What Clients Get Wrong About Their Financial Advisor
Most underestimate the true amount of fees they’re paying
With your financial life resembling a three-dimensional chess game — bills, retirement saving, sending kids to college — working with a financial advisor can be a very smart move.
What you pay for that help, unfortunately, can also be a bit of a challenge to figure out. A recent survey by State Street Global Advisors found that 60% of people working with an advisor believe the management cost of their investments (funds, exchange traded funds) is included in the fee charged by the advisor.
The hidden expense that adds up
Every mutual fund and exchange traded fund (ETF) you own, whether it’s in your 401(k) or an account your advisor manages directly, charges an annual fee known as the expense ratio. Expense ratios are hidden and never show up as a line-item expense on any investment statement. They are deducted from the raw performance of a fund or ETF; the return you see in your statement has been reduced by whatever expense ratio was charged.
The cheapest expense ratios can be less than 0.10% for index funds and ETFs, though for actively managed funds the norm is more than 0.60%.
When you’re working with an advisor who manages a portfolio for you that includes mutual funds or ETFs, you need to add the cost of those portfolios to what the advisor charges to land at the all-in fee.
All-in fees, all important
Many advisors who manage investment portfolios work on an “assets-under-management” arrangement with clients. According to the 2020 Inside Information Fee Survey, for clients with assets of $500,000, about three of four advisors charge at least 1%. That’s just for their services. If they use funds and ETFs, the underlying expense ratios are an additional fee clients pay — to the company managing the fund or ETF.
A few years ago the Inside Information Fee Survey reported that the average expense ratio for portfolios managed by advisors was an additional 0.50%. Given the encouraging trend toward lower-cost funds and ETFs, it’s likely that the expense ratio average for advisor-managed portfolios may be lower today.
The key is to know what your all-in fee is.
Less is definitely more for core funds
If your advisor is using mostly low-cost index mutual funds or ETFs, your average weighted expense ratio should likely be less than 0.25%. Plenty of U.S. stock index funds and ETFs charge less than 0.10%. International stock and bond funds might run a bit more.
If your advisor has you invested in funds and ETFs that charge more, that’s worth a conversation, if you are also paying the advisor an assets-under-management fee. If the portfolio is mostly actively managed funds, you need to make sure you’re on board with that approach.
Over long periods, very few actively managed funds consistently out-perform index funds, especially in the biggest (most popular) corners of the market.
For instance, the investment category known as large-cap blend includes portfolios that invest in the S&P 500 index. According to Morningstar, a mere 15% of actively managed large-cap funds managed to outperform large-cap index funds over the 15 years through 2020. The under-performance gap was 1.4 percentage points on average: 12.4% vs. 13.8%.
Expense ratios are likely to be an even more important factor in your investment success in the coming years, as many market pros expect the long-term returns for U.S. stocks to be much lower than what we have experienced for the past 10 years. One example: Based on current economic conditions, Vanguard estimates U.S. stocks might deliver in the range of 2.6% to 4.6% annualized over the next 10 years. For core U.S. bonds the expectation is a return no higher than 2.4%.
The value of professional portfolio advice
Once you know your all-in investment cost to work with an advisor who charges an assets-under-management fee, you can make an informed decision about whether you are getting value for that fee.
To be clear, paying even 1.5% a year in an all-in fee can be well worth it, if you feel strongly in your advisor’s approach, and it gives you the confidence to stick with a long-term plan. Studies also suggest that an advisor can help you avoid the costly psychological investing mistakes that can undermine success.
But if you learn you have a bunch of expensive, actively managed funds in market pockets where indexing is typically the more successful route, that should be a yellow flag.
Nor is the assets-under-management model the only way to pay managers. Especially when you have yet to build up a sizable investment portfolio (at least $1 million), working with an advisor who charges a flat monthly or quarterly fee or an hourly fee can be advantageous.
The bottom line is that professional advice can be a smart investment. But knowing your all-in fee is the only way to be sure you are in fact getting value for the expertise.
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