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RP: There are several questions you should ask before choosing to work with a financial adviser. One of them is: do you recommend actively managed funds, or low cost passively managed funds? The problem with actively managed funds is that they’re much more expensive, and that has a negative impact on your returns. In his book, Millionaire Teacher, Andrew Hallam describes using active funds as like ‘trying to walk up an escalator that’s going down’.
AH: 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 escalator’s heading 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 our rolling backward on an actively managed escalator.
RP: Many financial advisers recommend active funds because of their potential to outperform. But in practice, over the long term, very few of them do. Advisers who primarily use active funds, says Andrew, are like those who believe that 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 small, so, it’s much like the flat earth concept, they are touting that the earth is flat, they are touting that financial actively managed products will outperform a low cost portfolio of index fund, which is highly improbable over a lifetime.
RP: Why then do so many advisers still recommend active funds? The problem, says Andrew, is often simple: that’s the way they were taught.
AH: If 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 advisers might find out that hey, the statistical odds of success with our clients are 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.
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