Last week in Part I of Does It Pay to Pay an Advisor, I discussed why the do-it-yourselfer chooses to handle their own finances and that avoiding a financial advisor fee does not necessarily equate to saving money.
This week I’ll discuss the proliferation of cheap investment options (i.e. index funds and ETFs) and investment management solutions (i.e. robo-advisors). I’ll also explain why this low cost revolution has lead to do-it-yourselfers handling their own finances and the recent phenomenon that cheaper is better.
CHEAP INVESTMENT MANAGEMENT
Even though financial planning involves multiple facets, a recent Investor Survey by Dimensional Fund Advisors (completed by almost 19,000 clients across the globe) reflected that investment management is the most important service. As a result, it’s no surprise that over the last few years, there have been a proliferation of cheap investments and investment services cropping up.
Inexpensive investments such as index funds and exchange traded funds (ETFs) have allowed the do-it-yourselfer to avoid the expensive investment management fees charged by some advisors. Vanguard has been well-regarded as the pioneer of low-cost investments for decades now, so the concept of cheap investments isn’t new. However, more and more choices continue to become available causing investors to question whether or not advisors can add value.
In addition, there are the relatively new investment management providers known as robo-advisors (or “robos” for short). Some of the main players include Betterment, Charles Schwab, and Wealthfront. For those that don’t know, robos are basically online services that will invest your money for a relatively low fee. And in turn, they use really low cost investments (like those mentioned above) to keep investor costs down.
It seems as if everything in the financial services arena these days is driven by costs. But this begs the question of whether or not cheaper is better.
First let’s discuss the investment side of things. Larry Swedroe, Director of Research for BAM Alliance, wrote an article comparing the performance of very low cost Vanguard funds to the more expensive funds of Dimensional Fund Advisors (DFA). The article discusses that from June 1998 to December 2016, DFA funds significantly outperformed the less costly Vanguard funds. Why is this? It’s partly because DFA funds typically own smaller and more value-oriented (lower priced) stocks than similar Vanguard funds. DFA’s research shows that these two components have historically rewarded investors with higher returns even though the funds are more costly than Vanguard’s. Another reason for the outperformance is that DFA has a very patient and flexible trading style that doesn’t require them to blindly follow an index like many Vanguard funds do. Research has shown that when funds mirror an index, all the funds that track that index have to buy and sell at the same time which creates unfavorable prices.
I am not saying all of this to denigrate Vanguard or index funds. In fact, if you built a diversified portfolio of index funds and rebalanced periodically, you would likely end up with a good return in the end. I’m just pointing out that cheaper is not always better.
In the interest of full disclosure, my firm primarily uses DFA funds for client portfolios. Reason being is that their their strategy is heavily grounded in historical, academic, and Nobel Prize research. Everything they do is evidence-based.
Now let’s turn our attention to the robo-advisors. We don’t have long term performance data on robo-advisors like we do with DFA and Vanguard, since the robos haven’t been around for that long. However, in their short history, two things stand out.
First, robo-advisors continually tout tax loss harvesting as one of their wonderful benefits and how it provides extra return to investors. I recently debunked this in a couple articles I recently wrote for Investment News and Financial Advisor Magazine.
Second, a report from Condor Capital Management compared the results of robo-advisors in 2016 based on each of their 60% stock / 40% bond portfolios. The returns from among 9 robo-advisors literally ranged from 5.55% to 10.75%.
This is not exactly a ringing endorsement for using a robo service. Even our 60/40 portfolio that we use with our clients had returns ranging from 9.29% to 9.74% after fees. This outperformed 8 of the 9 robo-advisors tested even though our fees are significantly higher than those of the robos. The reason I say this is not to tout our investment performance but instead to show that fees are not the only factor.
It’s understandable that the low cost revolution has resulted in people managing their own finances or using the services of robo-advisors. But hopefully now you can see that cheaper is not always better and that you may find value in paying the fee of a financial advisor.
Stay tuned for the final article of the series next week where I’ll discuss evidence showing that paying an advisor does in fact pay off for people financially.
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