Here’s a dilemma lots of people face: “I have a financial adviser I trust, but I am wondering if I would be better off doing some things on my own.” Reader B.A. asked that question recently.
He then explained further, “... and he is charging me 2 percent a year on my account balance.”
That’s a painful dilemma. How much can you pay for expertise and the performance it is supposed to bring, particularly when you have no confidence in your own ability?
One way to sketch out an answer is to compare the performance of mutual funds over a period of time. You’d do this by measuring how those performances change from the top 10 percent performers on down.
We can do this using Morningstar Principia, a fund-screening database product that provides a wealth of data on every mutual fund and exchange-traded fund. When we do this, we’re not searching for the best fund in the galaxy. Instead, we’re building a map that shows us the odds, and distribution, of performance. Here’s a broad example:
Over the last 15 years, the data show that the average “moderate allocation” fund — what Morningstar calls a traditional balanced fund — provided an average annualized return of 5.45 percent and a median return of 5.02 percent. Funds at the top 25 percent level returned 6.03 percent; funds at the top 20 percent returned 6.33 percent; and funds at the top 10 percent returned 7.28 percent.
What this tells us is that “the spread” — the difference between the median fund return and the better-performing funds’ return — gets bigger as you move to performances that are increasingly rare. The spread between the median return and a return at the top 10 percentile is 2.26 percent a year. It’s only 1.31 percent to move from the median to the top 20 percentile. And it’s only 1.01 percent to move from the median to the top 25 percentile.
So, if someone is charging 2 percent a year to make your selections, his own fees are a substantial handicap. If the adviser selects a fund that does better than 80 percent of its competitors, it will gain 1.31 percent in performance — but lose 2 percent to his fee. In this particular example, your return would be reduced to 4.33 percent. That’s well below the 5.02 percent median return. Indeed, in this example the 4.33 percent annualized return would rank at the bottom 30 percent of such funds.
This means a 2 percent annual fee, by itself, can reduce a top 20 percent performance to a bottom 30 percent performance. That’s an enormous shift. More important, it makes the benign assumption that the adviser has the skill to select a top-performing fund.
Do these numbers change? Yes, all the time. Some time periods have bigger spreads; some have smaller spreads. The same search using stock funds would show bigger differences because stocks are more volatile than portfolios of stocks and bonds. Similarly, the performance differences for bond funds are smaller because bonds are less volatile than portfolios of stocks and bonds.
But if we invest in stocks and bonds and do that investing over a relatively long period of time — as life requires us to do — the performance spreads are surprisingly modest.
Now let’s take the examination a bit further. If you owned a moderate-allocation index fund over the same period — a traditional 60/40 mix of stocks and bonds such as the Vanguard Balanced Index Fund — your annualized return of 5.64 percent for this period would have been at the top 30 percentile. This ranking is typical of index investing against managed funds.
Using the same rankings, here is what an adviser has to do to overcome different fee levels:
* Overcoming a 2 percent advisory fee requires selection of a fund in the top 6 percent, a 1-in-17 chance.
* Overcoming a 1 percent annual advisory fee requires selection of a fund in the top 16 percent, a 1-in-6 chance.
* Overcoming a 0.5 percent annual advisory fee requires selection of a fund in the top 23 percent, a 1-in-4 chance.
The higher the fee, the greater the odds are against you. At 2 percent a year, defaulting to an index fund is a sound alternative.
SCOTT BURNS is a principal of Plano-based investment firm AssetBuilder Inc. His e-mail address is email@example.com.
— Universal Uclick