December 10, 2014 / 9:54 PM / in 3 years

SAFT ON WEALTH-Expensive, one-size-fits-all advice

(James Saft is a Reuters columnist. The opinions expressed are his own)

By James Saft

Dec 10 (Reuters) - Financial advisors do not appear to be carrying their weight.

A new study based on Canadian data shows that while advisors are able to put clients into better performing assets, they simply do not outperform their costs.

Even more striking, the data shows a tendency by advisors to shoe-horn clients into portfolios with little attention to the client’s own risk appetite or life situation.

"This one-size-fits-all advice does not come cheap. The average client pays more than 2.7 percent each year in fees and thus gives up all of the equity premium gained through increased risk-taking," write Stephen Foerster and Alessandro Previtero of Western University, Juhani Linnainmaa of the University of Chicago and Brian Melzer of Northwestern University (here)

Looking at data covering 10,000 advisors and 800,000 Canadian clients, the authors found a mix of some good effects from professional financial advice but little evidence that it is worth its costs.

One of the traditional ways in which advisors are said to help clients is by getting them comfortable with taking on a higher, more appropriate level of risk, usually through equity market exposure. Because of a change in regulation in Canada in 2001, which did not apply to Quebec, the authors were able to get an accurate view of this, even taking into account selection bias, i.e. the idea that people who seek out financial advice are more sophisticated and willing to take on risk. The study found that a financial advisor increases the marginal household’s risky asset holdings by a chunky 30 percentage points.

That’s great, and will produce extra returns, but what did not seem to be happening was the kind of tailoring that you would expect from a financial advisor. A good advisor will be sensitive to your own appetite for risk, which may be influenced not just by your own goals but by your particular life situation. A good advisor will also adjust a client’s asset mix depending on where they are within the life cycle, typically taking on more risk early in a working life and trimming it as retirement approaches.

Looking granularly at the data they found that how much risk appetite you had and how old you were explained about 13 percent in the variation of your holdings of risky assets.

IT ISN‘T WHO YOU ARE, IT‘S WHO YOUR ADVISOR IS

In contrast, who your advisor was played a much more important role, accounting for 32 percent of the variation in risk exposure.

This led the authors to conclude that advisors are basically coming up with a generic model portfolio and then using it or a slight variation of it on their clients.

“If advisors do not base their advice on investor characteristics, then what explains variation in recommendations across advisors? We find that advisors may project their own preferences and beliefs onto their clients,” according to the study.

That might possibly be good if an advisor had some special talent in markets, but the data did not back that up, either in regards to stock picking or market timing.

Here is where we come to costs, and the data is not encouraging.

The average dollar under the care of an advisor in the sample was paying out 2.67 percent annually in fees, including mutual fund expenses, front-end load fees and commissions paid by mutual funds to advisors. That is far more than the advisors demonstrated in alpha-generating ability through market timing or stock selection, an amount small enough to be “not statistically distinguishable from zero.”

Using one model and adding in fees the authors calculate that advice was costing 3.34 percent annually. If you use a life-cycle fund charging 1 percent annually as a benchmark for asset allocation costs, advisors are still costing clients more than 2 percent a year.

In other words, advisors may be doing clients a favor by getting them to hold more equities, but it is a move which could be done so much more efficiently without the cost of the active mutual funds into which advisors in the sample were putting clients.

This is not to say that advisors definitively don’t earn their keep. Advisors can create tax-efficient asset allocations, a source of outperformance not measured here. They can also, and this is crucial, help with planning. An advisor who through honest, frank advice encourages a client to save more or to delay retirement can be the difference between comfortable retirement and late-life financial peril.

That all falls under the category of counseling, and generally that is not what financial advisors get paid for, though perhaps they should.

With the rise of robo-advisors, which would seem to be both cheaper and more efficient than what was studied here, financial advisors are going to have to move towards a model in which they work not primarily to improve asset performance but client behavior. (At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft) (Editing by James Dalgleish)

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