Active Management and Financial Advice

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Yesterday’s Post = Confusion?

Yesterday I ran a post titled ‘Current Benchmarks for Active Management Are Too High‘. Somehow, the reader comments focused on financial advisor compensation. While I agree financial advisor compensation and value received for said advice requires scrutiny, this is completely separate from what I was talking about. Perhaps it would be better if I drew an analogy.

Hypothetical Scenario

Two identical twins, Warren and Benjamin, run an investment management company called Double Dollar Capital. They do everything the same. They both run Canadian Large Cap investment portfolios and always pick the exact same stocks to buy or sell at the exact same time. They both charge the exact same investment management fee of 0.50% per annum. The only difference is that Warren deals directly with high net worth investors who are charged 0.50% per year (and do not use a financial advisor), but Benjamin acts as a sub-advisor for Mutual Fund Company XYZ. (Mutual Fund Company XYZ sells a fund called the XYZ Canadian Large Cap Fund, but Benjamin is the portfolio manager. XYZ pay Benjamin 0.50% per year.) XYZ adds in a trailing commission to financial salespeople and other administrative costs for selling this mutual fund version. This brings the MER up to 2.00% for investors in the XYZ Canadian Large Cap Fund.

Stock Picker’s Digest is trying to determine the best stock-pickers for Canadian Large Cap investment mandates.

I’m saying that Warren and Benjamin’s performance is the same as it relates to Stock Picker’s Digest’s rankings.

The commenters are saying, “let’s talk about the cost of financial product distribution instead and try to determine if it’s worth it.”

The points they raise are valid and I agree with them, but this discussion is totally separate from what I was talking about. I think this would’ve been more clear if I had retitled the section “Indexes Are Not An Appropriate Benchmark” to “Indexes Are Not An Appropriate Benchmark for Gauging the Pure Stock Picking Ability of Mutual Fund Managers”.

Preet Banerjee
Preet Banerjee an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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Showing 6 comments
  • Shane

    Oh, I get it now! Yeah, totally understand your point. Really good analogy. Thought you had lost your marbles, but I now I realize the disconnect.

  • Patrick

    Sorry, I’m a bit slow today. I followed your argument and then your argument just sort of … ended. Can you show how your methodology ends up concluding that Warren and Benjamin are equally good stock pickers?

    • Preet

      Patrick, think of it this way: Since Warren and Benjamin make all the same picks, their stock picking performance must be identical. If their stock picking ability is identical, how can one be a better stock picker than the other?

  • Michael James

    So, the index is not an appropriate measure for judging the stock-picking ability of a mutual fund manager. That makes sense. However, the index (or the corresponding index ETF) is a good measure for judging whether a mutual fund is a good investment.

    So, even if a manager is a good stock picker, his or her mutual fund may still be a poor investment due to the unavoidable cost of “advice”.

    • Preet

      Yes, that is 99% of what I was getting at. The only modification I would make to that is “assuming a DIY investor could buy and hold an index ETF instead, the index ETF is a good measure for judging whether an investment advisor using embedded compensation mutual funds is worth paying for”.

      This would pertain specifically to advisors who offer no planning. Using this line of thinking, and going by historical numbers and accepted theory – it would be a hard case to argue using an advisor.

      In reality there are other things to consider. Most people couldn’t buy and hold ETFs long term (and some advisors similarly don’t stick to their plans either). If an advisor offers financial planning as well, then you have a hard time figuring what costs you pay for investment performance and what costs you pay for planning advice. In the end, all signs point to an unbundling of fees, products, and advice as the best framework for trying to ascertain value received for costs paid.

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