The Performance of Index Funds vs. Financial Advisors: Debunking the Myth
No, it is not true that stock index funds have outperformed 85% of financial advisors. Index funds and financial advisors serve fundamentally different roles in the investment landscape, making direct comparisons akin to comparing apples to oranges.
Understanding Index Funds and Financial Advisors
Index funds are investment vehicles designed to reflect the performance of a specific market index, such as the SP 500, while financial advisors offer personalized investment advice and planning services. These two entities are inherently different, and thus, a direct comparison of their performance is misleading.
Why SP 500 Index Funds Outperform Most Advisors
Index funds have been known to outperform a significant percentage of professional investors, be they mutual fund managers or financial advisors. Various factors contribute to this performance:
Cost Comparisons
Actively managed portfolios require significant costs associated with marketing and managing the portfolio. For example, if an actively managed fund charges a management expense ratio (MER) of 2%, the fund needs to return the market performance plus 2% to break even. Given that the average market return is around 10% annually, an actively managed fund needs to beat the market by 20% annually to achieve a neutral outcome. This is a challenging feat for most fund managers.
Diversification and Risk Management
One of the primary advantages of index funds is their ability to minimize unsystematic risk. The SP 500, for instance, is composed of over 30 trillion dollars worth of assets, spread across various industries and geographies. This diversification reduces the risk of picking winners and losers, making it easier to achieve market returns.
Active Management vs. Index Management
Active stock-picking strategies employed by fund managers often result in higher fees and lower returns compared to passive index funds. Index funds, such as the SPY, charge an MER of approximately 0.25%, which is significantly lower than the average MER of actively managed funds.
Robo-advisors, which predominantly use index funds, have also seen strong performance over the past decade. This period coincided with one of the greatest bull markets in recent history. Global share markets reached record levels, making index investing a safe and reliable bet. However, it is important to recognize that the current bull market is cyclical, and when the market eventually experiences a downturn, index investments can suffer significantly.
Market Trends and Human vs. Robo Advice
While index funds have had a remarkable track record of outperformance, it is not accurate to suggest that they beat 85% of human advisors in all scenarios. Financial advisors often provide high-touch services such as financial planning, relationship management, and personalized advice that go beyond simple portfolio management. This is particularly true for investment products that are not index-based.
The success of index funds is often attributed to the bull market of recent years. However, it is essential to acknowledge that market cycles are inevitable, and during a bear market, the performance of index funds may not be as favorable. In such periods, investors' perceptions and satisfaction with index-based investments can drastically change.
In conclusion, while index funds have consistently outperformed the majority of actively managed funds over the past decade, this performance cannot be directly attributed to the success or failure of financial advisors. The comparison of index funds and human advisors is more accurately framed as a competition between passive and active investment strategies rather than between different forms of professional advice.