Summary/TLDR
Many financial advisors have a single value proposition – they aim to “beat the market” or provide returns superior to those of a passive index. An objective analysis of this “service”, in the form of active portfolio management and mutual funds, however, reveals that it is an abject failure. The fact that clients pay a non-insignificant amount for these “services” only adds insult to injury. In these circumstances, we are led to the sober conclusion that many clients are paying their advisor for nothing.
Introduction – A Sad State of Affairs
This short series, consisting of two parts, is being written because I believe that many clients of so-called “financial advisors” are not getting the help that they need. In fact, in many instances they are being sold a product or service that is hurting them.
In Part 1, we’ll discuss how clients of advisors whose primary value proposition is investment related are being severely underserved. Investment related services often take the form of active portfolio management, in which advisors try to outperform popular benchmarks, or investment in mutual funds with high fees of their own.
Underperformance As Far As The Eye Can See
Active Portfolio Management
Active portfolio management employs a variety of strategies in an attempt to outperform, or “beat”, popular benchmarks such as the S&P 500. An advisor might engage in stock picking, market timing, trend following, “sector rotation”, or a variety of other things that, at face value, would surely grant the employer of such strategies a superior return. The pressure that advisors feel to “beat” indexes has increased substantially over the past few decades as index funds have exploded in popularity and availability while being almost free to invest in. Why would you need your advisor when you can just invest in these indexes for pennies? One reason might be that they can outperform these benchmarks in excess of their fee.
Active portfolio management sounds like it’s exactly what you’d expect out of your financial advisor. Surely, you expect that all these fancy strategies would translate into a higher return for you. Unfortunately, there are mountains of research that suggest otherwise. The most well-known of these is the SPIVA report, published annually by Standard & Poor’s, the latest of which was published on September 21, 2023.
The SPIVA (S&P Index versus Active) report exploring the success of professional fund managers in outperforming their respective benchmarks. Below is a table that shows the amount of U.S. Equity Funds underperforming their benchmarks.
The researchers found that over the past 20 years, 93% of these funds have underperformed their respective benchmarks. And in as little as 5 years, the failure rate is 89%. The results for international stock and bonds aren’t any more promising, and are discussed in an earlier post of mine.
And keep in mind that these are funds managed by professional investors with large budgets used to employ analysts and researchers to aid their quest for outperformance. They are not financial advisors. If so many of these well-equipped professionals fail at their task, what makes you think that your advisor, whose resources presumably pale in comparison to that of a mutual fund, will succeed?
Heaven forbid that your advisor charges you a fee to only turn around and stuff you in a mix of mutual funds which are overwhelmingly more likely to underperform! Or that they try to beat the market on their own, arguably putting you even more at risk of underperforming! Actually, I’m getting ahead of myself. We’ll save that for later…
High Load Mutual Funds
Shares of mutual funds can be split into different classes that change how the advisor who sells the fund is paid by the mutual fund company. The amount paid to the advisor is known as a “sales load”. The two “share classes” of mutual funds which pay a sales load are A shares, which pay the advisor up front, and C shares, which pay the advisor over time. Both are, in my opinion, antiquated products that unnecessarily diminish returns over time, often in a way that is not made clear to the client.
The “front-end” load on A shares that is paid up-front to the advisor is often as high as 5.75%! Discounts can be offered for larger purchases or if a lot of the mutual fund is already owned, but this is still a hefty charge.
C shares pay the advisor nothing up-front but charge the investor a higher amount over time (to pay the advisor a steady stream of income). It’s not uncommon to see C share mutual funds with expense ratios that exceed 1.00% annually. Finally, an additional fee is charged on C shares for those who sell after owning them for less than one year. This is known as a contingent deferred sales charge (CDSC).
Below is a chart of three S&P 500 index funds with an initial investment of $50,000. One is of an A share mutual fund, one is of a C share mutual fund, and one is of an ETF with no sales loads and a miniscule annual fee. In reality, no one would really use A or C shares for passive investment in an index, but this example shows purely the effect that these sales loads can have on returns over time:
While these products served a purpose in the past, I believe the invention and widespread availability of ETFs and index funds make them inappropriate for most circumstances.
Fees Add Insult to Injury
The shortcomings of active portfolio management and high load mutual funds are exacerbated when fees are heaped on top of them. In both cases, fees are often about 1.00% of the portfolio’s value.
A seemingly innocent 1.00% fee will add up over time. Below is a chart of two $500,000 portfolios invested in identical funds with different fee structures over the past 20 years. The portfolio with no fees is almost $600,000 smaller than the portfolio charged a 1.00% fee.
Conclusion
When all of this is taken together, we are drawn to a sober conclusion – that clients of advisors whose only value proposition is investment related are paying large sums for inferior services. Expressed more candidly – they would be better off without their “advisor”.
Now, I’m obviously not saying that financial advisors don’t deserve to be paid. But they should offer more to their clients than “portfolio management”. Here are a few areas where tremendous amounts of value can still be added to clients and that warrant paying a fee:
Tax return reviews and exploration of tax planning opportunities
Insurance policy reviews to ensure sufficient protection from all of life’s uncertainties
Retirement income and distribution planning
Estate document reviews and plan construction
Review of your employer benefits and advice on maximizing them
Planning for major purchases and life events (such as moving)
In light of the above, if your advisor is not offering these services, then why are you paying them?
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