What Your Financial Advisor Gets Wrong

Uh-oh. Is your financial advisor drinking the Kool-Aid? According to a new survey commissioned by the Financial Planning Association, 67 percent of advisors say that active investing beats passive investing. Among advisors who invest client money in mutual funds, an average of 70 percent goes into actively managed funds. That means at least two thirds of advisors -- and more importantly their clients -- are falling for "hope and hype over wisdom and experience" according to MoneyWatch blogger Larry Swedroe.

The Power of the Passive Approach

Blogging at MoneyWatch is just a side gig for Larry, who is the director of research at The Buckingham Family of Financial Services. And in his new book, The Quest for Alpha, Larry pored over research going back decades and found that active investing fails to beat out a passive approach. Even if your advisor has the skills to pick those needles out of the haystack the next problem is that there's no evidence that a fund or manager that has outperformed in the past will continue to buck the odds and keep outperforming.

Of course, that's not exactly news to MoneyWatch readers. Blogger -- and financial advisor -- Allan Roth has long shared his winning dare to be boring investment strategy that relies on passive index funds. And Dan Burrows recently called attention to the fact that since the onset of the financial crisis, the performance of a passive basket of stocks has "blown away" hedge funds.

Yet according to the FPA report, most advisors are stuck on trying to use active management to get you extra performance. In the FPA survey, 25 percent of advisors report they have increased their use of active funds in the past year, compared to 17 percent reporting they are leaning harder on the passive approach.

If your advisor is in the active camp, you might want to have a sit-down and discuss whether that's really paying off for you. The core conversation should be how the funds in your portfolio have fared compared to a relative benchmark. That benchmark is the passive bogey. The big hurdle you and your advisor need to get over is the notion that aiming for average is somehow aiming too low. But in fact, if you can lock in average year in and year out you will outperform everyone else trying to chase after above-average through actively managed investments. Remember, they have to beat the market consistently by more than the fees they charge in order to add value. Can't see your way to go 100 percent passive? That's rational given our irrational belief that we're better than average in everything else we do. But if you and your advisor are in sync about what really works over the long term, then you'll both see the advantage of committing most of your money to a more passive approach.

What Advisors Get Very Right
The same FPA survey also asked advisors how they go about evaluating mutual funds and exchange-traded funds. Asked to name the five most important criteria from a list of more than 20 fund-picking factors, the single most popular criteria, which turned up in 65 percent of the responses, was the expense ratio. Amen. As Morningstar has documented, low-cost funds are in fact the best predictor of future fund performance.

The advisors' ranking of fund-picking criteria is a pretty good cheat sheet of what all investors should be focused on.

Top 5 factors advisors pay attention to:
1. Expense Ratio (cited as a top 5 factor by 65 percent of survey respondents.)

2. Long-Term Relative Performance (50.4 percent)

3. Volatility (Beta, Standard Deviation) (43.7 percent)

4. Risk-Adjusted Performance (42.9 percent)

5. Style Consistency within portfolios (32.8 percent.)

Way down the list was Morningstar's Star Ratings, which just 10.9 percent of advisors said they consider one of their top 5 screening factors. As low as that is, I have to wonder about any financial advisor who would rely to any degree on what is widely known to be an extremely poor predictor of future performance. Perhaps those advisors, and their clients, will be better served by Morningstar's new Analyst Ratings that aim to rank funds on the basis of their expected future performance. But as Eric Schurenberg points out, Morningstar is setting an extremely high bar for its analysts. I'm waiting to see how broad based index funds fare relative to actively managed funds in the new Morningstar ratings.

Photo courtesy Flickr user Colin_K

More on MoneyWatch:
The Greatest Advantage of Passive over Active

Video: The Power of Passive Investing

Will Morningstar's New Analyst Ratings Help You Pick Winners?
How to Pick an Advisor: 9 Questions