If the average mutual fund had no costs associated with it, then the salesperson would be right. A total stock market index fund's return would be pretty close to average. In the long term, roughly half of the world's actively managed funds would beat the world stock market index, and roughly half of the world's funds would be beaten by it. But for that to happen you would have to live in a fantasy world where the world's bankers, money managers, and financial planners all worked for nothing—and their firms would have to be charitable foundations.
If your advisor's skin is thicker than a crocodile's, you might hear this next:
I can show you plenty of mutual funds that have beaten the indexes. We'd buy you only the very best funds.
The SPIVA Persistence Scorecard proves that selecting mutual funds based on high‐performance track records is naïve. Twice a year, the firm looks at the top performing actively managed funds: those that are among top 25 percent of performers. Then they wait a couple of years and determine what percentage of those winning funds remains among the top 25 percent of performers. Typically, about 75 percent of those “top‐performing” fall from grace after just two years.18
Neither you nor your advisor will be able to pick the funds that will win over the next year or decade.
If the salesperson's tenacity is tougher than a foot wart, you'll get this as the next response:
I'm a professional. I can bounce your money around from fund to fund, taking advantage of global economic swings and hot fund manager streaks, and easily beat a portfolio of diversified indexes.
Sadly, many investors fall victim to their advisor's overconfidence. Instead of building diversified accounts of index funds, they build portfolios with actively managed funds that are on a hot streak. But the results typically lead to underperformance or disaster.
Why Most Investors Underperform Their Funds
If you're countering your advisor's market‐beating claims with proof, he or she might start to panic. When the advisor's desperation peaks, you might hear this:
We use professional guidance to determine which economic sectors look most promising. With help from our professionals, we can beat a portfolio of index funds.
Colleges hire some of the brightest finance minds in the world to manage their endowment funds. They look at current trends, interest rates, corporate earnings and the economic landscape. But most of them lose to diversified portfolios of index funds. And those that win during one time period often lose the next. The publication, Pensions & Investments compiled 10‐year performances for 34 college endowment funds to June 30, 2020.19 However, these US fund managers could have saved a lot of effort if they bought Vanguard's Balanced Institutional Shares Index (60 percent stocks, 40 percent bonds). It beat 77 percent of American college endowment funds over the previous 10 years.
That's a small case sample. But researchers Sandeep Dahiya and David Yermack studied a larger case sample of 35,262 US non‐profit endowment funds. The researchers averaged their returns based on Internal Revenue Service filings from 2009–2018. On average, a balanced stock market index beat them by 3.97 percent per year.20
Armed with such knowledge, you should be able to fend off financial advisors selling inefficient investment products and saying that they (or their firm) can see the future (see Figure 3.1).
Are Most Financial Advisors Bad People?
When faced with evidence that conflicts with our beliefs, each of us should be able to change our mind. Several years ago, I thought financial advisors who built portfolios of actively managed funds fell under two categories: they were either naïve or evil (especially those selling offshore pensions to unwary expats). While some evil ones exist, most are just undertrained salespeople trying to make a buck from commissions and trailer fees. Their bias hurts investors, but it can hurt the advisors too. The most respected accreditation for financial advisors is a CFP (Certified Financial Planner or Chartered Financial Planner). Most financial advisors without this qualification are glorified salespeople with questionable training. But even the CFP training (which takes a fraction of the time to complete compared to a nurse, teacher, social worker or plumber's training) leaves most financial advisors woefully unqualified to build portfolios based on economic science.
Figure 3.1 Financial Advisors Can't Predict the Future
Illustration by Chad Crowe: Printed with permission.
I asked one of Canada's top financial planners, Benjamin Felix. He's a CFP with the firm, PWL Capital. “The CFP education program is designed to ensure that CFP professionals have a broad understanding of 12 topics core to the financial planning process,” said Felix. “Investments is one of those topics…but there is no requirement to fully understand the evidence in favor of buying and holding low‐cost index funds.”21 Edward Goodfellow, a CFP with PI Financial echoed the sentiment: “If advisors understood, from an academic perspective, how markets actually worked, they would be much more suited to provide advice. The problem is, markets are noisy and the advisors, investors and media get lost in the noise.”22 Olivia Summerhill, a Certified Financial Planner (CFP) with Summerhill Wealth Management, in Washington State says the same thing: “During the Certified Financial Planning extensive training, the focus is not on investment vehicles. A CFP candidate does not get any training in their program if actively or passively managed funds are better for clients.”23 That's why, if you have a financial advisor who built you a portfolio of actively managed funds, don't be too upset. After all, most advisors pee in their own drinking water.
Finance researchers Juhani T. Linnainmaa, Brian T. Melzer, and Alessandro Previtero gained access to portfolio performances for 4,688 Canadian financial advisors and about 500,000 the advisors' clients between 1999 and 2013. It was no surprise to see that most of the advisors bought actively managed funds for their clients. But they bought similar funds for their personal portfolios.
When comparing their performances to an equal‐risk adjusted portfolio of index funds or ETFs, the advisors underperformed by about 3 percent per year. Sure, the advisors paid fees that were higher than those charged by index funds or ETFs. But the advisors also chased past performance. They bought funds that were “doing well.” But they didn't read the SPIVA Persistence Scorecard. They didn't learn that funds that perform well during one time period usually lag the next.
That's why the advisors' personal money, and their clients' money, underperformed by 3 percent per year. Compounded over the 15‐year study, they unperformed similarly allocated portfolios of index funds by about 55 percent.
Chapter Take‐Away and Tips
1 Index funds (or ETFs) beat most actively managed funds over time.
2 While
