“My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost Standard & Poor's 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.” – Warren Buffett (Trades, Portfolio), 2013 Letter to Berkshire Hathaway (BRK.A) (BRK.B) Shareholders
I think it’s safe to say “very low cost” is a fair description for Vanguard S&P 500 ETF (VOO, Financial): You can invest $10,000 at an annual cost of $5 (or less than you probably spent on lunch today). For all intents and purposes, an investment in an S&P 500 index fund is essentially free. This could be a huge boon for the average person over an investment lifetime.
Of course, many people don’t try and navigate their financial future on their own: They enlist the help of an investment adviser/RIA, who will happily lend a helping hand for a “small” fee (a recent survey from TIAA/CREF showed 49% of adults have received professional financial advice).
As I see it, your average RIA has two primary roles: (1) understand individuals’ financial goals, help them set realistic expectations, etc., and (2) help them invest to reach those goals.
In the second bucket, we can go a step further: setting asset allocations, broadly balancing risk and return based on a client’s unique circumstances, working with the client to ensure rational decision making during periods of market volatility and so on. It’s important to note that the value an investment adviser offers to a client is not solely in the security selection process.
With that said, investing – actually deciding what to buy – is an important part of the relationship. In my experience, advisers tend to sell security selection (or more broadly their “investment process”) as part of their value add to clients. The unfortunate fact, as we all know, is that few advisers are likely to add long-term value through superior security selection.
The low-cost S&P 500 ETF seems like a reasonable solution: we can replicate the return of the index with very low fees. As Buffett suggests, this is an appropriate choice for most investors.
But here’s the issue: I’d be willing to bet that most advisers, for one reason or another, are still picking individual securities/mutual funds. While they’ve probably dabbled with index ETFs, it is unlikely many have shifted from individual equity selection to 100% indexed portfolios for their clients (I’d argue optics play a role: The advisers want to look like they’re hard at work).
It would be a mistake to simply accept the status quo. The burden of proof has shifted: Investment advisers should be defaulting to passively managed portfolios unless they have a good reason to do otherwise. As a client, you should address this. When you speak with your current or a potential adviser, I’d suggest asking the following question:
“For the portion of my portfolio that you plan on investing in equities, what type of return should I reasonably expect over time relative to the index? Are you essentially looking to replicate the volatility and returns of the broader market, or are you actively seeking meaningful excess returns (comes with tracking error, periods of underperformance, etc.)?”
If the adviser truly plans on deviating from the index, I’d follow up with these questions:
- Why do you believe you can achieve better than market returns over time?
- Have you successfully done so in the past?
- What percentage of your own net worth is invested in this manner?
In my opinion, the answers to those questions better be pretty darn convincing. On the other hand, if the advisers do not believe they can generate better than market returns over a long period of time, your followup question is clear:
“Why bother picking individual stocks if we can replicate market returns at a very low-cost?”
I do not have a good answer to that question.
Again, this doesn’t mean advisers cannot add value to the relationship (earn their fees). Financial planning is important to meeting long-term financial goals for many people. In addition, if your adviser can help you stay grounded during periods of optimism and pessimism in the market, it may be well worth the fees you’re paying. The point is that these other pieces are independent of individual security selection; the days of paying someone to trade your portfolio (i.e., generate unnecessary costs) with a low probability of long-term outperformance should end.
Conclusion
The individual investor now has a way to generate market returns at a very low cost. You should not be paying investment-related management fees (and other costs like trading and short-term taxes) so an adviser can “closet index” your retirement account. You shouldn’t pay extra for a portfolio that is all but guaranteed to lag the index over time (after costs). From there, you can ask yourself whether paying annual fees of 50, 75, or 100 basis points is appropriate for the other services your financial adviser provides. It's seems reasonable to me that you should no longer be paying the same rate as a "full service" client.
Unfortunately, I doubt there’s been a major shift in the business, at least so far. Clients continue to pay multiples of index fund expense ratios for similar returns. I hope that changes over time.
