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Make portfolio-building a priority to justify investment adviser fees

The study by four finance professors from universities in Canada and the U.S. found that actively advised investors have a much higher exposure to stocks, which, in theory at least, may be a good thing.


A new study says investment advice isn't worth the cost.

So, make sure that financial planning is part of the relationship you have with your adviser as well as portfolio-building with funds or stocks. "We conclude that, for the average investor, investment advice alone does not justify the fees paid to advisers," a team of four finance professors from universities in Canada and the United States say in a paper titled Retail Financial Advice: Does One Size Fit All? (read the study here).

The financial industry makes billions of dollars in revenue from charging fees and commissions to manage your money and it's keen to polish the image of advisers wherever possible. That's the story behind a series of reports that argue people are financially better off when they have an adviser. The most recent one, issued a few months ago, said increased use of advisers would grow the economy and ease concerns about insufficient retirement savings (read my comments about it here).

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The new retail financial advice study received funding from some mutual fund companies but this was not another round of Bay Street back-patting. According to Stephen Foerster, a co-author and professor of finance at the University of Western Ontario's Ivey Business School, the fund companies wanted to better understand how advisers do their work. Moreover, the companies were told the results couldn't be counted on to make them look good.

"We were very clear: Whatever we find, we find," Prof. Foerster said. "Our intent was to enhance the academic knowledge."

As it turned out, the study's findings should be a jolt to advisers who are investment jockeys. The economics of paying an adviser just to pick investments don't seem to work very well.

Adviser-bashers inevitably will use the study to support their view that money spent on advice is money wasted. But that's not actually the message here. Rather, it's that there needs to be more to client-adviser relationships than a focus on what investments to buy and sell.

Now is an ideal time for this discussion because securities regulators are considering a ban on the mutual fund industry's practice of burying compensation to advisers in the cost of owning funds. Investors would still pay fees on their investments, but the cost of advice would be broken out and paid directly to advisers and their firms. The retail financial advice study highlights where investors should look for value in fees paid to an adviser – much more in financial planning than investment selection.

At the heart of the study is a finding that shows the power of advisers to alter the behaviour of their clients. Prof. Foerster and his co-authors (Juhani Linnainmaa of the University of Chicago, Brian Melzer of Northwestern University and Ivey's Alessandro Previtero) found that people who have an adviser tend to invest more aggressively than those without.

The study calculates that having an adviser leads investors to have an estimated 30 percentage points more exposure to stocks. So while you might have 20 per cent exposure to stocks investing on your own, an adviser might design a portfolio with a 50-50 mix of stocks and bonds.

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The cynical argument here is that advised investors are being herded into equity funds because they pay advisers more than bond and money market funds. But Prof. Foerster sees the more aggressive stance taken by advisers as a good thing. "The evidence shows that, long term, equities do provide higher returns than other asset classes such as Treasury bills or bonds."

Here's why this is important: At a time when the country's financial readiness to retire is being questioned, stock market growth becomes an important factor in maximizing returns from whatever money we are managing to invest. In theory, then, advisers are adding value.

The problem with higher stock market exposure is that advisers don't seem to be doing enough work to customize it to client needs. In fact, the study found that the amount of risk taken by advisers in their own portfolios strongly predicts how much risk their clients have taken on.

This finding highlights a real strength of the retail financial advice study – it's based on real-life data for both investors and their advisers from 1999 to 2012. Prof. Foerster said the bulk of the study drew upon data drawn from roughly 581,000 investor accounts at the three mutual fund companies that initiated the study, and the personal accounts of thousands of advisers. "They provided us with what I think is unprecedented access to detailed data. We're not aware of anyone else who has had such detailed access to transactional data for a long period of time for both advisers and clients."

Advisers do some good for clients by getting them to invest more money in the stock market, but the strategizing that goes into the process can be haphazard. It's a package that doesn't add up when the cost to investors is considered.

The study says investors with advisers who deal in mutual funds pay average fees of 2.7 per cent for advice (including the management costs for investments and any upfront sales commissions). Where things get interesting is in the comparison of this fee to the benefits of having more money in stocks.

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Stocks have the potential to fall hard, but they offer superior long-term returns than bonds. This performance advantage is called the equity premium and, in the study, it's estimated at 6 per cent. If this premium is multiplied by the extra 30 percentage points of stock market exposure in the portfolios of clients with advisers, then we can say that advised investors should have returns that are 1.8 per cent higher than DIY investors.

Unfortunately, that return bonus goes to the adviser, not the investor. The study reasons that investors who don't want advice could build a portfolio with an all-in fee of 1 per cent. Subtract that 1 per cent from the 2.7-per-cent cost of advice and you're left with 1.7 per cent, which is pretty much your equity premium.

"The good news is that advisers are putting people in riskier assets that, long term, should have a higher expected return," Prof. Foerster said. "However, it appears that a lot of the benefits then would be eaten up by the additional costs."

His advice for advisers: Put more work into customizing portfolios for clients so they get better value for their fees. For clients, demand customized work rather than off-the-rack portfolios. "Make sure that your adviser understands your particular situation, where you are in your life cycle, and tailors a portfolio specific to your needs."

Globe app users click here for a profile of investors and advisers

Investors and Advisers: A Profile

Here are some details on the investors and advisers whose account data was used in a study on the value of investment advice by four finance professors at North American universities.

The Investors:

Their risk tolerance
Very low 4.20%
Low 4.30%
Low to moderate 8.50%
Moderate 51.50%
Moderate to high 19.70%
High 11.90%
Their investing time horizon
1–3 years 3.20%
4–5 years 9.40%
6–9 years 68.00%
10+ years 19.50%
Their financial knowledge
Low 42.80%
Moderate 51.40%
High 5.80%
Their net worth
Under $35k 4.90%
$35-60k 7.60%
$60-100k 10.30%
$100-200k 18.50%
Over $200k 58.80%

The Advisers

Gender - female/male26%/74%
Age51 years
Tenure4.4 years
Number of clients74
Number of accounts/client1.7
Number of funds/client4
Assets under advice, $K5,064
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About the Author
Personal Finance Columnist

Rob Carrick has been writing about personal finance, business and economics for close to 20 years. He joined The Globe and Mail in late 1996 as an investment reporter and has been personal finance columnist since November 1998. Rob's personal finance columns appear in The Globe on Tuesday and Thursday, and his Portfolio Strategy column for investors appears on Saturday. More


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