Active vs. Index Investing -- Financial Advisors

[SVT]

I went over to my dad's today and printed my rollover IRA forms. My dad asked me what I was printing and I told him. Then we started talking financials. He mentioned him and my step mom have met with a financial advisor and they're going to be handling their investments for him. He talked about how he asked them about their goals, time horizons and risk tolerance etc. and is picking the right investments for them. He also said they help with budgeting. He said he was going to give me his information as well in case I wanted to consult him with my finances. I told him I pretty much do it all on my own. (He already knows/should know that based on our past conversations).

Anyway, I asked out loud, kind of to myself, about the kind of investments this guy is picking for them. My dad couldn't really say. Part of the problem is my dad knows next to nothing about investments. I explained to him about active verse passive or index investing and the ins and outs of each and that most likely he's being invested in active funds. I went on about how active funds are more expensive because of the cost of people picking funds etc. and that it's hard for anyone to consistently beat the market over the long term (which would be the point of active funds verse index funds right?).

My dad said well he doesn't make any money unless he's making money. It sounds to me like he gets a percent each year from the investments maybe? (on top of the presumably active funds' 1-2%/year expense ratio? My dad also said that the guy mentioned getting 12%/year...and that was after I had talked about index investing and how the S&P 500 over a 30 year period averages 10, 11, or 12% per year.

After I left I got to thinking about this conversation. I can assume that this financial advisor is going to be taking my dads money and investing it in funds from another company, an investment company with active managed funds. Those funds I assume would probably have 1-2% expense ratios then this guy would take maybe 1% off the top for his fee.

Does that sound like what normally happens? Is there ever any desire for these financial advisors to take their customers' money and invest in index funds at Vanguard? I mean, I got to thinking, here I am going straight to Vanguard paying roughly 1/4% investing in index funds but there's no way these financial advisors could take a customer's money and invest it elsewhere and not make money doing that as well. I know this guy isn't going to Vanguard but even if he did, my dad wouldn't be paying as little as he would going directly to Vanguard.

I'd like to see a discussion on active verse passive investing in regards to fees and expenses and also in relation to going through a financial advisor versus doing it on your own.

[formerexpat]

I think that your father misunderstands; this guy makes money regardless of the direction of the market.

Is this guy an adviser with one of the big places [Fidelity, Schwab, etc] or independent from any of these companies? It could be that his fees are wrapped in the management fees of the funds or he takes an additional cut off the top.

There is a company called Dimensional fund advisers that are essentially buy and hold / index fund type managers and only go through fee only planners: www.dfaus.com/service/individuals.html

From what I understand, there is about a 50-75bps overall fee for these types of funds and while you can get lower through low cost index funds, not everyone [actually, not many people at all] have the ability to stay the course through all markets and continue regular investing over 30 year periods. This type of adviser would help clients get 9.25 - 9.5% of the 10% 30 year return instead of the average 2%.

Perhaps this is the type of adviser your father is going to for his needs?

It might be good for you to go to this guy just to hear his selling techniques. You appear to be financially aware enough to know a marketing ploy v a responsible financial adviser for your father.

I'm guessing that your relationship isn't one where your father would allow you to more actively manage? I manage the finances [both business and personal financial planning] for my mother and her husband...but I know everyone isn't as comfortable with that arrangement.

[Deleted]

Definitely sit with the guy and find out how he operates and what he typically invests in and why. Remember that the FA does not get the full expense load of the mutual funds, so he's not getting 1% plus the mutual funds' expense%. I'm sure they give him some % of the assets he manages, but you'll never know what %.

My parents have had very bad results with both B of A and Fidelity, and Dad is a retired broker (second career; engineer by training). Dad is back managing the investments himself and he's happy. I have one through Smith Barney and most of it's in a "wrap" account with a 1% fee, but carrying lower commissions and expenses when I trade. We don't get in an out of stocks very often. I do have some actiuvely managed commodities funds in there and they've done very well. I'm satisfied that the fees I pay are worth it and I like having a second opinion and someone who's always watching the market and will make recommendations to tweak things if needed. I have a regular job and can't monitor the investments full-time.

[RoadToRiches]

"My dad also said that the guy mentioned getting 12%/year"

This right there, I would run...Not because it's low or high, but the fact that the guy simply said that he will get your dad 12%. Is he psychic?

I am currently reading really good book. Mutual Funds for Dummies. I know it's a dummies book, but as someone who didn't really understand all the mumbo jumbo with funds, I now feel very comfortable looking at funds and knowing what I want. There are many other factors to look at besides return rate.

This guy is a salesperson. He will make money on your dad regardless.

Why would your dad go to salesguy to buy Vanguard? Why not go directly to Vanguard?

[SVT]

Mar 8, 2011 20:40:58 GMT -5 formerexpat said:

I think that your father misunderstands; this guy makes money regardless of the direction of the market.

Is this guy an adviser with one of the big places [Fidelity, Schwab, etc] or independent from any of these companies? It could be that his fees are wrapped in the management fees of the funds or he takes an additional cut off the top.

There is a company called Dimensional fund advisers that are essentially buy and hold / index fund type managers and only go through fee only planners: www.dfaus.com/service/individuals.html

From what I understand, there is about a 50-75bps overall fee for these types of funds and while you can get lower through low cost index funds, not everyone [actually, not many people at all] have the ability to stay the course through all markets and continue regular investing over 30 year periods. This type of adviser would help clients get 9.25 - 9.5% of the 10% 30 year return instead of the average 2%.

Perhaps this is the type of adviser your father is going to for his needs?

It might be good for you to go to this guy just to hear his selling techniques. You appear to be financially aware enough to know a marketing ploy v a responsible financial adviser for your father.

I'm guessing that your relationship isn't one where your father would allow you to more actively manage? I manage the finances [both business and personal financial planning] for my mother and her husband...but I know everyone isn't as comfortable with that arrangement.

It's with a company called Akers Financial Group. And no, my dad is very guarded with his finances and he seems uncomfortable when it's talked about, whether it's mine or his. He wouldn't ever let me know any details.

This is sort of off topic but my dad seems sort of resentful and jealous of me and how well I'm doing for my age...not that he knows much details as far as the dollar amounts of my savings but he knows my income. Anyway, he's mentioned before about how he got hosed during the crash and he pulled his money out of his 401k and I would guess he would be embarrassed(?) to disclose the particulars with me. I know I make like $10k/year more than him and that's about it. I only know that from the FAFSA.

[SVT]

Mar 8, 2011 21:06:12 GMT -5 RoadToRiches said:

"My dad also said that the guy mentioned getting 12%/year"


Why would your dad go to salesguy to buy Vanguard? Why not go directly to Vanguard?

My dad doesn't know anything. He doesn't use the internet and I don't ever see him research anything ever. I'm the type of person that also reads online and books on anything of interest to me that way I have an understanding on the subject and can make an informed decision. He doesn't do that. He doesn't know what to do. I know what to do but like I mentioned in the post above, I don't think he could see his son sit down with him and go over his financials, look at his goals, risk tolerance, time horizon to retirement etc, come up with a total asset allocation based on all that and set him up with a Vangaurd account and pick the appropriate index funds suitable to the asset allocation.

[formerexpat]

Anyway, he's mentioned before about how he got hosed during the crash and he pulled his money out of his 401k and I would guess he would be embarrassed(?) to disclose the particulars with me.

Sounds like the real issue is...

My dad doesn't know anything. He doesn't use the internet and I don't ever see him research anything ever.

Unfortunately, if he isn't willing to spend time educating himself, he'll end up always trying to chase returns...likely what he did with the crash. I imagine your father was one of the many that plowed their monies into the tech sector in 1998 / 99 / 2000 to see it crash.

It's unfortunate that he has too much pride to ask you for some insight and help. My father is the same way. It doesn't appear there is much you can do to help your father avoid any potential mistakes he is making with this firm.

Looking at this firm, it looks like they work with Nationwide and American funds. I suspect they get compensation from these firms for products they recommend to clients. BTW, does your father live in the Jarrettsville area - is that where you grew up? I'm in the Bel Air area, so just down the road. This area is nice.

I'm guessing since you're in your mid 20's that your father is in his late 40's to early 50's? I'm not sure how this adviser would be talking about a 12% total return for the portfolio at your fathers age, suggesting 100% equities for the next 30 years. [/size]

[SVT]

Mar 8, 2011 22:30:49 GMT -5 formerexpat said:

Anyway, he's mentioned before about how he got hosed during the crash and he pulled his money out of his 401k and I would guess he would be embarrassed(?) to disclose the particulars with me.

Sounds like the real issue is...

My dad doesn't know anything. He doesn't use the internet and I don't ever see him research anything ever.

Unfortunately, if he isn't willing to spend time educating himself, he'll end up always trying to chase returns...likely what he did with the crash. I imagine your father was one of the many that plowed their monies into the tech sector in 1998 / 99 / 2000 to see it crash.

It's unfortunate that he has too much pride to ask you for some insight and help. My father is the same way. It doesn't appear there is much you can do to help your father avoid any potential mistakes he is making with this firm.

Looking at this firm, it looks like they work with Nationwide and American funds. I suspect they get compensation from these firms for products they recommend to clients. BTW, does your father live in the Jarrettsville area - is that where you grew up? I'm in the Bel Air area, so just down the road. This area is nice.

I'm guessing since you're in your mid 20's that your father is in his late 40's to early 50's? I'm not sure how this adviser would be talking about a 12% total return for the portfolio at your fathers age, suggesting 100% equities for the next 30 years.

[/size][/quote]

He lives in Street, now. I grew up in Cecil County. I didn't realize you were that close to me but I knew you lived in MD. And yes, he's 50 and I had the same reaction when he mentioned the 12% to me, I just didn't say anything about it.

Part of the 'problem' here is the financial advisor is apparently a Christian and someone my step mom knows from when she was in school or something, so my dad trusts this guy...not saying he's going to get hosed but there's cheaper ways to invest than what he's doing.

I don't think they've actually started investing with him yet but it seems they've made their mind up that that's what they're going to do. I said I was curious what type of funds he was invested in and asked if he had paperwork with the specific information and he said no he does not, he just met with the guy not that long ago. I might go ahead and meet with him to get a better idea of what he has to offer. It may be good to do something like this anyway just as an educational thing to see what these type of people say and try to do.

And by the way, I don't know if my dad is the type to 'chase returns' like during the tech boom but he has always been big on real estate. Him and my mom had a nice size when I was growing up...until my mom divorced him and they had to sell because neither one could afford it separately. Come to find out from my step mom, my dad was counting on that house for retirement! My mom and dad was going to sell that house this decade sometime "when it would be worth a lot more" *ha* and then downgrade and use the proceeds for retirement.

[cytoglycerine]

Mar 8, 2011 21:06:12 GMT -5 RoadToRiches said:

"My dad also said that the guy mentioned getting 12%/year"

This right there, I would run...Not because it's low or high, but the fact that the guy simply said that he will get your dad 12%. Is he psychic?

I don't know what the rule is in the USA around this, but in my country, or in my province at least, it is illegal to promise a specific return to a client (unless that is the nature of the product, such as a CD) and it must be made clear that past performance does not indicate future returns. That being said, there is a big difference between the FA saying that your dad will "for sure" get 12% a year on the investment, and the FA saying that the average return over a specific time frame was 12%.

Mar 8, 2011 21:06:12 GMT -5 RoadToRiches said:

This guy is a salesperson. He will make money on your dad regardless.

100% true.


I've only had one experience with an FA from the "client side" of the desk (I was accompanying my mom to see her FA at the bank), and I found them to be unbelievably pushy and salesman-like. Throughout the whole meeting, they're sitting there going on and on about how my mom is young, has lots of time to invest, and should be going for an aggressive growth mutual fund. In reality, my mom is 57 (not "old" I know, but she's not "young" in terms of having her whole life ahead of her to allow her investment to grow, like they were insinuating), she plans on using the money in about 3-5 years, and is extremely risk-averse. She is very happy to trade potential returns to ensure the safety of her capital - she's the type who can't sleep at night if her money is in the market, and the market has one little hiccup.


We told all this to the two FAs at the bank we ended up talking to...Yet they still droned on and on about how "the market always comes back" and "you have to invest for the long term". They weren't telling her lies IMO, they were just giving her facts and information that were irrelevant to her situation. The whole ordeal really didn't sit too well with me, and I had serious considerations about calling the branch manager about it. I am one test away from being able to register as a mutual fund salesperson myself, so I know all about what is and what is not allowed by my province, and these guys were seriously skirting the line.


Anyway, what I'm trying to say in this long-ish rant is this - If your father is comfortable enough to talk to you about any specifics (sounds like he might not be), make sure he is happy with the investment he has and is comfortable with how it works, and didn't just take it because the FA said it was "good".


PS - Nothing against FAs in general, it can be a very tough job!! But the experience I had with my mom seriously irked me.

[Deleted]

I was in actively managed mutual funds through Merrill Lynch's Mutual Fund Advisory Fund program for about six or seven years, and I ended up hating it. I never made money except in the sense that I got back to where I started at. I understand that the market had severe downturns, but I seriously averaged 2% over a 10 year period . . . and this was before the last market crash!

It is very important to find out how the guy is being paid. Is he being paid by your dad and putting him in no-load funds or by the funds? If it's both, you should definitely advise your father to run.

How old is your father? I am 57. The best thing I did was to roll-over everything into an a target date fund at Vanguard. I did push the target date out five years since I think I could stall that long and didn't want it going conservative too soon. But even Vanguard has an actively managed program if that's what your father really wants.

[RoadToRiches]

Imagine that. I just got to the chapter that talks just about that.

Here is what it says:

Active versus index fund managers
Unlike other mutual funds, in which the portfolio manager and a team of analysts
scour the market for the best securities, an index fund manager passively
invests to match the performance of an index. Index funds are funds that can
be (and, for the most part, are) managed by a computer. An index fund manager
invests the fund’s assets so as to replicate an underlying index, such as
Standard & Poor’s 500 index — 500 large-company U.S. stocks. An S&P 500
index fund generally buys and holds the same 500 stocks, and in the same
approximate amounts, that comprise the S&P 500 Index.
Index funds are underrated — they don’t get the credit they deserve. Index
funds are a little bit like Jaime Escalante, that Garfield High School math
teacher of poor children in the ghettos of Los Angeles (see the terrific movie,
Stand and Deliver, about him). In a school where kids often dropped out and
were lucky to learn some algebra, Escalante got his kids to master calculus.
In fact, he got entire classes to work hard and pass the college advanced
placement exam for calculus. (The College Board that administers the AP test
couldn’t believe that so many kids from this school could pass this exam, so
the kids were investigated for cheating — that’s how Escalante’s story was
discovered, and he finally got credit for all the great work that he did.)
Low-cost index funds work hard by keeping expenses low, staying invested,
and holding on to a relatively fixed list of stocks. So, like Escalante’s kids,
index funds are virtually guaranteed to be at the top of their class. Over long
periods (ten years or more), index funds outperform about three-quarters of
their actively-managed peers investing in the same types of securities! Most
actively managed funds can’t overcome the handicap of high operating
expenses that pulls down their funds’ rates of return. Because significant
ongoing research doesn’t need to be conducted to identify companies to
invest in, index funds can be run with far lower operating expenses. (See
Chapter 5 for discussion of the exchange-traded funds, which are index funds
you can buy and sell on a stock exchange.)
The average U.S. stock fund has an operating expense ratio of 1.5 percent per
year. (Some funds charge expenses as high as 2 percent or more per year.) That
being the case, a U.S. stock index fund with an expense ratio of just 0.2 percent
per year has an average advantage of 1.3 percent per year. A 1.3 percent difference
may not seem like much, but in fact, the difference is significant.
154 Part IV: Establishing a Great Fund Portfolio
Because stocks tend to return about 10 percent per year, you’re throwing
away about 13 percent of your expected stock fund returns when you buy a
nonindex fund. If you factor in the taxes that you pay on your fund profits,
these higher expenses gobble even more of your after-tax profits.
Another often overlooked drawback to actively managed stock funds: Your fund
manager can make costly mistakes, such as not being invested when the market
goes up, being too aggressive when the market plummets, or just being in the
wrong stocks. An actively managed fund can easily underperform the overall
market index that it’s competing against. An index fund, by definition, can’t.
Table 9-3 lists the worst-performing U.S. stock funds over the past decade.
Note how much worse these bowser funds performed versus the major U.S.
stock market indexes (the performance of which one could replicate by
investing in an index fund).
Table 9-3 Worst Performing U.S. Stock Funds
Past Decade versus Market Indexes
Fund Annualized Total Return
Ameritor Investments –35.4% per year
Frontier MicroCap –25.2% per year
American Heritage Growth –13.9% per year
Apex Mid Cap Growth –8.3% per year
Ameritor Security Trust –6.3% per year
Stock Market Indexes Annualized Total Return
Standard & Poor’s 500 Index +8.1% per year
DJ Wilshire 5000 Index +8.7% per year
Source: Morningstar, Inc.
When you invest in broadly diversified index funds, you never see your funds
in the list of the top-performing funds — but then you never see your funds in
the list of the worst-performing funds, either. Don’t overestimate your ability
to pick in advance the few elite money managers who manage to beat the
market averages by a few percentage points per year in the long run. And
then don’t overestimate the pros’ ability to consistently pick the right stocks.
Index funds make sense for a portion of your investments, especially when
investing in bonds and larger more-conservative stocks, where it’s difficult
for portfolio managers to beat the market. Index funds also make sense for
investors who are concerned that fund managers may make big mistakes and
greatly underperform the market.
Chapter 9: Perfecting a Fund Portfolio 155
As for how much you should use index versus actively managed funds, it’s
really a matter of personal taste. If you’re happy knowing that you can get the
market rate of return and knowing that you can’t underperform the market,
you can index your entire portfolio. On the other hand, if you enjoy the game
of trying to pick the better managers and want the potential to earn better
than the market level of returns, don’t use index funds at all. A happy
medium is to do some of both.

[Deleted]

Mar 8, 2011 22:30:49 GMT -5 formerexpat said:

Looking at this firm, it looks like they work with Nationwide and American funds. I suspect they get compensation from these firms for products they recommend to clients.

I have a lot of American Funds in my portfolio although I'm now diversifying. The big negative with them is that the advisor is probably selling the A shares, which carry an up-front fee of 5.75% but lower annual fees. If you invest a lot that 5.75% decreases. You can get on their site, but last I looked, the up-front fee was 2% if you invested $500K or more across all their funds. Still, it gets raked off the top and not put to work for you.

I can't speak for Nationwide Funds, but you will NOT get 12% on a regular basis with American Funds. They're pretty conservative, which means they don't tank as badly when the market crashes, but conservative won't get you 12% year after year. Some of their others with international components have done better, but they carry more risk. There are certainly worse things to do with your dad's money than put them in American Funds, but you need to be comfortable with the associated expenses.