What Do You Pay Your Investment Advisor To Do?
Are you paying your broker or the manager of your actively-managed mutual fund to generate a higher return for you than you think you can get from lower-cost passively-managed index funds? According to Larry Swedroe and Andrew Berkin, authors of a new book entitled “The Incredible Shrinking Alpha,” you’re wasting your money.
The term alpha refers to any incremental return you get from an actively-managed investment that can be attributed solely to the skill of the investment manager. The authors assert that it has become more and more difficult for skilled institutional investment managers to outperform the average returns in the asset classes in which they invest. Why? Because historically most of the alpha they’ve been able to generate has come from exploiting investing mistakes made by non-professional individual investors. Since 1979, however, the percentage of U.S. stocks held by individual households has dropped from 48% to around 20% as those investors have turned more and more to mutual funds. So the institutional managers are now finding themselves trading mostly against each other. And at the same time the number of mutual funds – and institutional investment managers – has exploded. Today there are fourteen times as many funds as there were in 1979. With a limited amount of alpha available together with a higher level of investment skill among the players, it’s become significantly harder for any one institutional manager to consistently beat the rest. And when you add in the costs that they charge, especially if they’re managing a hedge fund, more often than not you’re actually ending up with less return than you would have gotten from simply investing directly in a benchmark index fund.
The authors use a baseball analogy to explain what they call the paradox of skill. From 1903 through 1941, seven players achieved a batting average of over .400, several of them more than once. This was at a time when the overall batting average was around .260. Since that time the overall average has remained around .260, yet not one player has been able to reach the .400 milestone, despite the fact that today’s baseball players are better athletes. You might argue that it’s due to better pitching and defensive play. While possibly true, on the other hand the strike zone has also shrunk, giving hitters today a huge advantage over their predecessors. Swedroe explains that the reason it’s become so difficult to outperform is that it’s the relative level of skill that plays the more important role in determining outcomes, not the absolute level. As he puts it, “This ‘paradox of skill’ means that even as skill level rises, luck can become more important in determining outcomes if the level of competition is also rising. The result is that, as the average skill increases, it becomes more difficult to outperform by large margins.” Statistically speaking, the standard deviation of outcomes becomes narrower. And luck – whether bad or good – by definition has no tendency to persist.
If your broker is selling you individual stocks in your brokerage or retirement accounts, then he or she is acting just like an active fund manager, promising you (directly or indirectly) better returns than you can get from a more diversified investment in a lower-cost index fund. And the returns you get from his or her recommendations are likely to suffer for exactly the same reasons.
So is there any value in hiring a financial advisor? Yes, but not for individual stock-picking or for returns-chasing. If you expect your investment advisor to get you the highest returns year after year, the book flatly states you won’t be successful no matter whom you pick. But if your goal instead is to strike a balance between wealth maximization and asset protection, a Certified Financial Planner (CFP) is trained to help you create an investment strategy based on cost management, tax optimization, and risk mitigation, all of which are things you can control, unlike returns. If you are going to work with an advisor, make sure to choose him or her for the right reasons.