The
12-Step Program
IFA President Mark Hebner's comprehensive overview of the pitfalls
of active management and the superior returns of risk-appropriate
Index Portfolios.
Learn more about the company that implements Nobel-Prize winning
strategies to deliver risk-optimized returns to more than 1,000
clients with over $1 billion under management.
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 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.
There ain't no free lunch -- 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.
