Some recent comments by Warren Buffett should be mandatory reading for anyone who works with or plans to engage an investment adviser.
The investing world's voice of reason has a strikingly jaded view of people whose job it is to help others invest their money. In his recent annual letter to shareholders of the company he runs, Berkshire Hathaway Inc., Mr. Buffett said paying for expert help causes investors "to earn only 80 per cent or so of what they would earn if they just sat still and listened to no one."
Call this a roundabout endorsement of index investing, where you buy mutual funds or, better, exchange-traded funds that make virtually the same returns as major stock and bond indexes. The ongoing fees associated with owning ETFs are much lower than mutual funds because, unlike mutual funds, there are no built-in costs to pay investment advisers.
But let's say you're the sort of investor who wants and needs an adviser, even while you're sympathetic to Mr. Buffett's view on how you can make more money just sitting still and listening to no one. Can you get both advice and index investing in the same package?
Yes, you can. Should you take advantage? Unless you have an account in the high end of six figures or more, probably not.
A persuasive case can be made that indexing as carried out with ETFs is an ideal strategy for do-it-yourself investors. By tracking the major indexes and avoiding the advice costs folded into mutual funds, it's possible to make returns that compare favourably with most mutual funds.
But the appeal of indexing is diminished, if not nullified, when the cost of advice is added in.
Advisers who use indexing generally work on a fee-based system, where the client pays a preset percentage of his or her assets every year. The percentage might typically start at 2 per cent for small accounts around the $100,000 mark and fall to 1 per cent or less for people with $1-million and more.
Making what the indexes make minus one percentage point is a reasonable proposition. But subtracting two percentage points from index returns may cut too deep.
The logic of indexing is that you can make a better return from a fund or ETF tracking a major stock or bond index than you can from the average fund. Take the Canadian equity fund category, for example. The annual average fund return for the 10 years to Feb. 28 was 9.6 per cent, while the S&P/TSX total return index made 10.9 per cent.
A major reason why funds tend to underperform the index on average is the embedded cost of advice. The average Canadian equity fund management expense ratio is 2.83 per cent and about one percentage point of that is accounted for by fees and commissions paid to investment advisers by fund companies for their work with clients.
ETFs have ownerships fees, too. But their MERs are so much lower that funds still have trouble competing. For example, the MERs for Canadian stock market ETFs are as low as 0.17 to 0.25 per cent. Subtract 0.25 percentage points from the index return of 10.9 per cent and you end up with 10.65 per cent, still a full percentage point higher than the average mutual fund.
Here, you see why indexing can make sense for do-it-yourself investors. What these investors save on advice goes directly to their bottom line.
One of the best things about combining advice and indexing is the transparency of the fees you're paying your adviser. To know exactly how much you're paying for advice, just combine this asset-based fee with the MERs of the ETFs your adviser uses.
