Over at our site at Young and Thrifty.ca I seem to have inadvertently started a holy war on behalf of index devotees everywhere. I recently published a post about how Investors Group was lowering their fees, yet even at this now “Canadian industry-standard” rate, the MERs were a massive drag on investment returns and simply not worth it. Between that thread and a former thread about Investors Group we gained a lot of attention and several Investors Group employees showed up to debate some of the finer points of my little spiel. What followed was a lively debate that I think can be fairly summarized in this way:
TM: Mutual funds (especially those in Canada) take HUGE cuts of your investment returns and no matter what anyone says there is simply no way that an investment adviser that puts you in mutual funds can ever offer enough value through any other service to make it worth it.
IG Employees: What you fail to realize is that not everyone is like you and wants to control their finances. We give value in so many ways through tax help, insurance recommendations, investment planning etc. The actual mutual fund recommendation is such a small part of what we do, that everything else we give a client easily makes up for the MERs we charge.
TM: You’re just wrong. The advice you give people might be good in certain cases (although I have substantial evidence that shows the majority of what most advisers recommend isn’t very good, and that is unrelated to their terrible investing advice) but it can’t possibly replace the compounded fees that you will charge over an investing lifetime. A much better option is to go to an advisor
IG Employees: You’re wrong, check out the slideshow IG gives us, you’re unqualified to make such judgements.
TM: Most mutual fund salesman/commission-based investment adviers are unqualified to do their jobs too, but that doesn’t stop them. Besides, I read a lot… so there!
And from there is just descended into a repetitive cycle.
A Value That I’m Missing?
So I’m here today to ask the broader question to you. Is there ever a case where the MERs we see in Canada (2.1% average) are justified considering everything else that a commission-based investment adviser brings to the table? Only this time, I’ve went over some of the texts (I love being a teacher in the summer) from my boy John Bogle of Vanguard and Time fame. I remembered the gist of his arguments at the time, but the specifics are quite interesting.
Investment advisers constantly use juiced numbers and logical arguments with huge holes in order to justify their means. There is a basic and simple reason for this. They make millions and millions of dollars off of recommending mutual funds and other advantageous investment products. In contrast, I have nothing to gain by advocating for a indexed investing approach. I’m not trying to sell you anything, literally the eBook I wrote on this topic is FREE! Given the obvious difference in motivation for providing investment advice, I think you have to view our respective arguments through that respective lens. In the words of Upton Sinclair (and repeated by Bogle) “It’s amazing how difficult it is for a man to understand something if he is paid a small fortune not to understand it.” This describes the whole mutual fund-toting industry from what I can tell.
Before I get into some actual hard math let’s take a look at one more quote by the legendary Warren Buffett, “By periodically investing in an index fund, the know-nothing investor can actually outperform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations it ceases to be dumb… Those index funds that are very low cost… are investor-friendly by definition and are the best selection for most of those who wish to own equities”
The Mutual Fund Sermon
As I have repeated time and again, mutual funds are just terrible investments. A recent DALBAR study (amongst many others) conclusively proved that less than 2% of mutual funds beat the market (after fees) over a 20-year time frame, and that identifying these funds ahead of time is nearly impossible. Study after study shows that mutual fund managers who beat the market for a few years in a row almost always revert back to the average given a long enough time span. There is just no debating the point that as a general group mutual funds are terrible investments. I will concede (as I have read a lot of Ed Rempel’s stuff) that there are managers out there that can beat the market over a sustained period of time. I’m not sure that most of us have access to those managers for very long (the bright stars go into hedge funds where the real money is) and most certainly none of these select few mutual funds would be any of the ones run by banks and/or insurance companies.
The question then becomes, just how bad are the mutual funds that most investment advisers recommend? The answer is very bad. Bogle quotes multiple studies that show commission-based investment advisers almost always recommend the latest and most expensive offerings that their parent company has just produced. The most enlightening data set was a Harvard Business study that looked at mutual fund recommendations from 1996-2002. During this time, the average self-directed adviser that picked mutual funds for themselves received an annual return of 6.6%. The average return on the funds that they were put into by “expert” money managers returned a whopping 2.9%!!! Oh, and that boring old index? Well it returned 10.48% annually. Even if you take a couple tenths of a percentage point off for transaction fees, it still isn’t even close. This is conclusive proof that the vast majority of funds that investment advisers who work on a commission basis will recommend to you are ridiculous and will steal your money.
Dude, That Guy Just Took Your Mom’s Money!
Another book I have recently read that hits on this same point is The Millionaire Teacher by Andrew Hallam. In the book, Hallam pulls back the curtains on the entire investment adviser industry when he talks about taking his mom to the bank to get her set up under a basic indexed investing plan. After several back-and-forths with the adviser, the bank representative breaks down and talks frankly with Andrew about what her training consisted of. Essentially the training she received was a 3 week crash course in how to sell mutual funds, and a load of talking points that confuse the topic and try to pressure investors into thinking they can’t possibly do anything for themselves. Then she revealed the sales process they were supposed to go through. Step 1 was to try and get the client the sign up for a “fund of funds” that had several mutual funds in it, and had several layers of fees. It is an absolutely ridiculous investment vehicle that should be illegal in my opinion. If the client didn’t bite, the next step was to get them into house funds that charged very high MERs and were extremely profitable. Only as a last resort, and only if the client repeatedly insisted upon it was the investment adviser ever supposed to look at low-cost ETFs or index funds. To me, this is basically game over for the mutual fund crowd.
Don’t take my word for it though, read Bogle, Hallam, Burton Malkiel, and many others. Even Charles Schwab, the huge mutual fund giant has stated publically that he himself has the majority of his portfolio in index funds!
Let’s take a look at the math of mutual funds (or the “humble arithmetic as Bogle would say) shall we?
If hypothetical Investor A has $20,000 in equities at the age of 30 in a registered account, and we assume an 8% benchmark equities annual average return over the next 35 years, a broad-based ETF, with all-in commissions and MERs calculated would return 7.7% (even though we could easily make an indexed ETF portfolio for less than that, we’ll be conservative).
A 2.5% MER that is fairly average for advisers to recommend in Canada would give us a 5.5% average annual return. Only the vast majority of mutual funds do not achieve index-like returns, and mutual funds that are recommended by advisers have even worse results than that! I couldn’t find any hard data on just how badly mutual funds underperform their indexes in Canada, so we’ll be extremely conservative and say 1%, even though their US counterparts are quite a bit lower than that. We are now down to 4.5% annual return. I won’t even get into the fact that mutual funds are less tax efficient, and often include back-end or upfront fees that would further eat into your nest egg. You could easily justify taking off much more just on that basis, alone.
For now though, let’s go with a 4.5% annualized return figure for the average Canadian mutual fund that Investor A gets put into by an investment advisor and a 7.7% annualized return for our Investor A if he follows the index strategy. We’ll assume all of the investing is done in registered accounts since most Canadians don’t max out all of their registered account space. This means none of the respective gains will be taxable, and the inflation effects are irrelevant since they are the same for both the index and mutual funds respectively.
Let’s take a look at our “Investor A” 35 years later if he didn’t add another penny to his account, and just let indexed returns do their thing.
Investor A with indexing: $268,274.63.
Investor A with mutual funds recommended by advisers: 93,346.96
Again, this isn’t even looking at yearly additions to a registered account or taking into account other mutual fund fees that are pretty normal. It is just an absolute barebones comparison, and a very vivid depiction of what sort of bite compounded fees take out of your investment portfolio over time.
Now the investment advisers are not wrong. They do provide many services that they should be compensated for, there is no denying that. My beef is with the crazy compensation model that hides how much is really being taken from investors that don’t really know they are being taken advantage of. Instead, I would claim that every investor out there would be much better served by going to an adviser that charged an upfront fee in exchange for whatever specific service you needed help with, or a package of said services. Heck, I would obviously recommend getting educated for yourself and reading up on it for your own benefit! After all, no one cares about your money more than you do!
So at the end of the day, is there any argument out there that leads you to believe that using investment adviser-recommended mutual funds is worth the advice on other areas that they give you? Is there ever a circumstance where sacrificing hundreds of thousands of dollars in investment returns over your lifetime is worth “the other” advice (advice that has a huge range of expertise behind it I might add) that you receive. Can anyone present an argument that shows upfront fee-based advisers are not in a much better position to give you an unbiased plan for your money since they have no vested interest in recommending certain products?