Cost Matters: But does your Advisor care?

Perhaps the most conspicuous disconnect in the financial services industry today revolves around cost.  It should be noted at the outset that the cost paid by a client comes in two forms: the cost of advice and the cost of products used to construct portfolios.  Both matter a great deal.

The adage that many in the financial services industry use is: “price is what you pay; value is what you get.” I’ll leave it to you to do your own due diligence about both the cost of advice and the value provided.  Today, I want to talk about the confluence of those two factors as it pertains to product cost.  The combination of quality advice with low-cost products can be a powerful one.  Unfortunately, my experience has been that some otherwise excellent advisors remain dogged in their determination to use high cost products:  or at least to be indifferent to cost as a primary determinant when making product recommendations.

After over a quarter century in the business, my sense is that many advisors who work at brokerage firms with a “traditional” mindset (i.e., a firm that has historically recommended individual securities as building blocks) are more cost conscious if only because the individual securities that they sometimes recommend don’t have MERs.  Of course, individual securities can add to portfolio risk due to their reduced diversification, so there’s a trade-off to be considered.

Big price difference between Mutual Funds, ETFs and Seg Funds

For those advisors like myself that want their clients to have broadly-diversified baskets to get access to specific asset classes and strategies, the options generally boil down to segregated funds, mutual funds and exchange traded funds.  All of these options cost money, but the difference in price is often substantial.  Does your advisor care?

In a ground-breaking paper entitled “The Misguided Beliefs of Financial Advisors” released in late 2016, some American academics show that many advisors are essentially indifferent to product cost.  The paper also shows that advisors tend to chase past performance and recommend unduly concentrated portfolios,  but those very real problems are beyond the scope of what we’re looking at here.

In my own very unscientific experience, it is the advisors who are the most inclined to have a mutual fund mentality (even if they are securities licenced) that have this attitude.  The attitude is particularly acute for those who have traditionally been paid using embedded compensation.  In other words, irrespective of what products the advisor is licenced to sell, my sense is that those who have grown up in a culture of actively-managed mutual funds are pre-disposed to continue using them even if there are cheaper options available.

There are product suppliers out there who have suggested that the value of advice is something like 3% annualized.  While I suspect that number might be a tad high, I cannot help but note that when the illustrations are done, part of the calculus involves the replacement of high-cost products with low-cost products.  A 1% reduction in product cost is depicted as a 1% value add.  Following the logic, how might one reasonably depict the value of deliberately NOT replacing expensive products with cheaper ones?  Is it a 1% value subtract?  Is it a 1% potential add that was missed as an opportunity cost?

Some of you might want to speculate regarding why a disproportionate number of advisors have “misguided” beliefs.  I know that I have a few theories of my own.  While it would be prudent to some day do more research to delve into the collective rationales of those advisors who feel this way, that’s not your concern now. Your concern should revolve around solving the problem at hand.

Copious evidence price determines long-term performance

The problem, it seems, is that in spite of copious evidence that cost is a primary determinant of long-term performance, many advisors don’t seem to think too much about it.  To repeat: there are a number of possible explanations for this phenomenon, but the real question, in my opinion, is: “what are you, as a client of an advisor who might have this attitude, going to do about it?”

My suggestion to you: confront your advisor with facts and demand that product recommendations be made that feature:

• Suitability;
• Transparency (how much does this cost?); and
• Reasonable Cost

If an advisor cannot (or will not) meet these simple criteria, then you, the client, will have probable cause to suspect that your advisor is among the many “misguided” advisors out there who have attitudinal biases that cloud their judgement.  The narrative seems to be something like; “paying extra to trade securities makes sense because the trading activity is the only way that one can ‘beat’ the market.”  The logic may be fine as far as it goes, but the premise is flawed. Consider this: the only way you can win a lottery is to buy a ticket.  Does that mean that buying lottery tickets is a sensible thing to do?

The arithmetic of active management

Nearly 30 years ago, Nobel Prize winner William F. Sharpe wrote a simple paper called “The Arithmetic of Active Management.” In it, he showed that the average actively-managed dollar MUST underperform the average passively-managed dollar.  He did this in about two pages using basic logic using grade-school math concepts.  His explanation is simple, clear, elegant … and devastating to those who recommend spending extra money to try to boost returns.

Let’s say a market has a long-term historical return of 8%.  If there were a number of managers who were trading stocks in that market, some would do better and others would do worse.  The process is zero-sum because they are trading with one another.  In other words, trading does not create wealth and it does not destroy wealth: it merely re-distributes wealth.  Those who gain do so at the direct expense of those who lose.

The outcome of this collective performance exercise would be equal to the market average MINUS the costs incurred.  If the average cost was 1.2% (which is about what a standard actively-managed F Class mutual fund costs these days), then the expected outcomes would be more or less normally distributed around the 8% average and then skewed to the left (i.e., made to be lower) by the amount of fees.  The average return would be about 6.8%.

My new book, “STANDUP to the Financial Services Industry”, I explain all this (and much more) in greater detail.  I also provide links to papers that you can use when confronting your advisor:  including the Sharpe paper referenced here.  While I admit that I am interested in learning why advisors have misguided beliefs, I am much more interested in helping consumers find ways to overcome them.

John DeGoey, CIM, CFP, FP Canada™ Fellow, is a Portfolio Manager with Toronto-based Wellington-Altus Private Wealth Inc. This blog originally appeared on the firm’s “Newswire” site on July 22, 2020 and is republished on the Hub with permission.