If you use a financial advisor you are losing money
I quick look at the SPIVA report and you will discover that about 90% of actively managed mutual funds and index funds DON’T beat the index, yet those are the funds all commission based financial advisor will recommend, because those are the funds that pay them commission. In addition to being in an underperformer fund, you will will have to pay for some advisory fee.
Conclusion: if you are using an commission based financial advisor, you losing out and your savings are going right into the pocket of the financial advisor and the company that hires them. You work so hard in your day to day job and someone else is ripping the benefit.
How mutual funds DON’T buy and hold as they advise other to do
Practically every financial adviser in North America gives the same piece of advice to their clients: “buy and hold”. Of course, financial advisers have a strong economic incentive to keep your account in their books, they don’t want you to sell because they get a trailer fee of 1.0%. This fee is paid to the adviser for as long as the client stays invested.
A common meeting between a financial adviser and client
- You meet your financial adviser. Either you choose someone at random at your local bank or one arrives at your kitchen table because a friend or a family member referred him.
- The adviser asks a few questions to determine your risk tolerance so that they can classify you in one of five investment risk tolerance categories. These categories are Conservative, Moderate Conservative, Moderate, Moderate Aggressive, and Aggressive.
- Once your risk tolerance has been identified, the adviser chooses one of their company’s mutual funds and buys it for you.
If at any time the value of the mutual fund goes down in value and you call in order to inquire about your account, you are told in firm terms. “Our strategy is to buy and hold.” You are told to hold until you need the money, and if you cannot handle the volatility, you are advised to switch to a more conservative category.
Given this piece of advice, “to buy and hold,” do you think that mutual fund managers follow it themselves?
Of course not.
While investors are told to buy and hold, many mutual fund companies have a portfolio turnover of over 100%. This means that 100% of the securities within the fund are replaced over the span of one year. It is not uncommon to see portfolio turnover as high as 500%. This is not the buy-and-hold strategy that is pushed down your throat.
Side note: The turnover of Index Fund is close to zero, but a financial adviser would never recommend and Index Fund because Index Funds don’t pay any trailer fees.
How is a portfolio with a high turnover a detriment to a mutual fund’s performance?
Lots of commission. The more turnover, the more buying, and selling. The more buying and selling, the higher the commission expense. The higher the commission expense, the less money for you the shareholder of the mutual fund.
Bid and ask spread. Stocks always have a price spread. For example, someone might be willing to sell shares of Royal bank for $21 and someone might be willing to buy shares of Royal back for $20. The difference of $1, between the-bid-and-the-ask, is called the spread. When a mutual fund wants to buy, they buy at the “Ask” price and when they want to sell, they sell at the “Bid” price, therefore they are always losing on the spread.
Market impact. The size of a big order to buy stocks can influence their price. Imagine that a mutual fund wants to buy one million shares of Royal Bank which is trading at $20. The mutual fund buys all the available shares which are selling at $20 and in order to buy more they have to offer more money, let’s say $21, and if they buy all the shares available at $21, then they have to offer to buy at $22 in order to be able to buy more shares. The bigger the quantity of shares a fund buys, they bugger the impact they create in the market and the more they end up paying for the shares they want.
Taxes. When a mutual fund buys and sells stocks, some of them are sold at a profit. When stocks are sold at a profit it triggers a capital gain. When there are capital gains, there are taxes to be paid. Unfortunately, it is the owner of the mutual fund, you, the individual investor who ends up paying those taxes.
Why do mutual fund companies have high turnovers?
There are two main reasons.
Seeking for Alpha: Mutual fund managers are always trying to outperform their peers and their benchmark. If they outperform their peers and the benchmark, they will want to use that outperformance for marketing purposes. In order to outperform, they are constantly buying companies they think will outperform.
Window dressing: Every quarter, mutual fund companies disclose to their clients the names of the companies they are holding. Right before the disclosure, they get rid of all their losing stocks and they purchase the most popular stocks of the quarter. This activity gives the impression that the fund always has the best stocks in its portfolio.
Conclusion:
Statistic research shows that buying and holding good companies is a long-term profitable strategy. If investment advisors want their clients to follow that strategy, maybe they should make sure the mutual funds they recommend also follow the same strategy.
What should an individual investor do? If you have a financial adviser, tell him that you like a buy and hold strategy and for that reason, you want to invest in mutual funds companies that follow this philosophy. To be more precise, you want to invest exclusively in Index Funds and/or ETFs.
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Comments
6 responses to ““Buy And Hold,” Money managers don’t follow their own advice”
Not even with dividend stocks? But I do agree ETFs are the better long term investment option
You conveniently left out the number one reason why mutual funds have a high turnover: client investments and redemptions. If a mutual fund sees a high inflow of client funds, the manager has no choice but to enter the market and purchase assets. Mutual funds can only hold a maximum percentage of cash, hence the requirement to buy regardless of how overpriced the assets are. If the same mutual fund that saw a high inflow of client funds sees a high outflow of client funds, then the manager is required to sell assets to meet the redemption requests. This, in turn, contributes to portfolio turnover. In other words, mutual funds have only so much control over portfolio turnover… Much of it is driven by the investor themselves, not the portfolio manager who has a fidicuary duty to minimize administrative costs and maximize investor returns. To mitigate portfolio turnover, portfolio managers will often require the investor to hold for at least 30 days before putting in a redemption request or be forced to redeem at a discount.
I am not a fan of mutual funds for their high MERs, but your characterization of portfolio managers as unwilling to “follow their own advice to buy and hold” is incorrect.
Excellent point.
You are right, I did forget about this additional reason for high turn over of mutual fund portfolios. It should have been right there, next to “seeking alpha” and “window dressing. ”
Another disadvantage of actively managed mutual funds is that they generally hold a cash position of 2% to 5% in order to better respond to client’s redemption. This means that there is always an amount of money not at work. A client is paying about 2% to 3% management fee in order to have 95% of his money working.
In spited that I forgot to write this reason for high equity turnover, the fact is that:
1. The average mutual fund has a turnover about 100%, with some mutual funds having turn overs as high as 500%.
2. Most mutual funds DO NOT beat their index
3. Investors would be better off with Index funds and ETF
4. Armed with this knowledge, investors should be able to dump their financial adviser who gets paid a trailer fee. They should get a fee-only adviser who would help them with asset allocation and buy directly from the maker, instead of paying thousands of dollars in commissions and account maintenance fees.
Thank you so much for adding your point of view to this post.
Good clear advice here. No Bull****.
Thank you Michael
Gusto es mio, amigo