The Value of a Passive Advisor

Tuesday, September 17, 2013 18,916 views

By now, you realize the benefits of an indexing strategy, and more importantly, the expensive false promises of active management.  So the next logical question is, "Why should I seek the help of an advisor when I can just create a portfolio of indexes on my own using index funds at a place like Vanguard or purchase ETFs through a low cost broker like Charles Schwab?"

For those with limited resources, funds from Vanguard or iShares offer an excellent assortment of index mutual funds for an investor to build a portfolio.  However, investors who have about $100,000 or more to invest may benefit from access to a broader mixture of asset classes.  As economic research has shown, asset class allocation is the most important factor in determining a portfolio’s expected return level. In fact, asset allocation is 100% responsible for the variance in investment performance, according to a comprehensive study entitled, "Investment Policy Explains All," which appeared in the Summer 1999 issue of The Journal of Performance Management

IFA most frequently advises its clients to invest in mutual funds offered by Dimensional Fund Advisors (DFA). Among other advantages, DFA provides unequaled access to a broad selection of asset classes. Their value indexes are more value-tilted, and their small-cap indexes are smaller" These two advantages provide higher risk-adjusted expected returns than a portfolio built with Vanguard. And for those asset classes that it shares with Vanguard and others like it, DFA just does a better job.  In part, DFA's indexes adhere to rules of construction that provide slightly greater latitude for allocating resources toward specific companies and the timing their inclusion within the indexes. This increased freedom enables DFA to avoid paying premiums for annual reconstitution or chasing stocks. The DFA funds provided by IFA also engage in a rigorous and highly profitable securities lending process, the proceeds of which go directly to the returns of the funds holding those shares.

Below are graphs showing IFA's use of DFA funds in direct comparison to Vanguard index funds and iShares.



DFA funds are only available through approved advisors like IFA to the general public. But a client does NOT pay IFA for their access to DFA funds. As demanded by DFA of its approved advisors, IFA's advisors are well educated in financial market theory, articulate in describing the tenets of investing, and steadfast in focusing the client on the benefits of long-term investing.  IFA advisors are committed to maintaining consistent exposures to risk-appropriate tilts toward small and value factors as identified by Fama and French, and they are committed to the tenets set forth in the Efficient Market Hypothesis and Modern Portfolio Theory. IFA provides, in a fully transparent way, all of the supporting data, documentation and theory for the reasoning behind the strategy.

But more than that, the ultimate value of a knowledgeable, passive advisor is their ability to provide the critical discipline needed to combat reflex reactions like pulling out of the market the way so many did as it spiraled out of control in late 2008.  Those people who pulled out in early 2009, and did not trust the market to rebound as it has consistently done throughout its history, may now be facing a much more bleak future than those who had the stick-to-itiveness to hold on.  IFA’s advisors stay fixed on the long-term and profitable history of the market rather than the stomach-churning volatility that can occur from month to month.  IFA knows what to do, and has the discipline to do it.   

Rash decisions are like a twisted hand diabolically spinning your retirement clock backwards.  They stifle an investors’ ability to achieve long-term capital market rates of return.  Knowing the hazards of responding to such impulses, IFA provides ample data to show WHY such investments are worthwhile and should be adhered to no matter what.

"Financial decision-making is not necessarily about money," says psychologist Daniel Kahneman at Princeton University. "It's also about intangible motives like avoiding regret or achieving pride."

Just what is the price paid to skirt regret? The Morningstar Indexes Yearbook: 2005 delivers the numbers. In the report, Morningstar Managing Director Don Phillips presented the considerable difference between the return of index funds and those actually experienced by the individuals who invest in them.

He then contrasted that with the experience of the advisor-directed DFA funds. Phillips quantified the ample costs of the impulsive behaviors of non-advised passive investors.  These behaviors resulted in the average no-load index fund investor receiving a return of 1.58% less per year than the actual funds themselves (7.07% vs. 8.65%) for the 10-years ending 2005.  By stark contrast, the average DFA fund investor received 0.91% more per year than the actual funds (10.81% vs. 9.90%) for the 10-years ending 2005.


Using the numbers from the study, we can see that for the 10-years ending in 2005 the combination of a better implemented indexing strategy and the steady, rational hand of an advisor is quite a potent one. The average advisor-directed DFA investor received an annualized return of 10.81% whereas the average no-load index fund investor received an annualized return of 7.07%. That is a difference of 3.71% per year or a 52% increase!

Phillips exalted the merits of DFA's success, "Consider the success Dimensional Fund Advisors (DFA) has had in selling its funds through advisors who undergo training on the merits of passive investing and in portfolio construction theory. Consider that over the past decade the dollar-weighted return of all index funds was just 82% of the time-weighted return investors could have gotten with those funds. Yet, the figures for DFA are much better. In fact, the dollar-weighted returns of DFA funds over the past 10 years are actually higher than their time-weighted returns, suggesting advisors who use DFA encourage very smart behavior among their clients, even buying more out-of-favor segments of the market and riding them up, rather than buying at the peak and riding the trend down, which is usually the case with fund investors," he concluded.

Legendary investor Benjamin Graham said, "People don't need extraordinary insight or intelligence. What they need is the character to adopt simple rules and stick to them." For investing, no truer words were ever spoken. Below is a video and a chart that summarizes some studies done of investor experiences with and without passive advisors.


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