You can approach investing in two ways: do it yourself (DIY) or hire a financial advisor. Many DIY investors employ a passive1 approach to investing by utilizing index funds. In essence, they are comfortable earning a return that aims to replicate the movements of an index, such as the S&P 500. The primary advantage with this approach is cost savings. Index investing is about 1-2 percent less expensive than actively2 managed funds. However, the cost differential could be as little as 1/2 percent or less. It all depends on the size of the managed portfolio.
It is important to understand that financial advisors have virtually no incentive to recommend a passive approach to investing, as there is typically no compensation to the advisor. This is why there is a conflict of interest. Of course, the lower fee from passive investing does not guarantee better performance. Many studies have shown, however, that index investing often outperforms their peers in the active managed arena.
The debate of passive vs. active has been going on for decades, and it is tough to analyze. Morningstar’s research analysis says that actively managed funds do their best at outperforming their passive peers in times of stress: the dot-com bust 2000-2002 and the credit crisis of 2009-2010. That makes sense that when fear rules markets, it takes active stock managers to navigate the muddy waters. On the other hand, during the good times, it is easy buying the index and going for the potential ride higher.
My research shows that less than 50 percent of U.S. stock investments beat the S&P 500 since 2000. Furthermore, the data suggests that the average actively managed stock mutual fund underperforms about 2 percent per year. Obviously, the 1-2 percent (average) fees charged by active mutual funds are a headwind not faced by passive index funds. I argue that costs should not be factored into the equation when comparing passive vs. active investing, as fees are not a function of the investing strategy.
In theory, all S&P 500 index funds should have the same performance as they are benchmarking the same index. There are a few differences, however, hidden in the various fund’s composition that cause the vast majority of investors actually to underperform the S&P 500. The primary reason for this underperformance is due to fund expenses, including trading costs. At the end of the day, passive investors are almost guaranteed to underperform the index they are trying to beat. For many investors, including the author, this is unacceptable, as we do not want to be a little below average. It is not in our DNA. Most of us are driven by the opportunity to beat the average (index).
If you know anything about Vanguard, you know they typically stand for DIY (do it yourself) passive index investing. According to a Vanguard 2013 research report, “Advisor’s Alpha,” Vanguard reiterates its long-held position that “over longer time horizons, active management often fails to outperform market benchmarks.” In other words, it is tough to beat Mr. Market, especially after expenses. Therefore, according to Vanguard, if a client-advisor relationship is based on the adviser delivering market-beating performance, the client is unlikely to get what they are paying for. But what if the advisor works to add value in other ways? According to Vanguard, a financial advisor could potentially add about 3 percent in value to a client’s portfolio.
If your financial advisor’s services and tactical recommendations are providing significant value, then cost should be a minor issue. Thus, it begs the question: How much is your financial advisor worth? I submit that a great advisor should be worth far more than the expense of your investment portfolio. If you are just paying your financial advisor to select investment products, such as stocks, bonds, mutual funds, etc., I believe you and your advisor are missing the boat on the added value of sound investment planning provides. For instance, I do a lot more work for my clients than just implementing investment strategies. I counsel on everything from estate investment planning issues to tax mitigation, to college planning, to insurance planning and review as well as liability issues. I consider myself my client’s life planner and they should, and often do, take advantage of all the resources that I have to offer where there is no cost.
It is my experience that specific investments are typically much less important than many of the other investment planning decisions. In the final analysis, you should determine the benefit that your advisor creates. If there is little to no value, there are plenty of competent, ethical, fee-based financial advisors anxious to talk with you or go the way of DIY.
Harry Pappas Jr., CFP®
Managing Director-Investments
Certified Estate and Trust Specialist
Pappas Wealth Management Group of Wells Fargo Advisors
1000 Sawgrass Village Suite 103
Ponte Vedra, Florida 32082
904-273-7955
harry.pappas@wellsfargoadvisors.com
Mutual Funds seek investment results that, before expenses, generally correspond to the price and yield of a particular index. There is no assurance that the price and yield performance of the index can be fully matched. Mutual Funds are subject to risks. Investment returns may fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost. Investing involves risk including the possible loss of principal. Past performance is not a guarantee of future results.1 A passive investment strategy typically involves limited ongoing buying and selling actions. Passive investors will purchase investments with the intention of long-term appreciation and limited maintenance. 2An active investment strategy typically involves the ongoing buying and selling actions by the investor. Active investors purchase investments and continuously monitor their activity in order to exploit profitable conditions. Wells Fargo Advisors is ot a tax or legal advisor. Investment and insurance products:
NOT FDIC-Insured NO Bank Guarantee MAY Lose Value
Wells Fargo Advisors LLC, Member SIPC, is a Registered Broker-Dealer and a separate non-bank affiliate of Wells Fargo & CompanyWells Fargo Advisors did not assist in the preparation of this report, and its accuracy and completeness are not guaranteed. The opinions expressed in this report are those of the author(s) and are not necessarily those of Wells Fargo Advisors or its affiliates. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Additional information is available upon request. Wells Fargo Advisors, LLC, Member SIPC.
