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June 26, 2008
Financial Advisor Double Whammy
Academics are slowly peeling back the curtains on the financial services industry to expose some serious shortcomings. One groundbreaking study, which I've referenced before, found that commissioned financial advisors don't bring any appreciable value to investors. It found that the mutual funds recommended by traditional advisors severely underperform the market as a whole.
No real surprise there, since the vast majority of the funds are expensive, actively-managed funds that typically pay the advisor fat commissions.
Now there's a study that shows that clients of commissioned financial advisors severely underperform within those same investments. In other words, not only does the mutual fund underperform the market, the investor underperforms the fund!
The reason, according to the authors, is that clients of traditional (commissioned) financial advisors are more likely than self-directed investors to try to time the market:
Our results sound a warning to fund investors who are considering whether to attempt market timing, either on their own initiative or through their broker's advice. On average, active investing leads to underperformance relative to a passive dollar invested in the fund. In addition, the use of an investment professional to trade shares is correlated with even worse investment timing performance.
The study, "Investor Timing and Fund Distribution Channels," is written by Mercer Bullard of the University of Mississippi, Geoff Friesen of the University of Nebraska-Lincoln, and Travis Sapp of Iowa State University. The authors studied 6,164 funds between 1991 and 2004.
Investors in load funds lagged the performance of the funds by 1.82% on average annually. Those invested in legal no-load funds (funds with no commission and a low 12b-1 fee) lagged their funds' performance by 1.91%. And those involved in Class B fund shares underperformed by 2.28%. The only investors who didn't underperform were those in pure no-load index funds.
This study shows that traditional financial advisors are no better than anybody else when it comes to timing the market. And they don't seem to do anything to curb the behavior of their clients who think market-timing is possible:
One potential explanation is that brokers seek to justify their compensation not only by helping their clients pick funds, but also by demonstrating their active monitoring through market timing advice. If this is the case, the evidence suggests that this advice, on average, is less than helpful. Another possible explanation is the well-documented psychological tendency of investors to overweight recent performance. Although investment professionals presumably are more aware of, and less, susceptible to, a short-term performance bias, their clients might be more susceptible to this bias than self-directed investors. … A third explanation is that some brokers may be able to appeal to their unsophisticated clients' short-term performance bias in order to increase sales compensation. Thus, brokered shares may show evidence of (bad) timing because of client pressure, the broker's financial incentives, or both. [emphasis added]
The authors were especially critical of advisors who put their clients in Class B shares.
Why do Class B shareholders fare so much worse? One reason might relate to questionable conduct by brokers. Class B shares often are an inferior choice for investors and have been the subject of a number of enforcement actions alleging misleading sales practices. Sales of Class B shares can provide higher compensation to a broker than other shares and therefore present an economic incentive to steer clients toward these shares.
…
It is possible that a broker who recommends Class B shares in order to maximize compensation may also tend to emphasize recent returns in order to allure investors. More prudent advice would instead tend to emphasize long-term performance, but on this count Class B shares fare poorly.
I think the biggest takeaway from this study is this: Ask yourself if your advisor is providing any value. Did you hire them because of their expertise? Their access to better investments? Their potential to keep you from making dumb mistakes? If they aren't providing any value, why are you still paying them?
SOURCES:
1. Bergstresser, Daniel, John Chalmers, and Peter Tufano, 2006, Assissing the costs and benefits of brokers in the mutual fund industry, Working paper.
2. Bullard, Mercer, Friesen, Geoffrey C. and Sapp, Travis, "Investor Timing and Fund Distribution Channels" (December 2007). Available at SSRN: http://ssrn.com/abstract=1070545
Kim Snider is the President and Founder of Snider Advisors, an SEC Registered Investment Advisor, focused on teaching individual investors a sensible, long-term investment approach focused on maximizing cash flow. For more information on Snider Advisors or the Snider Investment Method and how to stop enriching your investment advisors at your expense, please visit snideradvisors.com. Her book, How to Be the Family CFO: Four Simple Steps To Put Your Financial House in Order, will be in bookstores October 1, 2008.
Snider Advisors makes no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 888-6SNIDER to request the Snider Investment Method® Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments, including the Snider Investment Method™ are subject to risk, including possible loss of principal.
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Kim Snider is an author, speaker and host of Financial Success Coaching, Saturdays at noon, on KRLD Newsradio 1080, Dallas - Fort Worth. This blog is primarily devoted to empowering individual investors with information to help them be good stewards of their money. Above all, it is about achieving true financial success. Kim's book, How To Be the Family CFO: Four Simple Steps to Put Your Financial House in Order is in bookstores now. Order yours from Amazon or other fine booksellers today.
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