Why Hire a Financial Advisor When You Can Invest in Index Funds?

David K. Little, CFP®, CFA

As fee-only financial advisors in Fullerton, California, we get questions about investments all the time. One of the things people ask is why they should hire us when they can put their money into an index fund.

Pros and Cons of Investing in an Index Fund

To start, we say that index funds are not bad investments if they’re used properly. Their expenses are low, and good ones closely track the markets they follow. The problem we’ve seen is how investors use them.

One of the best examples of this problem is a prospect I encountered years ago. In the initial phone meeting I had with him, he mentioned that he was considering putting all his money into the Vanguard 500 Index Fund. This is a fund we use for some of our clients; however, I told him that putting all his money into the fund might be too aggressive, especially since he was contemplating retirement in the next year or so.

He didn’t understand my statement since he thought the Vanguard fund was a very good investment (and I agreed with him), and so we continued to talk about our theories on portfolio management. Finally, he told me why he thought it was a good idea: “But isn’t the Vanguard 500 Index Fund a risk-free investment?” he asked.

So, I got to provide some education and told him that while the risk of the fund underperforming the S&P 500 was low, it could definitely lose money. He didn’t become a client, but I hope he took at least some of the advice I gave him in the phone meeting. Shortly after we had our conversation, the Vanguard fund lost about 40% of its value during a slide that lasted more than two years.

Beyond investors who don’t understand how index funds work, even sophisticated investors have reasons for utilizing the services of an advisor as opposed to putting their money into index funds.

Probably the best reasons to work with an advisor are outlined in a study that Vanguard (the “inventors” of the index fund) did on the value of advisors (Advisor’s Alpha is the name of the study/white paper). Index funds can certainly be a part of the strategies as discussed below, but in Vanguard’s opinion, most investors are not equipped to execute such strategies on their own.

The Value of a Financial Advisor, Quantified

Vanguard concluded that advisors add value and improve investors’ outcome in seven areas. The value added ranges from “something greater than zero” (suitable asset allocation whose value is not quantifiable) all the way up to 1.5 percentage points per year for “behavioral coaching.” Below are the top three ways advisors add value, all from Vanguard’s study.

First, Vanguard reports that behavioral coaching adds around 150 basis points per year in value. Behavioral coaching refers to the value advisors provide by encouraging their clients to stick to an investment allocation even when the markets are overreacting (to good or bad news).

Vanguard quantified this value by comparing average investor returns with actual fund returns from 2007 through 2017. In virtually all cases, investors received lower returns than the funds produced, simply because they bought the funds at the wrong time (generally, they were chasing good performance) or sold the funds when they shouldn’t have (typically after downturns, when they should have been holding on).

Vanguard also studied self-directed IRA accounts that investors managed for themselves at Vanguard and came to a similar conclusion: Investors who made trades in those accounts almost without fail made the trades at the wrong time and cost themselves returns that they would have gained had they maintained their asset allocation targets.

Second, Vanguard found that in many cases, investors will spend money during retirement in the wrong order. In other words, they will take money out of accounts that should be left intact for tax purposes. Required minimum distributions (RMDs) need to be taken, but investors also should review several factors to help determine where money should come from every year in retirement:

  • Balances in taxable accounts

  • Balances in tax-free accounts

  • Current tax rate

  • Expected tax rate

  • Any change in circumstances (inheritance, life expectancies, etc.)

Without carefully considering all these options, Vanguard found that investors can cost themselves around one percentage point per year in returns (up to 110 basis points to be exact).

Third, “asset location” can influence investor returns, depending on how individual investors have their assets structured. Some investors have no flexibility if all their money is in retirement accounts. The best opportunity for advisors to add value here is typically found in a situation where investors have an approximately even split in their assets between taxable (joint, trust) accounts and tax-free (retirement) accounts.

According to the study, investors need to position tax-efficient investment strategies (municipal funds, index equity) in taxable accounts, and tax-inefficient strategies (high-turnover equities, taxable bonds) in retirement accounts. Doing this should minimize tax bills, and Vanguard posits that executing this correctly can add up to 75 basis points per year in value.

A Valuable Partner in Portfolio Management

Index funds can be a valuable part of portfolio construction, but investors should think carefully about more than just whether they should use these funds in their portfolios. Advisors can be valuable partners in decisions involving what investments to own, how they should be owned, and what spending strategies should be used even if portfolios are heavy users of index funds.

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