I DO NOT want YOUR money — the problem with fee only financial planners and percent of assets investment management fees
I do NOT want YOUR money. Really, I don’t want YOUR money.
To be clear, I do want to be paid by you a one-time fee for the investment and financial planning services that I provide to you. However, I do not want to be paid an annual percentage of YOUR assets like 99% of registered investment advisers who will take their fees out of YOUR assets year after year.
Why? Because you are unlikely to get what you expect, when you pay percent of asset management fees.
YOUR money is your money. You worked hard to build up the assets that you have. If I were to take a yearly percent of assets fee, then you would very reasonably expect that I should be able to justify my investment fee by delivering consistently higher returns. I should be able to improve consistently and reliably your net investment returns year after year, after all fees and taxes are taken into account. In addition, of course, I should be able to achieve these higher returns without increasing the aggregate risk of your investment portfolio, while reaching for higher returns.
I am smart enough and educated enough to know that I cannot do this for you. I cannot guarantee future outcomes — nor can anybody else. While there is no shortage of investment advisers who hint and imply that they can and will do better for you, just ask for a written guarantee of that superior market performance net of all fees and taxes and all of these eager advisors will vanish. Poof. Just like a large portion of your assets are likely to go poof, if you agree to pay percent of asset fees over time.
The problem with the “beat the market” crowd is that their members are overwhelming either uneducated, delusional, or liars — that is, too self-interested in their repeated fees to tell a truth they really do understand. If durable investment skill even exists, it is exceedingly rare. Both professional advisers and individual investors are greatly challenged to identify investment fund managers who might have truly sustainable skill. Then, of course, the question is whether any of these exceptionally rare managers can be hired at reasonable fees that would leave any excess for you that justify all your efforts to find these haystack needles.
At least I am aware of and understand the research literature, and I act accordingly. The research literature tells you that seeking superior performance is hopeless. Doing so raises your costs and taxes, reducing your net returns. You throw your money away on a mirage. The longer it takes for you to wake up to this fact, the more you will give away to the high expense financial services industry, before you wise up.
In his 2013 Financial Analysts Journal paper (March/April 2013 pp. 34-41), “The Arithmetic of Investment Expenses,” William F. Sharpe, Stanford emeritus professor of finance and 1991 economic Nobel prize winner, clearly demonstrated that a lump sum invested at very low fees (.06%/year) was likely to result in 38% greater wealth after thirty years compared to average mutual fund expenses (1.12%/year). If instead, the investment pattern was to contribute equal amounts each year over thirty years, the low fee investment strategy resulted in 20% greater terminal wealth.
To simulate various actively-managed fund tracking errors over thirty years, Professor Sharpe ran a million simulations using Monte Carlo analysis techniques drawing from investment return data since the beginning of the 20th century. (The numbers below are derived from the text and from the various figures in Professor Sharpe’s paper.)
- With moderate amounts of active fund tracking risk (2.5%/year), for the initial lump sum investment scenario, there was only about a 2% chance that an average cost active fund would result in a slightly higher terminal value after thirty years versus the low cost passively managed fund. However, contrast this unlikely outcome with the 50:50 chance that the terminal value of the low cost fund would be about 38% greater, and the approximately 10% chance that the terminal value of the low cost, passively managed fund would be about 70% greater!
- For the “equal amounts contributed each year over thirty years” scenario, the moderate tracking risk (2.5%/year) simulation indicated that there was only about a 3% chance that an average cost active fund would result in a slightly higher terminal value after thirty years versus the low cost passively managed fund. However, this compares with a 50:50 chance that the terminal value of the low cost fund would be about 20% greater, and about a 10% chance that the terminal value of the low cost fund would be about 35% greater!
With higher risk and higher tracking error (5%/year), Dr. Sharpe’s simulation indicated that higher cost actively managed funds could have a somewhat greater chance of beating low cost passive management. However, Professor Sharpe commented that “although betting on a relatively active manager with no ability to add value, on average, is a poor choice, the simulations show why a Darwinian process does not weed out such managers with great rapidity. … For those who choose funds with high expense ratios, hope may spring eternal.”
- With a high amount of active fund tracking risk (5%/year), for the initial lump sum investment scenario, there was about an 8% chance that an average cost active fund would result in a higher terminal value after thirty years versus the low cost passively managed fund. However, this compares with a 50:50 chance that the terminal value of the low cost fund would be about 40% greater, and about a 10% chance that the terminal value of the low cost fund would be about 100% greater!
- For the “equal amounts contributed each year over thirty years” scenario, the high tracking risk (5%/year) simulation indicated that there was about a 12% chance that an average cost active fund would result in a higher terminal value after thirty years versus the low cost passively managed fund. However, this compares with a 50:50 chance that the terminal value of the low cost fund would be about 22% greater, and about a 10% chance that the terminal value of the low cost fund would be about 60% greater!
This is only one example from the broad investment research literature, which clearly indicates that:
A) winners cannot be identified before-hand, and
B) low investment costs are the single most effective tool that an investor has in achieving higher wealth for each dollar they invest.
Percent of assets investment management fees and the futile pursuit of superior bond and stock market performance
Why is Professor Sharpe’s paper and the rest of the academic research literature on investment fees and active versus passive investment portfolio management relevant to whether an investment adviser charges a percent of assets fee? Professor Sharpe’s paper addresses mutual fund management fees, while percent of asset charges are a different layer of fees charged by financial advisers to their clientele.
Here is why. When investment advisors charge a percent of assets fee — and these fees typically exceed 1% per year unless you have over a million dollars to invest and can get a reduced percentage — you want that to work hard to grow your investment portfolio. One percent of $1,000,000 is $10,000 a year — year after year after year. When clients pay thousands of dollars per year, very reasonably they want a positive return on these fees.
Clients are very unlikely to be willing to pay so much money for a low cost, index portfolio that targets the market return. Instead, clients want their investment advisors to beat the market for them. The usual way to attempt this is for the financial advisor to invest the client’s money in actively managed funds with higher management expense ratios, higher investment risk, and as Professor Sharpe points out, a lower expected return compared to a passive portfolio that targets the market return.
The net effect is that clients who pay percent of assets fee will pay both account based percent of assets fees added to high actively managed fund fees. This creates a double whammy of excessive fees that combined are much more likely than not to lead to lower future terminal wealth, especially as the time horizon increases.
(And, if you think there is an excessive expense escape valve when your financial consultant does not use funds and instead tries his or her hand at being a stock and bond picker, think again. The research demonstrates that this is just more likely to lead to significantly reduced diversification and higher portfolio risk, along with all the extra trading costs and higher taxes on short-term capital gains rather than long-term capital gains.)
Therefore, this is why I never have and never will charge my clients a percent of assets fee. Instead, I charge either an hourly rate for my advisory services or a fixed contract fee for preparing a turnkey lifetime investment plan or financial plan.
I never play the superior investment performance game, because doing so is simply bad for you. I always recommend completely passive, index mutual fund and/or ETF investment portfolios with very low costs, very broad diversification, and asset class risk exposures that are appropriate to your risk tolerance.
Any investor who invests otherwise will play the investment performance game and is expected to lose more the longer they play. Furthermore, they are fated to pay attention to the wrong things over time. While you chase the performance mirage, you take you eye off the financial factors over which you have much greater control and that you can affect.
You cannot change the investment markets, and you should never try. You can only reduce your costs to the minimum. In doing so, you will adopt an entirely passive index investment strategy, which will inevitably be a lower risk strategy due to the very broad diversification provided by passive index investment strategies. You will also cut your investment tax payments, because portfolio turnover will be lower. Passive portfolios provide both greater tax deferral and reduced taxes, because higher portions of recognizable returns are taxed at favorable US federal long-term capital gains tax rates.
Once you are cured of any performance chasing and superior performance delusions, then we can start working together on the things that you actually can change and plan for. These include, for example:
- easy ways to cut your investment expenses to the bone through direct investing
- optimizing your investment portfolio to reduce taxes
- investment risk reduction through cost-effective asset allocation
- expense management, planning, and monitoring
- income and career planning
- real estate purchase and management
- retirement investment, income, and expense planning
- planning to pay for education
- modeling to understand the big picture for your family and your lifetime
… and the myriad of other planning tasks that I can help you with very cost effectively.Tags: Independent Financial Planner Pasadena CA, pasadena ca financial planner