How to ensure you get value for the cost of advice
The financial advice business is a big one. Advocis, the Financial Advisors Association of Canada, represents more than 17,000 members across the country. And the Investment Funds Institute of Canada reports that mutual fund assets totalled $1.983 trillion at the end of July 2021 while ETF assets totalled $313.6 billion. That’s a huge amount of money under management. And a large chunk of that is wealth that is managed by professional financial advisors on behalf of their clients.
The vast majority of advisors and money managers are professional and pride themselves on handling their clients’ money as if if were their own. In many cases, advisor will invest in the same assets as their clients – they eat their own cooking. But there are still a number of pitfalls for the unwary investor to watch for when dealing with some advisors.
1. Overcompensation
Commissions have long been the compensation of choice in the financial advisory business. With products like a mutual fund, the compensation is “built in” to the cost of distribution. While full disclosure has always been encouraged, it has not always been practiced. Most people think that the cost of commissions is “included,” and there is nothing that can be done about it. Not true. The reality is that in many situations, an alternative form of the product is available with no compensation “built in.” Instead, the advisor charges the client a clearly-spelled-out fee for services rendered. Always make sure you know what the advisor is charging in the way of fees and how they are compensated for any products they sell.
2. Tied selling
Straight-out tied selling is illegal in Canada. That’s when a financial institution attempts to sell you one product as a condition for obtaining another one. For example, if you have applied to a bank for a mortgage, the bank could not make a condition of the loan that you transfer your investment portfolio to the bank.
But tied selling does not typically occur so overtly. These days, a bank’s financial advisor who handles mortgages and lines of credit is often the same as the advisor who sets up investment portfolios and will try to sell both services to the same client. Some customers might feel that it’s convenient to have one advisor look after everything. While that may be true, each transaction needs to stand on its own merits. The rate and the terms of the mortgage should be competitive, and the investment portfolio being recommended should represent the advisor’s best attempt at meeting the client’s needs.
3. Proprietary funds
Most large financial institutions have their own mutual funds and exchange-traded funds (ETFs). While a proprietary fund is not necessarily a negative clients should exercise caution. There are several sources of profit in selling a mutual fund, including the sales charge, the management fee, plus the brokerage and custodian fees. A proprietary fund is not necessarily uncompetitive. But some extra due diligence may be required to find out why the advisor recommended, say, the the institution’s own Canadian equity fund from 40 or 50 others that are readily available.
4. Actively-managed versus passively-managed funds
The key selling feature of so-called “actively managed” funds is the pitch that the manager of the fund has some special ability to create a portfolio that would outperform the market. However, to date, there is no academic evidence to suggest that any fund manager has the ability to continuously outperform the market. Yet MERs for actively managed funds are usually higher than average, sometimes in excess of 100 basis points per annum.
As an alternative, many advisors will elect to structure a “passively-managed” portfolio using ETFs. ETFs consistently charge far less in ongoing management fees than mutual funds. And there is substantial academic evidence to show that ETFs as a group will substantially outperform their actively managed counterparts.
5. The “free” plan with hidden costs
You may frequently find advisors offering a “free” financial plan. In fact, the result in most cases is a plan that promotes the sale of specific products. The advisor may be captive of a financial institution or may be pressured to sell products from certain fund suppliers or managers. The impact of having an improperly prepared plan can actually be devastating. Just imagine arriving at retirement age and discovering that you have only about 70% of the income stream that you had anticipated.
Your retirement could be far more fulfilling if your “financial plan” addresses the following information in detail:
- The amount of money that you needed to save each year.
- The asset allocation that would give you the highest probability of maximizing your return with the least amount of risk.
- Tax planning strategies to minimize your overall tax.
- Judicious use of credit.
- Adopting a pre-retirement lifestyle that will allow you to also have the retirement lifestyle that you want.
6. Chasing performance
It is impossible to predict which investment fund will have good performance in the future. In fact, the typical trend is that the funds that are among the top performing this year are typically among the worst performing next year. And with all the evidence published on this topic, Yet many financial advisors and consumers alike continue to get sucked in by moving their money into a fund that performed well over the 12 months. If your advisor is continuing to make suggestions about moving from one fund to another, you have to ask why. Make certain that you are not playing the performance-chasing game.
