1300 369 045 Social Media Icon Social Media Icon Social Media Icon Social Media Icon

Index v Active Funds: The Hidden Costs Your Financial Advisor Isn’t Telling You About

11852723374_e9261322b9

Photo Credit: smiscandlon

Have you ever thought about how much you’re really paying for the advice you got from your financial planner? The direct costs are one part – and I think you should look at those closely to ensure you’re getting value – but take a look at the indirect costs.

Keeping costs down are a key to wealth – high costs put your future at risk.

Some of the most significant costs are hidden in your portfolio and are caused by product selection and your advisor’s bias towards actively managed funds.

Although most financial advisors recommend actively managed funds, in reality, the net return of active funds are consistently below most passive investments or index funds.

But apart from the underperformance and additional cost of active funds, there is another cost, which is often overlooked when investors compare active and passive (index) fund portfolios – a cost I’ll cover later in this post.

dt971013dhc0


What is an index fund?

Let’s start by understanding the difference between index funds and actively managed funds.

When you put your money into a managed fund, you buy units in an investment with other people. The money is pooled and a manager decides where to invest, based on parameters set down by the fund, such as asset class (shares, property, fixed interest, cash), geography, industry and so on.

For example, an Australian Share Fund buys shares in individual Australian companies listed on the ASX.

Most funds allow the Manager to invest into any assets within the parameters of the fund that the Manager thinks will provide the best return. The Fund has guidelines with which the manager needs to comply but, otherwise, the Manager has the discretion to determine what assets are held or traded or what investment strategy will maximise the returns.

In the case of the Australian Share Fund, for example, you are relying on the expertise of the fund manager to pick companies that will out-perform the overall share market.

This is an actively managed fund.

This active investment approach usually results in a high turnover of shares, increased trading costs and tax. In addition, the costs for a team of analysts to research (and often visit) individual companies increase the fee the active manager charges you to invest in the fund. So think about the impact of these additional costs on the eventual return; not only does the manager need to outperform the market but also the return they achieve has to be significantly better than the market for your net return to be worthwhile.

An index fund on the other hand takes a more passive investment approach and doesn’t bet on an individual fund manager’s capability to consistently (and safely) outperform the market.. It invests in the assets that make up its market index.

For example, an Australian Share Index Fund will invest into all the companies that make up a share index, such as the ASX200. The index fund will invest in each company in the same proportion as that company’s proportion of the market as a whole. If BHP makes up 8% of the market, an index fund will invest 8% of its money into BHP.

Which market (or index) you invest in, will depend on your objectives and should be determined by your advisor and yourself.

 

So which is better: Active or Index Funds?

3 things will impact the investment return of your managed fund: tax, cost and performance.

You can’t control tax, although you can limit capital gains tax by lowering turnover. Can you control performance and cost?

 

Active Funds Cost More

An actively managed fund will typically cost 0.5 – 2% more than an index fund.

To put this into context, if your portfolio returns 10% p.a. and costs you 2%, you are losing 20% of your earnings in fees.

An index fund will cost around 0.5% (compared with an active fund costing about 1.0 – 2.5%).

Exchange Traded Funds and Listed Investment Companies cost even less than managed index funds, and can be as cheap as 0.05% p.a.

 

Do Active Funds Perform Better?

Generally, no.

The year end 2016 SPIVA (Standard & Poors’ Index Versus Active Funds) Scorecard shows that, over the last 5 years, 93% of actively managed International Share Funds have underperformed the S&P Developed Large/Mid Cap Index (the average return of all companies in that sector).

And it isn’t much better for the Australian fund managers.

Over 10 years:

  • 74% of active Australian Share managers underperformed against their index.
  • 87% of Australian Bond funds underperformed.
  • 89% of active International Share managers underperformed against their index.
  • 77% of Property funds failed to beat the index.

 

The following table came from the report:

spiva-australia-year-end-2016

The only exception to the pattern of active funds failing to meet their benchmark index is Australian small companies managers (who invest in companies outside the ASX100). The reason these managers consistently beat their index is that they can avoid the many speculative resource companies that eventually collapse. However, these types of companies are not usually in the portfolio of a large cap Australian share fund.

So, in addition to an underperforming active managed fund, most people are paying an extra 0.5 – 2% in costs, every year. This increases the net loss, when compared to the cheaper and better performing index funds.

Even as I prepare to post this article, the Harvard Business Review featured research by the Wall Street Journal that showed the average return of 2,000 Hedge Fund managers over 10 years was 72%, while an index fund (composed of 60% stocks and 40% bonds) returned 100% for the same period.

Hedge funds are able to use a diverse range of investment strategies to get you a return above the market average – and most people assume they do. For that expertise, managers are paid well (the top 25 highest paid hedge fund managers were paid $21 billion in 2013). That money comes from investors like you – so make sure you are getting your money’s worth.

 

The additional layer of fees

If your financial advisor recommended your active fund portfolio, you are probably paying an ongoing fee for that advisor to monitor the portfolio.

The problem with an active investment approach is that it needs constant monitoring and adjusting. The reason for this is that fund managers lose key staff, underperform, close, etc.   This causes some active funds to substantially underperform the benchmark.

As I have noted, this active portfolio usually results in a worse return than the index – a return further reduced when the fees of the fund and your advisor are taken into account.

dt000120

 

What should you pay for portfolio advice?

Your financial advisor can provide a range of ongoing support other than a portfolio recommendation, such as insurance, budgeting, superannuation and debt management.

But what you pay for the portfolio management advice should be based on how good your financial advisor is at picking the right funds.

If your advisor charges a fee for their ability to pick a portfolio of active funds (rather than an index fund), I think they should be accountable for the performance of their portfolio against the benchmark index.

The performance of the active managed fund portfolio must justify the advisor’s initial fee for investment advice and ongoing monitoring and management.

In other words, what you pay for ongoing investment advice should depend on what growth your actively managed portfolio achieves (minus fees) when compared to the benchmark index.

Most financial advisors don’t hold themselves accountable for the performance of their portfolio against a benchmark index.

And as you are paying extra for active funds and portfolio advice, the net return should be openly examined and discussed at review time.

The bottom line is this: many financial advisors ongoing fees are based on portfolio management so make sure they are providing a return that covers the extra costs, when compared to a passive portfolio that doesn’t require the same level of maintenance (such as a portfolio of index funds).

 

What does your advisor do to manage a portfolio of funds?

Your advisor probably charges an annual fee to ‘manage’ your portfolio of funds. They will use independent (or in-house) research that will alert them when a fund becomes poorly rated and is likely to underperform. Unless there is an urgent need to switch out of a fund, you are not likely to be told to move until your annual review. For those advisors that do trade regularly, most underperform the average market return.

For this, many advisors charge $3,000-4,000 p.a. I’ve seen financial planners charging over $10,000 p.a. for an ongoing service that doesn’t amount to much more than a portfolio performance snapshot every 6 months – with no analysis or justification for the extra ongoing fees.

Two weeks ago, I spoke to James, a retired Sydney-sider who has a portfolio of about 20 actively managed funds. This high number of funds suggests that James’ advisor isn’t confident which fund managers will perform well. That advisor is essentially hedging his bets and has ultimately recommended a portfolio that will perform close to the market average (index). But for a far greater expense to James.

Some advisors argue this number of funds provides additional diversification but an index fund does just that, only better.

For this portfolio advice, James is paying his advisor a fee of $3,000 p.a. And the active funds are costing about 1.5% p.a. more than index funds available within James’ super fund, which in James’ case is about $9,700 p.a. extra. The total cost is $12,700 above an inexpensive index portfolio.

I asked James what the overall performance has been against the benchmark and he didn’t know. His advisor doesn’t tell him, despite charging James $3,000 p.a. for the management of this portfolio.

How then does James’ advisor justify his $3,000 p.a. ongoing fee? He could do so by holding himself accountable for the extra cost. Especially when he has recommended James invest his hard earned savings into expensive funds. It took about 5 months for James to save $3,000 in his super fund while he was working. I think he deserves to know if his expensive portfolio is performing better than the less expensive options.

Most of the research and reporting software financial planners use will show a performance comparison with the benchmark for each asset class.

But you have to check yourself, as your financial planner is probably not used to being held accountable for the performance of their expensive portfolios.

Recently I spoke with a Perth-based nurse, Faye, whose planner has just written a proposal to manage her portfolio. Faye’s advisor has given her a report showing that the recommended managed funds have been underperforming the index by about 1.5% for the last 6 months.

Faye is paying an extra 1% p.a. for these expensive active managed funds and about 0.75% p.a. for this planner’s advice advice. That’s just under $5,000 p.a. for Faye.

While 6 months isn’t long enough to measure the performance of a portfolio, these are the figures Faye’s new advisor included in his financial plan. Despite the figures suggesting that the expensive managed fund portfolio will underperform, Faye’s new advisor has not addressed the likelihood of his portfolio costing Faye more money.

When Faye raised this underperformance and additional cost with her new advisor, he told her the managed funds give her more control – an answer that does not address her question which is essentially, “does that control give me an extra return or any other benefits?” – and no, it doesn’t in her case.

Faye brought up the idea of index funds with her advisor, after reading several books on investment. Faye’s planner said he could switch her funds into an index fund if she wanted. But this raises 2 questions: Who is the expert in this relationship? And, what value is Faye getting for the 0.75% p.a. her advisor wants to charge for ongoing advice?

A hint for finding a good financial advisor: If your advisor doesn’t believe enough in their strategy to stick with it when you question the rationale, then you are not likely to get advice that’s best for you. Rather, you’ll get the advice they think you want to hear.

My experience tells me that Faye’s situation is typical – most financial planners are so used to recommending expensive managed funds that they no longer compare the net returns against the benchmark index.

Most financial planners do not think critically about the indirect fees their recommendation costs their clients, nor the value of their own advice fee.

The financial services industry has a natural bias towards expensive managed funds with an additional layer of fees incurred so a financial planner can manage that portfolio. This is because it pays more. 

The best way to ensure your advisor is motivated to minimise the indirect fees that drain your wealth, is to make sure your advisor only gets paid by you. By law, an independent financial advisor must avoid all conflicted fees.

 

So what do you do?

After reviewing thousands of financial planning files over the years, my experience tells me few advisors compare the performance of their clients’ active funds with the index.

And I am yet to see a portfolio review that shows a return that takes into account the advisors ongoing fee, comparing it to a less labour intensive portfolio of index funds.

So if you have an active managed fund portfolio, ask your financial advisor to provide you a report that compares the performance of your portfolio with the benchmark index for each asset class or market you are invested in (click this link and use this text).

Make sure it covers a few years (if your portfolio has been in place that long). Also, make sure it includes the performance of funds you were switched out of in the past (it’s easy to recommend a good portfolio looking backwards).

Check the returns are net of investment management fees. If your net return is below the benchmark by more than 0.5%, then you are underperforming most index funds.

You then need to subtract your advisors fees for portfolio management. Hopefully, you are ahead of the benchmark index after fees.

If this gets too confusing, email me a portfolio summary and I will check for you.

And, as I said above, use this text to help ensure you get exactly what you need.

If you want your money to last, you should scrutinise these ongoing investment and portfolio management fees. A few thousand dollars a year in fees adds up to $100,000’s in lost savings over your lifetime.

 

Contact me if you want to talk about your portfolio.

And….

For a laugh, watch ABC’s The Checkout cover the topic…

 

If you found this article helpful, share it with people you know
Posted by: Justin Brand
I'm an independent financial advisor and blogger doing my best to make financial services less complex, dull and intimidating.
Join my email list for free advice