Low-risk investors: Why sometimes even a modest fee can eat away at your returns

Norman Rothery is the value investor for Globe Investor's Strategy Lab. Follow his contributions here and view his model portfolio here.

Never ask your barber if you need a haircut. That's Warren Buffett's advice but it isn't primarily about money-grubbing hair cutters. He's pointing out that you should be mindful of the self-interest of others.

It's something clients of financial advisers should remember. After all, financial advice comes with both benefits and costs. In some cases, the costs overwhelm the benefits and not every adviser will say when they do.

Good financial advisers provide an array of services to their clients.

They'll develop an investment plan that includes asset allocation advice, security selection, and tax optimization. Continuing services include rebalancing and hand-holding during downturns.

They're also up-front about the fees they charge. In Canada, fees often come in the form of commissions or other fee arrangements based on the size of a client's portfolio.

However, in my experience there are a large number of investors who are unaware of how much they pay for financial advice. A few are even under the impression that they get the advice free. As a result, they have little ability to properly weigh the value of the services they're receiving against what they're paying. That's a dangerous situation to be in when one's life savings are on the line.

I was thinking about the cost-benefit tradeoff when examining the portfolio of a risk-averse investor. The investor was looking for reassurance that his adviser had put him into a low-risk portfolio.

The portfolio contained a mixture of bond funds and balanced funds.

Over all, about 67 per cent of it was in bonds and 33 per cent in stocks. That's a little on the aggressive side of conservative for my taste but not entirely out of line. After all, conservative investors should put a small amount of their money into stocks – provided they can hold them through thick and thin – in an effort to boost long-term returns.

But the cost-benefit issue becomes significant when dealing with a bond-heavy portfolio because investment-grade bonds yield very little at the moment. Even a modest fee can really eat away at its returns.

Index investors solve the problem by gravitating to low-fee exchange-traded funds (ETFs) like those offered by Vanguard Canada. The firm provides exposure to the Canadian bond market through its Aggregate Bond ETF (VAB), Short-Term Bond ETF (VSB), and Short-Term Corporate Bond ETF (VSC), which have annual fees (MERs) of 0.19 per cent, 0.15 per cent, and 0.15 per cent respectively.

While the ETF fees are low, the yields they offer are also modest. The average yield to maturity for the Aggregate Bond ETF was only 1.9 per cent at the end of August, according to Vanguard. It was 1 per cent for the Short-Term Bond ETF and 1.7 per cent for the Short-Term Corporate Bond ETF.

You can get higher yields by taking on more risk. For instance, you might opt for bonds with longer terms to maturity or bonds with lower credit ratings. But conservative investors usually aren't keen on taking on a great deal of risk.

If you stick to a fairly conservative mix of Canadian bonds – like that offered by the Vanguard Aggregate Bond ETF – you'll likely get similar yields on a before-fee basis. Thing is, the average annual fee for the portfolio I was looking at was 2.1 per cent. Subtract the fee from the expected yield of 1.9 per cent and the investor might expect to lose about 0.6 per cent annually on the bonds. That's not much of an investment.

Alternatively, investors in similar circumstances might think about managing the fixed income side of their portfolios themselves. After all, most investors feel comfortable shopping around for GICs and a five-year GIC ladder provides a yield of about 1.5 per cent these days.

Those who are a little more experienced might opt for the Aggregate Bond ETF. Or they could let their advisers clip away at their portfolios.