Who Can Best Manage Your Investments?

Individual investors manage their accounts differently from institutional and advisor-managed investors. To quantify that difference, Morningstar recently released its annual Mind the Gap study, which examined actual returns earned by investors versus returns of funds. In this article, we’ll look at the statistics, what they mean, and how investors optimize their results.

The Mind the Gap Study

According to the study, “investors earned about 6% per year on the average dollar they invested in mutual funds and exchange-traded funds over the trailing 10 years ended Dec. 31, 2022. This is about 1.7 percentage points less than the total returns their fund investments generated over the same period. This shortfall, or gap, stems from poorly timed purchases and sales of fund shares, which cost investors roughly one fifth the return they would have earned if they had simply bought and held.”

In other words, when individual investors move in and out of the market, they end up hurting their returns.

To put this shortfall in perspective, let’s say an investor started with $100,000 as of Jan. 1, 2013. Earning an average annual return of 7.7% would result in a total of about $210,000 after 10 years. By lowering the return to 6%, the total drops to approximately $179,000. The reduction of 1.7% per year reduced the investment balance by more than $30,000 after 10 years.

The recent study showed that the 1.7% gap is consistent with previous rolling 10-year results. It should also be noted that gaps vary according to type of fund. Funds with smaller gaps include U.S. equity funds, taxable-bond funds, and asset-allocation funds. Funds with wider return gaps include sector and nontraditional equity funds.

The bottom line is that buying and holding funds will generally produce higher returns than attempting to time the market. In fact, the authors recommend that investors use asset-allocation funds and hold them for the long term. Based on this study, would simply buying and holding asset-allocation funds make more sense than using an advisor?

Value of an Advisor

In a recent article by Vanguard, “Putting a Value on Your Value: Quantifying Vanguard Advisor’s Alpha,” the value of “behavioral coaching” by advisors added as much as 200 basis points (or 2%) per year. This figure is similar to the 1.7% gap in the Morningstar study!

Whether 1.7% or 2%, if this was the only value provided by advisors, then an investor with resolve to stay the course would not benefit from an advisor. However, according to the Vanguard analysis, advisors can add up to 2% or more in net returns from other factors:

• Low-Cost Funds: 30 basis points
• Rebalancing: 35 basis points
• Asset Location: Up to 75 basis points
• Spending Strategy: Up to 120 basis points

In “An Empirical Evaluation of Tax-Loss-Harvesting Alpha (Summary),” the CFA Institute determined the benefit after costs from ongoing tax-loss harvesting was 69 basis points annually.

Thus, if we add in the value of tax-loss harvesting, the advisor benefit—without behavioral coaching—can potentially be 2.7% or more per year. Even with an average fee of 1%, clients who think they don’t need coaching would benefit by about 1.7% per year by using a tax-aware advisor.

What Investors Should Do

In a perfect world, investors would not react emotionally to market events; they would stay invested and stick to their strategies. In reality, individual investors fall short. According to Morningstar, they fall short by 1.7% per year. To counteract the tendency to stray, investors can use advisors.

But an advisor’s value cannot be measured solely by the behavioral coaching component. Advisors also add value through other means such as rebalancing, spending strategies, and tax savings. Thus, to avoid a performance gap and to take advantage of other benefits, investors should consider using highly qualified advisors.

Note that all advisors are not alike. A fee-only advisor will put the clients’ interests first (as fiduciary registered investment advisors) and not sell products. From there, investors should evaluate advisors based on the 4 C’s:

• Competence: Experience, education, and reputation
• Compensation: Fee-only
• Credentials: Such as a certified financial planner or a certified public accountant/personal financial specialist.
• Comfort: Comfort in sharing your financial and personal information as well as feeling like your advisor really listens to you

Summary

• Investors should not attempt to time the market.
• Holding diversified, low-cost investments is key to maximizing long-term returns.
• Using an advisor can help avoid trying to time the market.
• A tax-savvy advisor can add value above and beyond annual fees.