Avoid advisers who recommend active funds

Before choosing a financial adviser, it is essential to ask the right questions. One of the most revealing is whether they recommend active or passive funds.

Actively managed funds come with higher costs, and over time, those fees eat into returns. As investment author ANDREW HALLAM explains, the odds of outperforming low-cost index funds with active funds are slim.

The good news is that more advisers are now turning to low-cost passive funds. If yours does not, it may be time to find someone else.

1. High fees make active fund investing harder

Andrew compares active fund fees to walking up a downward escalator. You are moving, but the costs are constantly pushing you back. Passive funds, by contrast, allow your investments to grow without the same drag.

2. Outperformance is statistically unlikely

Over a ten-year horizon, very few active fund portfolios beat a low-cost index fund portfolio. Continuing to believe otherwise, Andrew argues, is like insisting the Earth is flat.

3. Some advisers do not keep up with the evidence

Many advisers still use active funds simply because that is how they were trained. Even when shown the statistics, they often find it hard to change long-held beliefs, especially when those beliefs align with their firm’s sales model.

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https://www.evidenceinvestor.com/post/what-active-funds-and-budgets-have-in-common 

https://www.evidenceinvestor.com/post/two-warnings-for-investors-choosing-active-funds 

https://www.evidenceinvestor.com/post/how-do-active-funds-perform 

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TRANSCRIPT

Robin Powell: There are several important questions you should ask before choosing to work with a financial adviser.

One of them is this: Do you recommend actively managed or passively managed funds?

The main problem with active funds is that they are much more expensive, and that has a negative impact on returns.

Investment author Andrew Hallam describes using active funds as like trying to walk up an escalator that’s going down.

Andrew Hallam: As a kid, we probably all wanted to try that. But progress isn't very encouraging. If you truly want to get to the top of the escalator, even within a timely period, because the escalators had a downward. 

And that's how I compared investment fees. I said investment fees are like a downward heading escalator. And when we're looking at the fees on actively managed mutual funds, and we're trying to walk up the escalator and the fee is rotating those steps down towards us, it's going to take us far longer to achieve our financial independence or our goals. 

Whereas if you're looking at low cost index funds, they're so cheap that the escalator isn't really perceptively moving at all. 

So you are just walking up those steps instead of fighting steps that are rolling back were on an actively managed escalator. 

RP: Many financial advisers believe that actively managed funds are worth paying for because of their potential to outperform.

But over the very long term, very few of them do.

Advisers who use them, says Andrew, are like those who believe the earth is flat.

AH: Statistically speaking, the odds over a ten year period. Plus the odds of you picking a collection of actively managed funds and beating a portfolio of low cost index funds are extremely, extremely small. So it's much like the flat Earth concept they are touting that the Earth is flat. 

They're touting that financial, actively managed products will outperform a low cost portfolio of index funds, which is highly improbable over a lifetime. 

RP: Why, then, do so many advisers still advocate using active funds? Well, often it’s simply because that’s the way they were taught.

AH: But this isn't part of their training. And then they work for a financial services firm. And what the financial services firm does is it buys actively managed products. And then on the side, these advisors might find out that, hey, the statistical odds of success for our clients are far better with low cost index funds. 

But if they've already made up their mind, and they already believe that they can pick actively managed funds that will win. 

Once somebody has made up their mind on a concept, it is really difficult to convince them despite the evidence that you show them. It's really difficult to convince them to change their mind. 

RP: Thankfully, more and more advisers ARE using passive, or broadly passive, funds.

So, if the first adviser you speak to doesn’t, keep looking until you find one who does.