"We provide the investor with a better risk-adjusted return. That's why our service is superior to index investing." This is a common claim from financial advisors.
Individual investors, on the other hand, lust after high returns. They write and ask for tips on high return funds rather than index funds.
In fact, risk and return are related. It is very difficult to create portfolios that offer high returns with reduced risk.
What professional advice can do is produce a portfolio that makes sense. This will be a big improvement on a portfolio that doesn't make sense. A reasonable (but not inevitable) professional portfolio will have a variety of asset classes. It will probably contain a number of investment styles, mixing growth and value funds or large cap and small cap funds.
This is not what most people do on their own. I have seen home-brew portfolios that are loaded with large cap growth funds--- and nothing else. I've also seen a lot of exciting portfolios that bet the ranch on high tech, obscure countries, junk bonds, or gold.
That isn't what a good advisor will do. Unless you tell your advisor to "swing for the fences" the odds are he'll busy himself trying to construct a portfolio with a carefully calibrated level of risk.
That said, building a portfolio where you'll get more return and less risk than a portfolio built with index funds is very difficult.
This isn't because index investing is magical. It's because making good investment choices is difficult. Since management fees reduce returns but have no impact on risk, the task of offering higher returns with less risk is more difficult as fees rise.
Let's do some simple searches of the Morningstar mutual fund database. The idea is to count the funds that provide higher returns with less risk than the index they are measured against.
• The Whole Universe Test. If you search a wide field--- all funds that specialize in domestic stocks--- you start to get a sense of how difficult it is to add return without adding risk. Some 2,844 domestic equity funds have been in operation for at least five years. While 1, 011 had less risk, only 438 offered less risk AND more return. That's only 15.4 percent. Worse, many of the 438 funds would not have been on the list as recently as two years ago. Some 238 of the funds, for instance, are large, mid, and small cap value funds. Many were in net redemption as recently as 1999 when investors fled value funds due to poor returns.
• The Narrow Investment Style Test. There are 563 funds that Morningstar categorizes as "large blend" with five-year histories. These funds tend to invest in the same pool of stocks as funds that duplicate the S&P 500 index. Of the 563 funds, 303 had less risk. Only 72 funds had a higher return and less risk. That's less than 13 percent of the sample.
• The Standard Balanced Portfolio Test. There are 477 funds with five-year histories that Morningstar classifies as "domestic hybrids." This means they invest in a combination of U.S. stocks and bonds, generally in a 60/40 percent mix much like the typical pension fund. Only 50 of these funds provided a higher return, with lower risk, than the Vanguard Balanced Index fund. This fund mixes 60 percent Vanguard 500 Index fund with 40 percent Vanguard Total Bond Market fund. Only 10.5 percent of all managed funds provided a better risk/return than a simple index fund.
The fact that only 10 to 15 percent of managed funds provide higher returns with less risk doesn't mean it is impossible for a sharp advisor assemble the portfolio that individual investors crave.
But it is a statistical long shot.
Many will claim higher return/lower risk portfolios. Few will actually deliver.
This article contains the opinions of the author but not necessarily the opinions of AssetBuilder Inc. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational puposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.
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