What Am I Paying For?

The long-term track record of active fund managers is not sufficient to justify the AUM fees that they charge.

Fees erode compounding. The average annual return of the S&P 500 market index over the last 50 years was 9.4%. Let’s put this in perspective. If we presume this same return for each of the next 40 years and invest $10,000 in an S&P 500 index fund today, our $10,000 would turn into $363,658. Our investment increased over 36-fold and all we had to do with it was nothing for 40 years. Now imagine we hire a financial advisor charging an assets under management (AUM) fee of 1% to manage the money. At the end of the 40 years, we look back and realize that they achieved the same average annual return as the market’s 9.4%. How has this impacted the value of our $10,000 after 40 years? What if the AUM fee is 2%?

Simply introducing a 1% AUM fee decreases the value of our investment after 40 years by over $100,000. If the fee is 2%, the value is more than cut in half. AUM fees directly counteract the power of compounding within your portfolio.

But what if your prospective financial advisor is telling you that they will beat the market return? You need to answer two questions:

QUESTION #1: How much does my advisor need to beat the market return by each year to justify their AUM fee?

QUESTION #2: Is it realistic to expect my advisor to beat the market return by this much over my investment horizon?

We will use a breakeven analysis to answer Question #1.

Sticking with our example from above where the market return is 9.4% annually, the dark green section of the graph shows how much a financial advisor must beat the market return percentage by (referred to as the portfolio “alpha”) to offset their AUM fee. The lower the AUM fee, the less they will need to beat the market by, but if they charge a 3% AUM fee, they would need to beat the market by 320 basis points just for you to break even on their AUM fee.

The more subjective question is whether this is realistic to expect, which is Question #2. There have been countless studies performed looking to answer this very question and they all have come to the same conclusion: NO.

Eugene F. Fama of Chicago Booth and Kenneth R. French?of Dartmouth College studied the performance of active fund managers to assess how professionals do in picking stocks and building out a portfolio. They found that most active fund managers do no better than we would expect by chance alone. From 1984 to 2006, the aggregate active fund beat the market by 10 basis points per year, a far cry from covering the 320 basis points required to cover a 3% AUM fee or even the 110 basis points required to cover a 1% AUM fee.

Going back to our example from above, if your financial advisor beats the market return by 10 basis points each year and you are paying a 1% AUM fee, your portfolio value will be $256,793 after 40 years ($106,865 less than if you elected not to hire a financial advisor and “settled” for the market return). Fama and French then dug deeper to determine whether this result is even statistically significant enough to conclude that the performance was anything but pure luck. By looking at what they refer to as the “true alpha” adjusted for the impact of luck, Fama and French concluded that the 10-basis point alpha cannot be attributed to anything other than luck. The top 3% of fund managers performed roughly well enough to cover their fees, but they did not add much value to investors beyond simply covering their fees. For every 100 financial advisors, you can expect approximately three of them to perform well enough long-term to cover the fees you pay based on their skill in picking stocks.

In short, a passive S&P 500 index fund is expected to achieve roughly the same annual return as the top three percent of active fund managers over long periods of time. It is important to remember that the variance from year-to-year is large, meaning that it should not be surprising to see a financial advisor that beats the market return in any given year, just like it should not be a surprise to see a financial advisor underperform the market significantly in a year. But the data is consistent, and the conclusion is clear when looking at long-term studies like that performed by Fama and French. The long-term track record of active fund managers is nowhere near sufficient to justify the AUM fees that we commonly see them charging. And the lack of evidence suggesting active fund managers can attribute their success to anything but luck begs the question whether it makes sense to pay a financial advisor an AUM fee at all.

Luckily my pessimism around the financial advising industry ends here because there are many ways that advisors can add value beyond just beating the market return year-in and year-out. The greatest asset that financial advisors possess is the ability to provide a neutral, third-party perspective on your toughest financial decisions. Advisors can bring expertise around tax strategy, risk management, retirement planning, estate planning, and many other areas that impact your financial wellbeing. The one commonality to all of these value-add activities: The size of your investment portfolio has nothing to do with any of them. Therefore, an AUM fee based on the size of your investment portfolio makes no sense to compensate a financial advisor for these activities. An AUM fee only makes sense if the advisor can consistently beat the market return by more than their fee amount. If this were the case, your interests would be aligned to grow your investment portfolio such that the advisor receives a higher fee amount. If they cannot do this, they are simply collecting fees for taking value away from your portfolio.

So what are the takeaways? If you currently have a financial advisor, look at their performance for the duration of time that you have been working with them. Use this formula to determine whether they are adding or taking away value from your portfolio each year:

Note that this should only include your long-term investments in stocks and should not include bonds or cash holdings. When you perform this analysis for all of the years that you have been working with your advisor, the overall return ought to be positive. If it is not, you should demand a change to the advisor’s fee structure immediately.

If you are considering a prospective advisor that charges an AUM fee, require them to show you their track record over the past ten years evidencing that they have consistently added value for their clients AFTER accounting for the fees they charge. The more years of data the better, but ten years should be the minimum to qualify them for further consideration. If they cannot provide this data or do not show a history of consistently adding value for their clients, kindly close the door.

But don’t be misled. I open up the possibility that advisors can justify their AUM fees, but at the end of the day I am a firm believer that AUM fees are not the right way to compensate financial advisors. As our economy continues to evolve, we are finding ways to better compensate where value is added. It is time for the financial advising industry to catch up.

For a more comprehensive example of how fees and taxes impact an investment portfolio, see my post from last week here. I plan to discuss alternative fee structures in a future post as we explore how to best compensate financial advisors in alignment with the ways that they add value for their clients.

I welcome any questions, comments, or alternative examples in the Comments section below. What have you experienced with your financial advisor?

Disclaimer: This content is for informational purposes only and should not be construed as investment or tax advice.

?Sources:

“Luck Versus Skill in the Cross-Section of Mutual Fund Returns.” Eugene F. Fama and Kenneth R. French.?Journal of Finance, October 2010.