Owen Smith knows that breaking up is hard to do. But it’s time to dump his financial advisor. I’ll call him Peter. Three years ago, Peter said he could build a portfolio of actively managed mutual funds that would beat their benchmark indexes. It’s a silly claim to make.
Finding funds that have done well in the past is easy. It’s like looking up which golfers have won the last ten U.S. Opens. To pick future winners, you need a working crystal ball. But Peter could do it. At least, that’s what he said. In his valiant quest, he stuffed Owen’s portfolio with yesterday’s winners.
He should have built a portfolio of index funds instead. Here’s why.
Twice a year, S&P Dow Jones Indices publishes The Persistance Scorecard. This research consistently shows that funds with strong track records rarely keep winning. Their 2014 scorecard evaluated 687 U.S. mutual funds that were in the top quartile of performers as of March 2012. By the end of March 2014, just 3.78 percent of the funds managed to remain in the top 25 percent.
Just 1.90 per cent of the large-cap funds, 3.16 per cent of the mid-cap funds and 4.11 percent of the small-cap funds remained among the top quartile. Staying at the top of the money manager heap is a really long-odds proposition.
Last week, Owen emailed Peter to ask how his funds were doing. Peter lied. “Virtually all of your funds have handily beaten their underlying benchmark
I checked Owen’s fund performances. In the three years since Owen bought them, they trail their benchmark indexes, on average, by 3.54 percent per year.
I'm not surprised that Peter lied. Advisors can earn strong commissions and trailer fees from actively managed funds. These help to make Mercedes payments. Those selling index funds might have to settle for Mazdas.
Harvard economist Sendhil Mullainathan, Markus Noeth of the University of Hamburg and Antoinette Schoar of the MIT Sloan School of Management published a study, The Market For Financial Advice.
They hired actors to approach financial advisors with a fictitious $500,000 portfolio. In some cases, the portfolios were made with low-cost index funds. The researchers wanted to see what kind of advice the advisors would give. Over a five month period, the actors made nearly 300 visits to financial advisors in the Boston area.
When shown a portfolio of index funds, most turned up their noses. Eighty five percent said actively managed funds were better. As Upton Sinclair said long ago, “It is difficult to get a man to understand something, when his salary depends on his not understanding it.”
Richard A. Ferri and Alex C. Benke did a study for their white paper, A Case For Index Fund Portfolios. Between 1997 and 2012, they found that portfolios made up of 1 actively managed fund per asset class stood an 82.9 percent chance of losing to a portfolio of index funds. Portfolios with 3 actively managed funds per asset class had a 91 percent chance of underperforming. This study was done using funds available to Americans. Investors in other countries pay higher fees. This means their odds of beating the market are even worse.
Most advisors have seen similar studies. Are they bad people for choosing less effective products—and lying about them? Perhaps not. Studies show that money can make a good person, well…less good.
In 2006, Kathleen D. Vohs published a study called The Psychological Consequences of Money. It showed that money makes us selfish. Subjects played the board game, Monopoly, with an experimenter who posed as a subject. When the game was over, the board was put away. In some cases, a large stack of Monopoly money was left on the table. In other cases, a small stack or no money remained.
At this point, somebody walked into the room and dropped a box of pencils. It was a staged experiment to see if the subjects would help to pick them up. The subjects with a large sum of Monopoly money on the table picked up the fewest number of pencils.
During another test, an experimenter pretended to have a tough time with a problem. Those whose minds were imprinted by money beforehand weren’t very helpful. It was the opposite for those who weren't primed by money.
According to Nobel Prize winner, Daniel Kahneman, in his book, Thinking, Fast And Slow, “The psychologist who has done this research, Kathleen Vohs, has been laudably restrained in discussing the implications of her findings.”
What might she say about financial advisors, with real money sitting on their tables? Her insight could explain why many will lie.
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller Millionaire Teacher and Millionaire Expat: How To Build Wealth Living Overseas