equity compensation planning, investment management, tax planning, and others, on a fee-only basis and as a fiduciary, acting in clients’ best interests. If you’re thinking about hiring a new investment manager and would like a second opinion on your investments, schedule a complimentary consultation.