Why Your Financial Advisor Doesn’t Like Index Funds

I often hear stories from investors who have asked their financial advisor for low-cost index funds, and are met with some sort of rebuttal. Those are only stories, but we do know that as at the end of 2016, only 11.3% of Canadian investment fund assets were invested in low-cost index funds.

Based on the data, it is probably fair to say that the majority of financial advisors are not recommending index funds to their clients.

I think that most financial advisors have good intentions, but there is clear academic and empirical evidence that the actively managed funds that they often recommend are not in the best interest of their clients.

The evidence is clear, and your financial advisor is probably a good person, so why are they still selling actively managed mutual funds?

In this episode of Common Sense Investing, I’m going to tell you why most financial advisors are not recommending index funds.

I think that there are four main reasons that financial advisors are not excited about recommending index funds. Commissions, career risk, their value proposition, and a lack of knowledge.

Let’s talk about commissions. The reality for Canadian investors is that the majority of financial advisors in Canada operate by selling mutual funds that pay them commissions. Financial advice in Canada is generally held to a suitability standard – in other words, as long as the advice is suitable for the client, it does not have to be in their best interest. This causes a problem for investors where their financial advisor can legally sell them products that generate large commissions for the advisor, at the expense of the client. Low-cost index funds do not pay commissions.

This isn’t news to anyone. This conflict of interest is becoming increasingly well-understood by investors, which is causing an increasing number of financial advisors and their firms to offer fee-based services. On a fee-based model, the client pays the advisor directly, removing the commission incentive for recommending high-fee products. Removing commissions may seems like an easy fix, but commissions are not the only reason that most financial advisors don’t recommend index funds.

Think about a financial advisor who has been in business for 10 or 20 years. Chances are that they have been selling actively managed mutual funds or picking stocks for their clients for the duration of their career. Investment fads have come and gone, but they have settled on some strategy that their clients are comfortable with. It is highly unlikely that this strategy has been investing in low-cost index funds.

It would be extremely challenging for any advisor to change their story and start recommending low-cost index funds. Doing this would effectively mean telling their clients that they have been wrong about their approach to investing, and need to make a drastic change. It would be an admission that all of their market predicting and manager selection has not been adding any value.

That brings us to the next challenge for advisors. What is the value of a financial advisor? For many years, it has been selecting mutual funds or individual stocks. A meeting with a client might consist of reviewing the performance of the stocks or funds in their account and making decisions about selling them to invest in something else. Any advisor that operates this way would have an obvious challenge in recommending index funds. All of a sudden they are no longer able to add value. How would they keep their clients?

It’s pretty obvious that there would be some major challenges for an advisor that decided to start recommending index funds to their clients.

Making that decision would require significant conviction. It is accepted as truth in the academic community that index funds are the most sensible investment for most investors. Getting to that point of understanding does require some time spent absorbing the body of evidence that supports investing in index funds. If an advisor has a successful business without index funds, they have little motivation to invest that time.

It doesn’t help that actively managed mutual fund companies offer material designed to convince advisors and their clients that actively managed funds are still the best option. It’s like doctors being told by the tobacco companies that cigarettes are healthy. Advisors have little motivation to gain an understanding of the research, and are being fed anti-evidence stories ? by the big fund companies.

I’ve just told you four reasons why financial advisors are unlikely to recommend index funds. Most of these advisors will offer you reasons that index funds are scary. An advisor might say that index funds have no chance at beating the market, or that they will be disastrous in a down market. While these reasons to avoid index funds may sound good in a sales pitch, they are refuted by the data. On average, active funds lag the performance of index funds, including during down markets.

The fact is that investing in actively managed strategies, whether in a mutual fund or through stock picking, increases your fees, transaction costs, and risk. When you make an active decision to be different from the market, you are betting that your active manager is going to be able to outperform by selecting the right stocks and bonds at the right time. Statistically, there is a very small chance that they will be able to do so. The result for you is higher expenses, and less tax efficiency in exchange for a relatively small chance at better performance, and a large chance of underperformance compared to the market.

If your financial advisor is investing your money in active strategies, it is likely that they are either being influenced by commissions, or they are not aware of the evidence supporting index investing. If they are not influenced by commissions and are aware of the evidence, then they are intentionally taking on active risk, which has a very low probability of working out in your favour. Do you want to be taking on extra risk in return for a small chance at beating the market? If you do, then your advisor might be a great fit for you.

With the low probability of consistently achieving market beating returns, it is far more sensible for most people to simply capture the returns of the market using low-cost index funds. If your financial advisor disagrees, you might be better off elsewhere.

I’ll be talking about a lot more common sense investing topics in this series, so subscribe. I want these videos to help you to make smarter investment decisions, so feel free to send me any topics that you would like me to cover.