Advisors generally do a good job in helping their clients make smart decisions with their money. Most try to help clients obtain a meaningful understanding of capital markets. Most try to make reasonably suitable recommendations. These advisors will diversify between equity and income, value and growth, small cap, large cap and a number of other ways, too.
What I see less of though is a diversification between active and passive products and strategies. This, of course, could be an all or nothing proposition or a mix and match (core and satellite) combination.
Most financial advisors recommend an all active approach all the time. These same advisors insist they have no bias at all and that they go out of their way to help their clients make informed decisions about the products and strategies being pursued.
I beg to differ.
My sense is there are advisors who are deliberately silent on the matter of cost impacts when discussing options with their clients.
Here’s a simple example. Why not show clients both options? Don’t direct them one way or another to start. Simply explain that both options are on the table and that over the course of their lifetime, both would likely be reasonable depictions of their overall investment experience.
For anyone who wants a credible bit of background and rationale regarding what follows, please read William F. Sharpe’s “The Arithmetic of Active Management”. If you can’t locate a copy, you can get it here.
Sharpe’s paper provides a simple way of combining the notions of risk, return and cost. It shows that both historically and logically, an average investor’s expected return is the return of the asset class minus the cost of the product used to get exposure to that asset class- plus or minus a degree of variance.
In my illustrations, Option A features a 9.5% average expected return with a relatively modest variance (tracking error), while Option B features an 8.5% average expected return, but with a fair bit of additional variance (positive or negative “alpha”).
Since the differences are due to product cost and the likely dispersion of returns, we’re left with Option A hugging a benchmark minus a lower cost, +/- a tracking error and Option B costing more and having a greater variance of possible return outcomes due to security selection.
One would reasonably expect modest tracking error for the passive option and a much higher variance for the active option. If markets return 10% and the passive option costs 0.5%, while the active one (featuring no advisor compensation) costs 1.5%, then the long-term difference is 1% per annum- forever.
Is it worth a certain 1% cost increase if that choice is most likely to involve a similar reduction in long term returns with a wider dispersion of outcomes? Remember that for every person on the right side of the centre line in either option, there’s another on the left side. There are pros and cons to both approaches, but which option is a typical investor more likely to choose if asked? Both options have a constituency.
Considering the choices available according to Sharpe’s paper, investors should clearly understand their two options. Here’s a value proposition that you may wish to consider taking to them. Ask “If I could show you how to save tens or even hundreds of thousands of dollars over the course of your lifetime by simply replacing your current investment products with products that have a similar expected pre-cost risk and return profile, but which cost 1% less and have less expected volatility, is that something that would interest you”?
All I know is that every time I ask that question, I get a resounding…Yes.
In fact, the only people I’ve ever met who don’t give such a response are the people who would never asked the question in the first place.