80% of investors, who use the services of financial advisors, expect to beat the performance of the market. They pay higher fees and they take more risk to achieve this goal. Are they being rewarded for the additional expense and risk?
Financial advisors have to create expectations when they sell investment products and services. The expectations are usually a response to a frequently asked investor question: “What can I expect if I select you to be my advisor”? Advisors are reluctant to answer, “I don’t know” or “It depends on the performance of the securities markets”. They want to give you a more concrete response.
There are several markets because there are several asset classes starting with stocks and bonds. A market may also be a sub-set of securities in an asset class. For example, the S&P 500 is an index fund that duplicates the performance of large capitalization, U.S. stocks. Therefore, the S&P 500 is the “market” for this asset class.
Beat the Market?
If you pay high fees you should expect higher returns. There are no guarantees, but rational investors expected to be rewarded for higher expenses and increased risk exposure.
In this case, you are paying higher fees to active money managers who are “trying” to beat market returns. Using the S&P 500 as a proxy for the market you expect your advisor to recommend money managers who outperform the market net of all expenses.
There are two sets of fees. Your financial advisor wants to be paid and so do the money managers who are paid to invest your assets. We are going to assume the advisor’s fee stays the same regardless of the management strategy you select.
You could select active money managers who are seeking to outperform the market (S&P 500). Their fees range from 1% to 2% based on the types of investments they make. For example, an international stock manager generally charges a higher fee than a domestic stock manager.
Or, you could select a passive manager that seeks to duplicate the performance of the market. For example, you invest in an S&P 500 index fund that duplicates the performance of the index. Index funds do not require expensive investment professionals (chief investment officers, analysts, portfolio managers). Assets are managed by computer programs, and updates are infrequent. A typical fee is .25%.
You can achieve market performance for .25%. Why pay a 1% fee that is four times higher? There is only one rational reason. You expect to be rewarded with beat the market performance.