Investment advisors are becoming the enemy
There is considerable pressure on politicians and regulators to address this expensive and, according to commentators, near fraudulent activity. Is the expected action dumb?
Dumb might not always be dumb
Neither politicians nor bureaucrats are dumb. Of the many I know, I think that is a fair assessment. Why then do they seem to make dumb assessments of the situations in front of them?
There are three possibilities:
- I don’t fully understand their purpose. After all, they have a bigger constituency to address than I can understand. I could be wrong about what’s “dumb.”
- They are busy with many policy decisions and would reach the right conclusion if they could devote enough time to it.
- They are doing things that will look good for the public, most of whom have little or no knowledge of the problem. Superficial things passing as deep facts. Popular regulation is always a good thing. Right?
The investment fee case in point
According to popular belief, active investment is a weaker solution than passive investing. This observation is leading to a wider public pension system and to sterner regulation of investment advisors.
Is that pandering to the public who believe this story. Is the story, passive investing is better, factually supportable?
Why do passive funds look so much cheaper?
- There is an inherent flaw in the passive theme. Passive investing does not and cannot generate stock prices. Only people trading in the market do that. Passive follows active.
Active managers, including individuals, allocate capital, generate prices and the index follows. Passive gets a free ride for the value of research done by active investors. That is a significant advantage as anyone who has ever analyzed the financial results and prospects of a business can tell you.
- Think about what would happen if index funds owned all the stock. There could be no prices. Then what?
- In terms of fees and costs to manage investments, ETFs and some index funds are not less expensive than managed funds. Managed funds are a basket of things other than management of money. Most people have not thought that part through.
- Passive funds do not provide anything other than investment packages. There is a significant do-it-yourself cost to using index funds and ETFs.
Why do people believe in passive investing?
People like simple ideas and they tend to hang on to the first thought they acquire on any subject.
Media of every kind has attached themselves to the simple idea that money management costs are too high. You will hear these thoughts:
- Only a tiny fraction of active managers beat the index over 10 years. True.
- Compounded over a long time, fees consume a meaningful share of the potential earnings. True, also.
- Warren Buffett says you should own the lowest cost funds available to you. That’s true if you know what you need to do and have Warren Buffett’s discipline and propensity to save capital.
- It is currently fashionable, even sophisticated.
The simple thought is let’s not pay high fees. Better an ETF with a cost of 0.5% than a fund with a management expense ratio (MER) of 2.25%.
The problem is far deeper than that.
Why do good restaurants charge more for a meal than one you might prepare and eat at home?
A wise assessment begins with a question, “What do I get for the other 1.75%?”
The way you think about that is two part.
- What’s it for?
- Does it help?
A fund’s MER of 2.25% tend to break into several parts.
- Sales taxes roughly 0.25% in Ontario. You might want to talk to your politician about that. It is just another revenue tool to them.
- Investment management fees and cash expenses are about 0.70%. Higher than an index fund, but similar to an ETF.
- Most jurisdictions require a dealer who is responsible for ensuring representatives are properly trained and comply with the various laws they must address. Dealers maintain and enforce “suitability” guidelines. If a client holds nothing but cash, or there is an 80-year-old who owns junior gold miners in quantity, or there is no risk assessment, you could expect the dealer to intervene. Dealers also maintain records and web sites that the client can use. Tax reporting is automatic. Dealers cost about .40%.
Does a dealer help you? That’s your decision.
Personal investment advisor Probably around 0.9%.
Investment advisors, contrary to your first thought, do not manage your money. Advisors select suitable investment managers and then manage you. The manage you part is the one that ETFs and index funds in a self directed investment account cannot provide.
You need to decide if it is worth the price. Consider if the potential costs of avoiding the price may be higher. Consider:
- Advisors analyze and synthesize your situation and help you derive a strategic financial plan related to your wishes, your needs and your resources.
- Advisors do analysis work to determine the proper level of savings given your chosen lifestyle, expected future income, possible inheritances and employer provided plans.
- Advisors do tax analysis and look for you-specific vehicles to gain advantage.
- Advisors do debt analysis and make assessments about the method of debt chosen, its price, and the validity of investing before or after debt is reduced.
- Advisors can help with cash management.
- Advisors have access to many money managers that are not available to the public.
- Advisors find and recommend financial tools that help implement your vision.
- Advisors help implement the chosen course of action.
- Advisors explain the paperwork that comes from the manager and the dealer.
- Advisors keep track of achievement against the plan.
- Advisors recommend changes when your circumstances change, or when new risks or opportunities appear in the world.
- Advisors explore and/or point to other financial areas you should consider to achieve your plan. Insurance, wills, powers of attorney, and business agreements, being common.
- Advisors communicate. Partners, children, other advisors like lawyers and accountants, are part of your life. Sometimes you need someone to explain what is happening.
- Advisors motivate people to set money aside for their future needs.
- Advisors are your guide. When the market is up a lot or down a lot, people are emotional. Greed and fear always affect results badly. Who will talk to you about a time to sow and a time to reap when the market is up? Who will talk you in off the ledge when it is down? Markets fluctuate. People’s ability to deal with that fact does not.
- Advisors are your conscience. They remind you about why you are doing what you are doing. When left to their own devices, people lose track of why and stop implementing.
So, does it help you?
If each advisor value part is worth 6/100ths of 1% you get your money’s worth. Warren Buffett can ignore all of them, but you cannot.
My experience says they are not all of equal value and not all relate to every client. My experience tells me the last three values alone can pay for the whole deal.
So why do people think fees are not worth the money?
- They confuse price and cost. There is a cost to do nothing too and it never shows up in the analysis of pay nothing. Saving one cost and substituting an unknown cost is not entirely smart.
- Advisors often don’t do show and tell. They should. They are valuable and even though fees are expensive, people with advisors end up with more money than those without.
You can get higher yields or greater wealth.
It is a paradox that can be explained simply. Greater wealth comes from investing sooner, with more capital, more consistently, and leaving it there in good times and bad.
When you think about it, portfolios are like keeping score in golf. In golf, they don’t ask you how, they ask how many. In the case of portfolios, how much.
Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario. In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.
Please be in touch if I can help you. email@example.com 866-285-7772