Want the greatest bang for the buck from your advisor?

Last week, Good(?) news, mutual funds perform better in recessions than expansions , discussed how difficult it is for active managers to exceed the index and how difficult it is to find the few who will outperform in the future. If it appears that it is so difficult for active managers to outperform the index (due to management fees, incremental  transaction costs and taxes due to turnover) then if you still want help in making investments then where should spend your money management fees or your personal effort to get the best bang for your dollars/time?

You might consider spending your money is on asset allocators and/or your time on asset allocation. Asset allocation may be a less costly and more rewarding area as it is focused on risk reduction for a given return. Old world money managers used to manage balanced portfolios (assets were allocated typically between stocks and bonds/cash) for the wealthy with the emphasis on steady returns while minimizing volatility. (In my portfolio, I tend to spend my effort on asset allocation rather than stock picking). An emerging trend is Target-Date or Lifecycle funds. In these funds asset allocation is determined based on time left until your target retirement year. So if today is 2007 and your target retirement year is 2037, then today the “Target 2037” fund will have a very high proportion of stock, however by 2032 the stock content will be reduced to reflect one’s lower risk tolerance as one approaches retirement. (Of course as not all 30 or all 55 year olds have the same risk tolerance, this may not be the perfect answer, however this may be a lot better than other alternatives for those not knowledgeable in the art of investing and not willing to spend the money for advice and not prone to monitoring their portfolio) For example Vanguard offers very low cost (about 0.21%) lifecycle mutual funds built on their index fund family; unfortunately these are not available to Canadians (as far as I know). In Canada, Fidelity offers Target-Date funds called Fidelity ClearPath Portfolios which come in three flavors: deferred sales charge, initial sales charge and those available only through fee-based advisors (who also charge additional fees); annual management expenses are 1.95%, 1.80% and 0.80% respectively. The Fidelity fund fees are considerably higher, thus resulting in a corresponding drag on the expected returns. 

Target–Date ETFs appear to start becoming available in the U.S., with TDAX filing with the SEC for an offering based on Zack’s Lifecycle Index. Normally access to U.S. ETFs solves the cost problem of Canadian index funds, however a U.S. Lifecycle Index, even if it becomes available and it’s reasonably priced, may not have the appropriate asset mix for a Canadian resident (i.e. someone who is spending they money in retirement in Canada). If you, with or without and advisor, select an appropriate asset allocation for today and another one for your retirement target date then you could build a low cost portfolio from ETFs and evolve it over time toward the target allocation, mimicking Target-Date funds, until low cost versions become available.

So back to the question asked at the beginning: if you will spend money on advice, where will you get the greatest bang for the buck? Richard Croft tackles this problem in the Financial Post in “Portfolios benefit from advisor input”. He looks at investment counselors and portfolio managers, stockbrokers, financial planners and your bank and what roles they usually play. He identifies the various roles played by each.

Croft starts identifying what investors need: setting of long term performance objectives consistent with investor’s risk tolerance, and help not to panic and change course due to short term volatility. He then concludes with “But longer term, I think the advisors’ real value is helping investors understand what role specific investments play within the broader portfolio, and more importantly, what role the portfolio plays in a long-term investment plan. Advisors who fulfill that role will, in my opinion, end up with the most successful practices.”

I suspect Croft is right, that the most important piece of the puzzle that an advisor brings to the table is understanding your objectives and risk tolerance and then helping you set up a savings plan and asset allocation consistent with objectives/risk tolerance (usually done by financial planners). If you don’t have objectives, and you don’t have a savings and investment plan aimed at achieving those objectives, then you don’t know where you are going to and you don’t know how you are going to get there. So, a good place to start spending your hard earned money is with a financial planner who will help you generate your roadmap to retirement. Implementation can then be done with low cost index funds or ETFs.