1. Not All DFA Advisors Provide the Same Advice, and Bad Advice can Easily Wipe out Years of Fee Savings.

Since advisors are paid to provide advice, an investor's job is to determine who will provide the best advice in the future.  IFA believes that the honor of advising clients must be earned by the quality and quantity of information provided at the beginning of the evaluation process. The better the information and the resulting education, the more likely an advisor will provide the highest level of advice in the future.  After all, the best way to learn is to teach.

Many investors believe that all DFA advisors will give equal quality advice, have an equal understanding of the principles and strategies of Dimensional Fund Advisors, and will provide equal reporting and service in the future even though they have different fee schedules. They assume that they can have a free lunch.

Investors should carefully consider their decision as to whom they select to manage their life savings, because not all DFA advisors provide equal expected returns net of all fees, portfolio risk and advisor risk. Entrusting your hard-earned money to the lowest bidder involves additional risks. There is a fair price for quality advice.

2. Case In Point #1:

The following is a recap of a phone conversation that occurred on November 20, 2009 between an IFA advisor and the individual referenced in this case.

Bad advice can be very expensive! A wealthy gentleman was about to invest with IFA when he came across the web site for a cheap advisor.  Basing his investment decision solely on the difference of fees, he signed up with the cheap advisor.

The client had recently received roughly $20 million from the sale of his business. On March 3, 2009, when the DJIA was at 6,764, he instructed the advisor to invest his $20 million in a portfolio of DFA funds. He had heard that Warren Buffett had said that investors should be fearful when others are greedy, and be greedy when others are fearful. Being fearful, the cheap advisor refused to invest the funds.  His advice was to wait until the time when the advisor believed the markets had "leveled out." The advisor told the client he had many years of experience and that the client should "trust his judgment". After a long slide, the market hit the bottom 3 days later. It seems likely that this was not the only client that received this advice, but we cannot be sure.

The rock-bottom-fee advisor never did feel it was the right time to invest, putting him squarely in the category of a market timer. The client stayed in cash, and as he calculated, missed out on a $9 million increase in his portfolio value. Once he computed his 45% lost opportunity, he decided to fire the cheap advisor. The client's mishap is roughly equal to 200 years of his annual fee savings. Investor returns often vary widely from fund returns, primarily due to unwise investor behavior. Good passive advisors are supposed to prevent this behavioral finance faux pas, not encourage it. Not all advice is the same.

 

3. Case In Point #2:

The following exchange between a low-cost advisor and his client revealed the high costs of poor advice. The client eventually stated that "he would not stay there, even if it were free."

An Actual Email From the Client of a Low-Cost Advisor
(Dated Feb. 1, 2005):

..."I need more than a few sentences in terms of reporting and analysis of each quarter's activity. .. Your bearish sentiment about the US economy has led to a market-timing strategy that's hard to reconcile with my belief in passive index investing. I realize that you were trying to protect me by recommending an extremely defensive allocation of 30 [stock]/70 [fixed income]. Several IA's [Investment Advisors] have made the point that my modest equity allocation has cost me well over $1 million of lost opportunity. This is terribly frustrating since, as you know, big upward moves come in a relatively small number of days and if you're not in the market, you miss out on them." ... Perhaps your worst fears about the economy will come to pass and I'll regret having a larger equity allocation."

The Low-Cost Advisor's Email Response
(Dated Feb. 2, 2005):

"You're betting against some of the brightest and richest minds in the business, Buffet, Templeton, Gross, Grantham, Roach.  The weakness of the DFA models is the assumption that the numbers are constants; they are not. [DFA has never made such claims.*] LTCM's [Long Term Capital Management's*] 1998 blow-up illustrated that similar models [to those of DFA] can completely fail; one of their [LTCM] Nobels is on DFA's board. I've made a difficult decision. I'm not going to tell clients the risk anymore because it's not good for my business... I'll just give them the DFA numbers and tell them there's no guarantee of a repeat but that's the best we have, so don't underweight equities.  It's not my money." * added comments

 

4. What Happened?

This cheap advisor appeared to be bearish on future stock returns and questioned DFA’s model for capturing the returns of globally diversified capitalism. This type of sentiment runs counter to the basic ideas behind investing in DFA funds in the first place. DFA’s principles articulate that no one can forecast short term market returns. From the time of this email in February 2005 to August 2006, the S&P 500 was up 10.36%, virtually same return as its 80 year annualized average of 10.27% for the period ending Dec. 2006. Bad advice can be very costly.

This an exact quote from a cheap advisor's web page titled "ASSET ALLOCATION FOR BEARS" which indicates a lack of understanding about market timing and index investing. "We cannot know that a long-term secular bear market is in place until we're well into it. In late 2002 I wrote that we might be enmeshed in the worst bear market since the 1930's. It had all the characteristics of a long-term secular bear market. Percentage declines on the major indexes were the worst since the Great Depression."

Comments like these prove a lack of understanding of equity markets, especially since the IFA Index Portfolio 100 was up 48.75% in 2003. The clients of this low-cost advisor probably missed out on most of that return.

5. What is the Cost of Bad Advice?

A great example of how expensive bad advice can be comes from the returns of different index portfolios in 2003. If an advisor had not properly advised clients on their correct risk level and put them in an index portfolio equivalent portfolio to IFA Index Portfolio 30, they would have earned an 18.89% return. If the client had a risk capacity of 60 and had invested in a more appropriate Index Portfolio 60, they would have earned 32.01%, a 13.12% difference. A low cost advisor cannot lower his fee enough to make up for bad advice. The client from the above email had a $7 Million portfolio, and ended up with a $924,000 gap in one year of returns between good advice and cheap advice.

A second example of bad of advice is that a cheap advisor got himself, and some of his clients, into auction rate securities. As he stated, "Markets froze as Merrill Lynch refused to back the assets. It taught me once again that Wall Street is not on the investor's side." [ A little late to figure that out. ]

A knowledgeable advisor would have avoided auction rate securities in the first place. Any fee savings can easily wiped out for many years by a loss like this.

A third example of bad advice that came from a low cost advisor's description of their "Best Call" being the "buying of commodities and gold for a four years." Kenneth French and Truman Clark of DFA and Vanguard founder, John Bogle, have stated that commodities do not add value to portfolios. Their research and discussion can be found HERE. This error alone could wipe out any of the fee savings from a low cost advisor.

A fourth example of bad advice comes from a low cost advisors "Most admired investor of businessman" choices. He choose George Soros and Warren Buffett. Neither name indicates that this advisor has a good understanding of efficient markets and the randomness of stock market returns. Heroes in this category should be those academics that participated in the creation of Modern Portfolio Theory.

A fifth opinion IFA does not agree with is the position on Tax Loss Harvesting. On the website of one cheap advisor, the advisor disparages the value of tax loss harvesting, claiming that it offers no real value because all it accomplishes is resetting the cost basis to a lower level, meaning that taxes will ultimately be paid, and perhaps even at a higher tax rate. Of course, this ignores the possibility of an investor holding his equity positions for the remainder of his life, wherein he can benefit from the realized losses while his heirs receive a step-up in cost basis upon his death.

Furthermore, IFA encourages loss harvesting due to the possibility of using the losses from one asset class to offset gains in another asset class. For example, in 2007, REITs were down 18.7% while emerging markets were up 36.0%. Simple rebalancing would have incurred full capital gains costs in emerging markets, while tax loss harvesting would have allowed at least part of this cost to be offset.

IFA’s position is that harvested losses provide a real value to investors, even if it is only postponement of tax payments, simply due to the time value of money. Furthermore, IFA does not speculate on the future direction of tax rates.
Since tax loss harvesting can involve a complex set of trades, one can understand why most advisors would not want to subject themselves to the risk of something going awry with the trades where they would have to cover the cost in order to make the client whole. Certain cheap advisors state they will perform tax loss harvesting but only if the client requests it. IFA, on the other hand, proactively offers it to all clients for whom it makes sense. However, IFA will not perform tax loss harvest trades without the client’s explicit consent.

So, it is good to remember that bad advice can be very expensive and there ain't no such thing as a free lunch (TANSTAAFL) -- even amongst DFA advisors.

It's Unwise to pay too much… But it's worse to pay too little.  When you pay too much, you lose a little money - that is all.  When you pay too little, you sometimes lose [a lot, or even] everything, because the thing you bought was incapable of doing the thing it was bought to do.  The common law of business balance prohibits paying a little and getting a lot - - it can't be done.  If you deal with the lowest bidder, it is well to add something [to the bid] for the risk you run. [In other words, the increased risk is equal to a higher cost, that is not recognized in the price.*] And if you do that [add the risk of not getting what you should to the price*], you will have enough to pay for something better. - John Ruskin (1819-1900) *added comments

6. The Value of Paying the Right Price for Advice and Service

Before you make a decision about using any advisor, you should CAREFULLY investigate the differences between fees charged and services provided. It is unwise to pay too much, but there are potential hazards for paying too little.

IFA knows that clients expect plenty for the fees they pay. Value-added benefits for a fair fee of about 1% for the first $500,000 and a tiered discount on larger assets under management should include a well-run office space with a professional and qualified staff that will:

• efficiently execute and maintain the integrity of risk-appropriate investing, incorporating the sound research behind the Fama/French models
• ensure timely, accurate buys, rebalances, account monitoring, and reporting
• maintain sufficient errors and omissions insurance to protect your assets

You get what you pay for with IFA and other fairly-priced DFA-approved advisors. In the end, clients of “cheap” advisors will most likely pay dearly for the advisors’ underestimating the costs of properly operating their business.

 

7. Do Your Research:

A previous bank president with a $4 million account was considering obtaining advice from a cheap advisor, but thought he should visit the advisor's office first. After arriving at the advisor’s home, he was so concerned about the setting that he decided forgo the cheap route and pay a fair price for his advice.

If low cost advisors don't have a "real" office, they may skimp on other essentials such as proper security, quality software, computer backups, E&O (Errors and Omissions) insurance, written policies and procedures, and other important features that indicate a commitment of a "real" business instead of an experiment. IFA has 12 advisors serving the needs of clients, along with an additional staff to assist in prompt customer service, trading, opening of accounts and money transfers.  Don't ASSUME that you won't have problems if you don't have that support. Despite what they may tell you, errors happen, and just one could make up several years of advisor fees. Schwab has a Trade Error Department whose only job is to correct and bill investment advisors for such errors.


8. Do They Think They're Smarter Than DFA?

Many advisors like to put a "spin" on the DFA approach. They attempt to convince investors that they "have a better solution" than DFA with strategies like "market timing" or fund substitutions. Such strategies should be skeptically analyzed, with insistence on proof that they actually benefit investors.

Index Funds Advisors employs a "pure" approach that follows DFA strategies without attempting to do it better than Fama and French. We try to educate our clients and prospects and provide a solid platform for successful investing. Our extensive web site and President Mark Hebner's book prove our understanding of how capital markets work. Therefore, IFA may be considered your minimum or zero risk advisor.

The stock market has plenty of risk to manage on its own. Think twice before adding a additional layers to your portfolio in the form of higher "investment advisor risk."

In summary, investors must determine an overall risk budget, which includes the risk allocated to an investment advisor and the risk allocated to their index portfolio. A client of a cheap or low-cost DFA advisor should lower the risk exposure of their index portfolio by at least 15 points out of 100 on the IFA risk exposure scale, adjusting downward for the additional risk of a low-cost advisor, for example, from an IFA Portfolio 75 to a 60. This will compare to the total risk exposure of an IFA client with minimal or zero advisor risk. Doing that results in a 1.1% lower expected return from the cheap advisor portfolio, plus whatever fee savings. This hasn't looked like a good deal over the last 50 years, according to annualized returns up to 2007. Since the IFA maximum fee is about 0.225%/quarter, or 0.9% annually, you cannot lower the fee enough to make up for the difference.

Does a lower fee exceed the 1.1% reduction in expected return of a risk reduced index portfolio? Is there really a savings?

Research has shown that there are risks that are actually uncompensated, like concentration risk. The additional risk of lower-quality investment advice actually increases the standard deviation (range of outcomes) of your expected returns and lowers its average. Is there really a free lunch?

If price was the only thing that mattered, we would all be driving Yugos.

 

To learn more about Index Funds Advisors and a Fair Price for Advice, visit ifa.com.

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