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July 14, 2014 at 10:33 AM
DFA advisor Eric Nelson says investors can beat the performance of index funds and in so doing get the tremendous value an advisor offers essentially for free.
The Servo Wealth Management principal is wont to sift through data to find how to eke out extra basis points of return.
In a recent post, Nelson follows this familiar format by comparing the performance of three investment approaches over the past 10 years: conventional active management versus index investing versus what he calls “structured investing.”
Looking at seven different asset classes (six stock portfolios and one bond category), Nelson finds that active management performed the worst, trailing the index in five out of seven cases.
But the performance results are actually worse than they appear, he says, because of what is known as “survivorship bias”: As many as 40% of these funds have performed so poorly that even in the space of 10 years they have been shut down, their unflattering data unfactored from the category’s average.
Index funds, by simply mimicking an appropriate benchmark and keeping costs low, beat active funds, but fall short of the performance of “structured funds” in all seven categories — by 1% or more in many instances.
Structured funds, like those offered through Dimensional Fund Advisors, are managed to capture higher risk and higher return characteristics that are found in areas such as small-cap and value investing. Nelson says they are taking index investing to the next level by accenting higher returns and extending the benefit of lower costs by avoiding portfolio turnover.
The difference among these alternatives can be seen especially vividly in the case of U.S. large value stocks, where active funds delivered average returns of 7.1%, index funds 8% and structured funds 9%; in the emerging markets category, the spread was 11.2%, 12.6% and 13.5% for active, index and structured funds respectively.
Discussion board critics have assailed Nelson’s approach, arguing that DFA funds are inaccessible to individual investors without an advisor, whose added fees would erode the funds’ purported advantage.
But Nelson turns that argument on its head by arguing that advisory fees are not paid for fund access but rather for essential wealth management services, and that those services are essentially delivered “for free” as a result of structured funds’ superior historical performance.
“What I tell prospective clients…is: Hiring me most likely will not cost you anything above the results you’ll earn investing on your own,” Nelson tells ThinkAdvisor.
The reason for these “free” advisory services, though, has less to do with investment performance and more to do with the discipline a good advisor can impose on naughty investor behavior.
Nelson asks: “If the average investor is costing themselves 2%+ per year [according to three estimates from the St. Louis Fed, Morningstar and John Bogle that Nelson discusses in his current blog post] due to poor decisions, is paying me 0.5% to 0.75% to avoid those bad decisions a net cost? Or are you 1.25% to 1.5% per year ahead assuming you are the average investor?”
