In Do You Need a Financial Advisor?, I wrote about the value that a financial advisor can bring to your wealth management requirements.
I realize that competent financial advice may be relatively expensive. But the long term benefits often greatly outweigh the up-front cost. In discussing this cost-benefit relationship recently, I was asked if I could provide an example or two of the potential benefits that a financial planner can provide.
So here are two short real-life examples of adding value to a client’s wealth.
Fundamental Tax Strategies
A competent financial planner should be able to provide guidance on basic tax strategies. And I am not talking about complex items like estate freezes or preparing tax returns. Just common techniques such as income splitting and effectively utilizing tax deferred investment accounts.
In one real-life Canadian situation, the husband earned significantly more than his wife. About $135,000 annually versus $35,000. Yes, there were children, debt, education, and other issues, but I shall focus on income splitting. Prior to financial planning, they were both maxing out on their individual tax-deferred retirement plans, but not utilizing spousal plans nor looking at income splitting options. By incorporating a few simple tax strategies, they saved $49,000 in taxes payable over the next 5 years and $239,000 over the next 20 years based on current tax rates.
Not a bad return for spending perhaps $3000 to $5000 on a competent professional advisor.
Knowing the Investment Options
A competent financial advisor can help guide clients to the right investments for their portfolio requirements. And again, I am not talking about futures trading or creating butterfly option strategies. But straightforward, every day, core investments.
In Canada, this is not always an easy process. According to the Morningstar Canada data that I use in my own analysis, there are about 14,230 mutual and exchange traded funds in the Morningstar database for Canadian investors. That is a lot of options to wade through.
I constantly meet individuals who pay 2.5% annually on their mutual funds. Often, there are very similarly constructed index funds available that can be substituted for much less cost.
For example, consider the following data from Morningstar Canada as at May 31, 2012. Note that all listed funds are Canadian Equity and use the S&P/TSX Composite TR Index for their benchmarks. So very similar funds. Note also that the index benchmark annualized total return for 3 years is 6.4% and 5 years is -1.1%. Finally, note that the median expense ratio is 2.32% for Canadian Equity funds.
RBC Canadian Equity and Fidelity True North are two of the biggest Canadian Equity mutual funds in Canada. Both have over CAD 4 billion in assets under management. So they must be great funds if they were able to attract all that investor capital. Right? And both are actively managed, so they must be getting into the best stocks? Right?
RBC Canadian Equity has a 3 year annualized total return of 3.7% and a 5 year annualized total return of -3.0%. Both significantly lower than the benchmark returns for each period. RBC’s expense ratio is 2.03%, lower than the median but still relatively high. This obviously reflects the active management efforts in finding the best stocks.
Fidelity True North has a 3 year total return of 4.1% and a 5 year total return of -2.3%. An improvement over the RBC fund, but still significantly lagging the benchmark. Fidelity’s expense ratio is a whopping 2.49%, but with better performance than RBC, perhaps worth it.
Then we get to the fund that I often recommend in this asset class. The iShares S&P/TSX Capped Composite Index ETF. Its 3 year total return was 6.1% and its 5 year was -1.4%. Both periods track the benchmark returns quite well. And the iShares ETF nicely outperforms both RBC and Fidelity.
But for the superior performance from iShares, we have to pay a very hefty management fee. Right? Wrong. iShares only has an expense ratio of 0.27%. Yes, 0.27%. 1.76% less than RBC and 2.22% less than Fidelity.
And for very similar funds. For all the “active” management, let us look at the top 10 holdings in each fund. These make up between 45-50% of total fund assets, so the top 10 greatly impact overall fund performance. Of the top 10 holdings, iShares and RBC share 9. And iShares and Fidelity share 6. So is it worth paying plus or minus 2.00% more for active management?
Why investors would purchase a total of CAD 8 billion in RBC and Fidelity Canadian Equity funds when they can get a better price and performance from iShares is beyond me. Good marketing, an ingrained belief that active management must be better than index funds, commissions paid to financial advisors by RBC and Fidelity to ensure their funds are pushed, those are the only reasons I can think of. It sure the heck is not the performance over time.
I would say this is another good example of why I recommend a passive investment approach. By mirroring the benchmark return and minimizing costs, over time you can often outperform active management as they must deal with higher costs.
Value Added to the Client
In our first example, we saw the reduced taxes payable through simple income splitting.
That kind of savings can be reinvested to really grow your capital. At a 5% return over 20 years (assuming straight-line savings on the $239,000), those tax savings would compound through reinvestment to over $400,00 in additional wealth in a tax-deferred plan.
In the second example, we saw the reduced cost and improved performance of my iShares recommendation over two of the largest Canadian Equity style mutual funds.
Ignoring compound returns earned from lower costs and better returns, just consider the annual cost savings. Say you have $100,000 invested in the Fidelity fund, charging an expense ratio of 2.49% per annum. That means you are paying $2490 each year for the privilege of investing with Fidelity. Move that $100,000 to iShares and you will only pay $270 annually. A saving of $2220 each year.
And that saving can be reinvested and grow on your behalf over time. Over 30 years, at an annual return of 5%, that $2200 will grow to over $153,000. In my opinion, much nicer to grow in your investment account, than on the income statements of either RBC or Fidelity.
As for cost, maybe a competent financial advisor will charge you $3000 to assess and restructure your portfolio. It may sound like a fair bit, but as you can see, the payback period may be quite short. And the cumulative benefits significant.
Two easy examples of how the potential benefits in using a competent financial advisor can be much higher than the cost.
So while no one may “need” professional financial expertise, the value added may be well worth your consideration.