Part I of this blog explained how the disclosure loophole in the fiduciary duty standard can swallow the duty entirely.
Below is one way to protect yourself if you are working with a fiduciary or plan to work with a fiduciary advisor.
What matters most to investors is their portfolio’s performance.
Most investors don’t care if the advisor is getting paid to recommend superior products. But they bristle when they find out that their advisor is pushing sub-par products or ones with high fees just because they enrich the advisor.
Ask for a Hypothetical Portfolio
Ask your investment advisor for a comparison of the actual performance of the recommended mutual funds or Exchange Traded Funds (ETFs) to a hypothetical portfolio of low-cost index funds. The comparison should cover at least five to seven years of actual performance.
Research shows that the one of the biggest determinant of a portfolio’s performance is its asset allocation. That is, the percentage of stocks and bonds in the portfolio.
If your advisor is recommending a portfolio with 70% stocks and 30% bonds, then the hypothetical portfolio should also use a 70% stock / 30% bond allocation. Reinvest all dividends and capital gain distributions.
You can compare the actual performance of the recommended portfolio to the one of low-cost index funds.
The benefit of this approach is that it looks at real data from real funds. Although past results are not guarantees of future results, they are useful for comparison purposes. This approach also guards against buying new “backtested” products that don’t have any real market experience.
Finally, this approach avoids all the disclosures that advisors use to weaken their fiduciary duty and gets to the heart of the matter – investment performance.
I have used this approach for several clients to see how their portfolios would have done had they been invested in low-cost index funds. The hypothetical portfolios that I created with low-cost index funds beat the client’s real performance of between 10% and 36% over the three- to five-year periods studied after considering advisor fees.
Let me say that again. Their total returns would have been 10% to 36% higher using a low-cost index fund strategy and not advisor-recommended products!
Specific Hypothetical Parameters
Ask the advisor to use either the Fidelity or Vanguard versions of the low-cost index funds that cover the entire stock and bond markets.
In the example above, if the advisor is recommending a portfolio of 70% stocks and 30% bonds, then ask him / her to model the following portfolio with two funds.
- Vanguard Total Stock Market (VTSAX) 70%
- Vanguard Total Bond Market Fund (VBTLX) 30%
Or you can use the Fidelity flavors of the same funds that cover the entire market.
- Fidelity Total Stock Market Fund (FSTVX) 70%
- Fidelity Total Bond Market Fund (FTBFX) 30%
If the advisor recommends a certain percentage of international stock exposure, use that percentage in either of these funds in the hypothetical portfolio:
- Vanguard Total International Stock Index (VSIIX) or
- Fidelity International Stock Market Fund (FSIVX)
They can model the hypothetical portfolio with a lump sum invested at the same time or to simulate monthly contributions. Your financial advisor should have software to run hypotheticals either way.
Here are three signs that say look for another advisor:
- If they object to doing the analysis. Every advisor has software to run the analysis. Its pretty easy to do. Maybe 30 minutes worth of work.
- If they say they adjust the funds as market conditions change. Indicate that you’d like to use a “buy and hold” strategy in your portfolio.
- If they are recommending funds that weren’t available five years ago. To me this means there is no track record and are not yet proven.
You can use this approach for investment accounts (IRAs, brokerages) and for variable annuities or life insurance products with an investment component. The advisor can compare the actual performance of their recommended products to a portfolio of low-cost index funds.
In sum, ask your advisor to run a hypothetical portfolio using low-cost index funds that match the asset allocation strategy they are recommending. This is a very reasonable request of any advisor with a fiduciary duty.