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Start Here: “The Ultimate Guide to Personal Finance”

Be the Expert: What would you tell this novice investor?

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If there is one thing that drives me crazy, it’s “experts” who make a quick buck off of ignorant people by recommending products that are NOT in their best interest.

One of my readers, Matt, recently emailed me for advice about applying the suggestions in my book. He was considering switching his mutual funds to index funds and asked what his financial adviser thought.

Here was her response:

Hi Matt – All mutual funds have expense ratios (fees) to cover transaction costs, statements, research, prospectus, etc.  While index funds typically have lower expenses than a managed fund, you are in effect only buying an index.  You have no one selecting the holdings for the fund, nor is there anyone who makes the decision to sell a stock that is dropping.

For example, in 2008, as banks stocks were dropping rapidly, if they were a part of an index like the S & P 500, they were still held by the fund,  while a  manager of a fund could lower the funds exposure to this sector, thus attempting to limit the downside risk to the portfolio.  Additionally, a fund manager researches and finds companies that could represent an excellent value or a stock that has strong potential growth prospects and add it to the portfolio.  An index fund does not do this.  They add a stock when the stock is added to the index itself.

Please let me know if you would like to discuss further.

What do you think? What would you recommend Matt do?

Note: Let’s be constructive. It would be easy to rip this adviser a new one. But what should Matt do?

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89 Comments

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  1. Ripping the adviser is irresponsible, we don’t have enough context.

    We need his original e-mail to his adviser to know why she would respond in that way. Did he ask “Why would I choose a manged fund over an index fund?” Her response could be valid based on the questions she was responding to. Or did he ask “What is the best type of fund available?”

    We also need to know his goals. Is he looking for higher risk and reward than an index fund can offer?

    I would suggest that he define his goals. From there you can research which combination of investments are most likely to meet his goals.

  2. My first thought is to check the accuracy of what the adviser is saying. What mutual funds was she advising in 2008-2009? Go to google finance and compare the selected funds to one of the low cost index funds championed by Ramit. Maybe she is truly a rockstar and recommends funds that consistently outperform the indexes.

    More likely, the situation she describes did not occur, and the managed fund did just as bad or worse than simply holding an index fund due to the additional management fees. Either way, take a look at the data so you can make an objective decision on the value of managed mutual funds versus index funds.

    • So I just went ahead and did a quick comparison and the results surprised me. I looked at a balanced mutual fund with an expense ratio of 1.42%, American Funds American Balanced C (BALCX).

      I compared this to a lower cost index fund by vanguard in the same morningstar style category (large blend). Vanguard Target Retirement 2045 Inv (VTIVX). This fund carries and expense ratio of just 0.19%. This fund is an example of the type of fund that Ramit recommends, and is one of my personal holdings.

      Looking at a comparison of both of the funds I was surprised to see the higher cost mutual fund outperformed the vanguard index fund in the past 1yr and 5yr time periods and performed nearly identically in the past 3yr time period, despite higher management fees. Link to Google Finance – http://goo.gl/GQAFn

      So maybe there is some truth to what his adviser is saying.

    • Paul E: lots of managed funds beat indexes in 1 or 3 or 5 years. Once you get over 10 is where the indexes tend to start winning, and over 20 almost no managed funds beat the indexes. At least part of the reason is the higher fees compound over larger periods of time negate any short-term wins.

  3. I would make the switch to index funds, and a strategy that does not attempt to outsmart the market or predict the future (I use an ETF version of Harry Browne’s Permanent Portfolio strategy, but there are several good strategies out there).

    Past results are not a guarantee of future performance, but he could ask her which funds she recommends, and ask what his balance would be vs. an S&P 500 index fund, both historically and specifically during the 2008 crisis. I don’t get the sense that actively-managed funds did much better than the index; most probably did worse. By specifying what his balance would be, that should take into account the effect of a higher expense ratio.

    Since multiple studies say that over the long-term, index funds outperform actively-managed funds, he could also ask why it would be good for him to make less money from his investments.

    I figure the answers to those two questions would pretty much seal the deal.

  4. If what his financial adviser recommends interests him, I’d suggest he should invest in a mutual fund with the guidance of his adviser. Together they can select a fund manager(s) that he feels will provide returns that will match his appetite for risk.

    However, Matt should be buying something like, SPY, where his expense ratio is far lower than a mutual fund. He can replicate the gains (losses) of the index, thus earning (losing) what the market is earning (losing). Over the long run, his average yearly compounded gains will be between 5 and 10 percent, or historically 8%.

    Matt should ask, how his adviser makes money. If she fails to address that she is compensated by selling mutual funds (most are), then Matt needs to run for the hills. If she does disclose this, Matt should consider a fee only adviser that can provide unbiased advice.

    He should also give a quick check to this website I found: https://www.futureadvisor.com/

    It will recommend low cost ETFs that will create a diversified portfolio based on his risk tolerance, time to retirement, etc.

  5. Don’t buy managed funds. The “experts” are *rarely* able to beat the index funds anyway. Get a lifecycle fund with the correct target retirement date for you. It will be automatically reallocated to become more conservative as you near that date. Plus, it maintains a certain percentage of each type of asset no matter what: if one chunk of the pie becomes too big, the fund will sell part it off and buy something of the types that are lacking.

    Net effect is that you get index-average returns, don’t have to micromanage your portfolio, and don’t have to pay someone else to micromanage your portfolio for you (and fail miserably the majority of the time). Just set up an automatic transfer from your bank account or direct deposit, and you’ll never even miss it.

    Your adviser may receive a commission on these products, and therefore may have a conflict of interests. If she doesn’t work for a fee from you, this is *definitely* the case. Approach with caution.

  6. From her response alone, I assume he either asked specifically about ETFs or that she works for a particular fund company w a vested interest. Where does she stand on managed index mutual funds? Is she pointing to a specific time period because she wants to sell him on the idea of managed funds or because he’s looking into investments for the short-term (vs. say in a retire accnt)?

    At any rate, who says you have to buy just one index fund. Her justification of “in effect only buying an index” assumes Matt will only be selecting a single fund. He’s read Ramit’s book, why would he ever do that?

  7. This is really a debate between passive vs. active investing. Taking a buy and hold approach with index funds and/or traditional mutual funds is how I would define passive investing, and by doing a little research you create an allocation yourself and don’t really need the services of a financial advisor. You can take the same approach with mutual funds that are managed by a portfolio manager, which in most cases is also taking a buy and hold approach within the mutual fund. Again, you can simply do a little research and buy and hold a portfolio of mutual funds. I consider this to be a passive strategy as well. The only major difference between these two approaches is the fees associated with purchasing index funds which tend to be much lower than traditional mutual funds. The latter approach is where you may seek the services of an advisor that can help in selecting good money managers that manage these mutual funds. The idea being that these “managed” mutual funds can perform better than a comparable index or index fund. The challege that the individual investor faces is finding an advisor that has the client’s best interest in mind and can do a good job of researching successful money managers over the long term. Very difficult to do as not all advisors (even within the same firm) are created equal.

  8. I would ask for an example of a mutual fund that beat the SPY index during 2008. I’m guessing she doesn’t know of one, it was just an example she was making. Always ask for data. And, if you have an index like the S&P 500, a stock that’s tanking falls out of it when it’s no longer in the 500.

    Matt, you essentially asked someone selling SUV’s if they think a Prius is a good idea. Of course she’s going to be against them. She doesn’t make money off of a Prius, she makes it off of an SUV. (Don’t prefer either actual vehicle, just best analogy I could think of, guys usually understand car analogies ;))

    My advice would be to read the Intelligent Asset Allocator book (or a review where they tell you the cliff notes) and then pick your ETF’s.

  9. Why not use both? Index funds and actively managed funds both have a place in a portfolio.

  10. I have been a financial adviser for 6 years. Here is my industry’s dirty little secret: Over 80% of actively managed mutual funds under-perform their benchmark after adjusting for fees/commissions and we all know it! Financial advisers put clients’ money in them because they pay us and mutual fund wholesalers provide us extra money/support to grow our businesses.

    But guess who performs much worse than these mutual fund managers? The average investor! Emotions tend to make the average person buy high and sell low.

    Financial advisers can add value buy helping individuals control the fear/greed emotions that lead to bad decisions. We also add value by offering other services (ex. financial/retirement/estate planning) that many are not directly compensated for.

    Matt needs to make sure he is receiving enough added value from the adviser to justify the fees/under-performance.

    • If you really need a financial adviser, use a fee-only adviser who has a fiduciary duty to look out for his clients best interests. These advisers almost always use low cost index funds and charge the client a percentage of invested money or a flat yearly fee.
      Another option is The Garrett Financial Planning Network. This is good for those with low account balances.
      My favorite and lowest cost method is to use the collective wisdom of The Bogleheads (http://www.bogleheads.org/)

    • I agree with what Kirk said. However, it is difficult to say what the purpose of the money is from the investor to switch to index funds. I am proponent for index funds. Financial advisors do make a percentage off the assets they gather assuming they are licensed accordingly.

      And the average investor does make their decisions based on emotions which is a losing stratedgy. They don’t realize it but they are timing the market.

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