An Interview with Ric Edelman - Is High Cost Indexing an Oxymoron?

Last Updated Nov 6, 2009 10:43 AM EST

A couple recently came to me with a portfolio managed by Edelman Financial. The portfolio was built using low cost passive funds from DFA, iShares, and Vanguard, which was all good. What wasn't good was that they were paying 1.79 percent in annual fees to Edelman. Doesn't this defeat the very purpose of indexing? So I spoke to founder, Ric Edelman, about his practice.

A little background
Edelman is the best-selling author of such books as Rescue Your Money, and was recently named the top independent investment advisor by Barron's. Edelman explained how his firm differentiates itself, which included:
  • Providing consistency without a cookie cutter approach.
  • Scalability by reaching small investors and giving discounts to large portfolios.
I challenged him on his firm's anti-cookie cutter position by noting this client had the same allocations in their IRA account as in their taxable account. He agreed that asset location was important, and noted his advisers do consider it.

The average size of a portfolio at Edelman Financial is about $350,000, and he clearly does cater to smaller portfolios.

A change in attitude
In reviewing this couple's Edelman portfolio, I couldn't help but notice this passive indexing portfolio was quite a change from the advice contained in some of his earlier books, which criticized index investing. Edelman stated this change came about from the mutual fund scandal and his subsequent revelation that active managers were not adding value.

The price of advice
But is 1.79 percent annually on top of the underlying fund fees defeating the purpose of indexing? Edelman's web site has a paper entitled Do You Really Know the True Cost of Your Advisor? In the paper, he compares his total fees on a $250,000 portfolio (including the fund fees) of 2.29 percent to his estimate of an average advisor portfolio of 4.01 percent. He looks pretty good by comparison.

So I asked Edelman: If a balanced portfolio earns about 3.5 percent annually above inflation, isn't the investor giving up most of that real return? There was a little hesitation before Edelman answered that the consumer was getting far more than investment management for that fee. They were also getting financial planning advice outside of their investment portfolio, such as getting the right mortgage, college planning, and other services. He added that he accepts accounts with as little as $50,000.

Testing the quality of financial advice
I can't speak for any of Edelman's other clients, but the couple that came to me had a mortgage and some other debt that was at a much higher rate than their cash and bonds in the Edelman account were earning, after fees. Edelman's site has a column on it entitled Ten Great Reasons to Carry a Big Long Mortgage. While the piece was several years old, Edelman surprised me by saying he now believes this more than ever.

Intrigued, I asked why someone shouldn't pay off their mortgage rather than earning far less in the cash and bond portion of their portfolio. I used the example of paying off a 5.5 percent mortgage vs. earning 2 percent after fees in an Edelman account.

Edelman didn't go where most advisers go by either improperly comparing a mortgage to an equity return, or quoting the after-tax mortgage rate of 3.5 percent without considering the taxes on the bonds. Instead, he stated this negative spread was worth the value of the liquidity the consumer would have by having access to this cash.

I then pushed just a little harder and asked, what if the person had access to cash via a non-cancelable home equity line of credit (HELOC) loan or had a large enough supply of cash, even after paying off the mortgage. Edelman was against both and noted he had never seen a non-cancelable HELOC.

I was left with a nagging suspicion that Edelman's position may be biased rather than fact-based. The fact is that Edelman's fees are reduced when funds are withdrawn from his management, and I still question his advice on carrying a big long mortgage.

My take
Ric Edelman is a smart and articulate adviser who is one of the few that will cater to investors with portfolios as small as $50,000. Edelman should be applauded for both his transparency in fees and for helping this consumer stay the course, when the market plunged.

While I think that paying 2.29 percent to index is better than paying the same for an active portfolio, high cost indexing is an oxymoron. My investing mantra is "costs matter," and I don't think one can have a good portfolio when costs are over 1.00 percent. Many investors I surveyed on the Bogleheads Forum apparently agree.
Keep costs low! If you can't do a simple portfolio like the second grader portfolio with one-tenth of what Edelman charges, then look for cheap alternatives such as Portfolio Solutions, which charges 0.25 percent, though you will need a larger portfolio to make this cost effective since they do have a $2,000 household minimum charge.

Remember, you can have a bad low-cost portfolio, but you can't have a good high-cost portfolio. My take is that high-cost indexing is an oxymoron, and 2.29 percent isn't even a close call.

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    Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.

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