RULE 7

Peek Inside A Pilferer's Playbook

If you've read what I've written so far about indexed investing, I hope that you're planning to open your own indexed account. Or perhaps you'll want to find a fee-only adviser who can set it up for you.

Either way, if you currently have a financial adviser buying you actively managed mutual funds, you're probably thinking of making the split.

That might be easier said than done. I like to think that the majority of investors who have attended my seminars have decided to index their investments—to save costs and taxes—while building larger accounts than they would have done with baskets of less-efficient products. But not all have. I know many would-be indexers spoke to their financial advisers, fully intending to break free, but the advisers' sales pitch froze them in their tracks.

Many financial advisers have mental playbooks designed to deter would-be index investors and they initiate their strategies with remarkable success, metaphorically ensuring that their clients continue climbing Mount Kilimanjaro with 50-pound packs on their backs.

How Will Most Financial Advisers Fight You?

Often, when a friend or family member wants to open an investment account, he or she asks me to come along. Beforehand, I briefly talk to the new investor about the markets, how they work, and the merits of index investing. I tell the person that every single academic study done on mutual fund investing points to the same conclusion: to give yourself the best possible odds in the stock market, low-cost index funds are key.

Walking into a bank or financial service company, we're then settled into plush chairs across from a financial adviser selling us on the merits of his ability to choose actively managed mutual funds. When my friend brings up the merits of index funds, the salesperson has an arsenal of anti-index sales talk.

Here are some of the rebuttals the advisers will give you—desperate, of course, to keep money flowing into their pockets and the firm's. If you're prepared for what they might say, you'll have a better chance of standing your ground. Don't forget. It's your money, not theirs.

This is where a salesperson pushes a client's fear button—suggesting that active managers have the ability to quickly sell stock market assets before the markets drop, saving your mutual fund assets from falling too far during a crash. And then, when the markets are looking “safer” (or so the pitch goes), a mutual fund manager will then buy stocks again, allowing you to ride the wave of profits back as the stock market recovers.

It all sounds good in sales theory, but they can't time the market like that—and hidden fees still take their toll. Ask your adviser to tell you which calendar year in recent memory saw the biggest decline. He should say 2008. Ask him if most actively managed funds beat the total stock market index during 2008. If he says yes, then you've caught him talking out the side of his head. A Standard & Poor's study cited in The Wall Street Journal in 2009, detailed the truth: The vast majority of actively managed funds still lost to their counterpart stock market indexes during 2008—the worst market drop in recent memory.¹ Clearly, actively managed fund managers weren't able to dive out of the markets on time.

What's more, a single stock market index is just part of a portfolio. Don't let an adviser fool you with data comparing a single index fund with the actively managed products they're selling. As you read in Chapter 5, smart investors balance their portfolios with bond indexes as well.

I've heard this from a number of advisers. And it makes me smile. If the average mutual fund had no costs associated with it—no 12B1 fee, no expense ratio, no taxable liability, no sales commissions or adviser trailer fees, and no operational costs—then the salesperson would be right. A total stock market index fund's return would be pretty close to “average.” Long term, roughly half of the world's actively managed funds would beat the world stock market index, and roughly half of the world's funds would be beaten by it. But for that to happen, you would have to live in the following fantasy world:

1. Your adviser would have to work for free. No trailer fees or sales commissions for him/her or the firm. The tooth fairy would pay his mortgage, food bills, vacations, and other worldly expenses.
2. The fund company wouldn't make any money. Companies such as Raymond James, T. Rowe Price, Fidelity, Putnam Investments, Goldman Sachs, (and the rest of the “forprofit” wealth-management businesses) would be charitable foundations.
3. The researchers would work for free. Not only would the fund companies bless the world with their services, but also their ranks of researchers would be altruistic, independently wealthy philanthropists giving their time and efforts to humanity.
4. The fund managers doing the buying and selling for the mutual funds would work for free. They would be so inspired by their parent companies that they would trade stocks and bonds for free while lesser-evolved mortals worked for salaries.
5. The fund companies could trade stocks for free. Large brokerage firms would take the financial hit for the trading done by mutual fund companies. Recognizing the fund companies “value-added” mission, brokerage firms would pay every commission a fund company racked up from trading stocks.
6. Governments would waive your taxable obligations. Because the fund companies are such a blessing on the world, the world's governments would turn a blind eye to the taxable turnover established.

If the fantasy scenario above were correct, then yes, a total stock market index fund would generate very close to an average return.

But in the real world, advisers suggesting that a total stock market index gives an average return are proving to be well-dressed Pinocchios or post-Columbus sailors with a “Flat Earth” complex.

But a tough salesperson wouldn't give up there. Next, you might hear something like this:

It's pretty easy to look in the rearview mirror at the last 15 winners of Golf's British Open Championship and say: “See, here are the champions who won the British Open over the past 15 years. These are people who can win. This knowledge qualifies me to pick the next 15 years' worth of champions—and we'll bet your money on my selections.” Studies prove that high-performing funds of the past rarely continue their outperforming ways.

Just look at the system used by Morningstar's mutual fund rating system. No one in the world has more mutual fund data than Morningstar. Certainly, your local financial adviser doesn't. But as detailed in Chapter 3, the funds given “top scores” by Morningstar for their superb, consistent performance usually go on to lose to the market indexes in the following years.

Even Morningstar recognizes the incongruity. John Rekenthaler, director of research, said in the fall 2000 edition of In The Vanguard: “To be fair, I don't think that you'd want to pay much attention to Morningstar's ratings either.”²

So if Morningstar can't pick the top mutual funds of the future, what odds does your financial planner have—especially when trying to dazzle you with a fund's historical track record?

If you're the kind of person who enjoys winding people up, try this comeback out the next time an adviser tries selling you (or one of your friends) on a bunch of funds that he claims have beaten the index over the past 15 years.

OK—maybe that's a bit mean. You aren't likely to see any of those funds in his 15-year-old portfolio reports.

If the salesperson deserves an “A” for tenacity, you'll get this as the next response:

Just thinking about that kind of love gives me goose bumps. Many advisers will lead you to believe that they have their pulse on the economy—that they can foresee opportunities and pending disasters. Their sagacity, they will suggest, will enable you to beat a portfolio of indexes.

But in terms of financial acumen, brokers and financial advisers are at the bottom of the totem pole. At the top, you have pension fund managers, mutual fund managers, and hedge fund managers. Most financial advisers, as U.S. personal finance commentator Suze Orman points out, are “just pin-striped suited salespeople.”

Your financial planner could have just a two-week course under her belt. At best, a certified financial planner needs just one year of sales experience at a brokerage firm, and fewer than six months of full-time academic training (on investment products, insurance, and financial planning), before receiving his or her certification. With some regular nightly reading, it wouldn't take long before you knew more about personal finance than most financial planners. They have to sell. They have to build trust. They have to make you feel good about yourself. These skills are the biggest part of their jobs.

When arbitration lawyer Daniel Solin was writing his book, Does Your Broker Owe You Money?, a broker told him:

This might explain why it's often common to find investors of all ages without any bonds in their portfolios. Predominantly trained as salespeople, it's possible that many financial representatives aren't schooled in the practice of diversifying investment accounts with stocks and bonds.

Noted U.S. finance writer William Bernstein echoes the gaps in most financial adviser training, suggesting in his superb 2002 book, The Four Pillars of Investing, that anyone who invests money should read the two classic texts:

1. A Random Walk Down Wall Street by Burton Malkiel
2. Common Sense on Mutual Funds by John Bogle

“After you're finished with these two books, you will know more about finance than 99 percent of all stockbrokers and most other finance professionals,” he said.⁴

From what I've seen, he's right.

When my good friend Dave Alfawicki and I went into a bank in White Rock, British Columbia, in 2004, we met a young woman selling mutual funds. Dave wanted to set up an indexed account, and I went along for the ride. The adviser's knowledge gaps were extraordinary, so I asked the question: What kinds of certification do you have and how long did it take? She received her license to sell mutual funds through a course called Investment Funds in Canada (IFIC). It's supposed to take three weeks of full-time studying to complete the course, but she and her classmates finished it in just two intensive weeks.⁵Before the two-week course, she knew nothing about investing.

A year later, I went into another Canadian bank with my mom to help her open an investment account. We wanted the account to have roughly 50 percent in a stock index and 50 percent in a bond index. Of course, the adviser, as usual, tried talking us out of it.

But once the adviser recognized that I knew more about investing than she did, she came clean. To paraphrase the discussion, she shocked us with this:

I appreciated her candor. By the end of the conversation, the adviser was asking me for book suggestions about indexed investing and she gratefully wrote down a number of titles. At least she was willing to take care of her personal portfolio.

Three years later, a different representative from the same bank phoned my mom. “Your account is too risky,” he said. “Come on down to the bank so we can move some things around for you.”

Thankfully, my mom was able to stand her ground. With 50 percent of her investment in bond indexes, the account wasn't risky at all—but it wasn't profitable for the bank.

If you notice a financial adviser has a university degree in finance, commerce, or business, hang tight for a moment. Find someone else with one of these degrees and ask this: During your studies at university, did you study mutual funds, index funds, or learn how to build a personal investment portfolio for wealth building or retirement? The answer will paradoxically be no. So don't be fooled by an additional, irrelevant title.

Most brokers and advisers really are just salespeople, and well-paid salespeople at that. In the U.S., the average broker makes nearly $150,000 a year—putting them in the top five percent of all U.S. wage earners. They make more than the average lawyer, primary care doctor, or professor at an elite university.⁶ And if they're recommending actively managed funds, they're a bit like vendors in the guise of nutritionists selling candy, booze, and cigarettes.

The Totem Pole View

Financial advisers and brokers are at the bottom of the totem pole of financial knowledge. At the top, you'll find hedge fund managers, mutual fund managers, and pension fund managers.

Generally earning the highest certification in money management—as certified financial analysts—pension fund managers have the leeway to buy what they want. These are the folks managing huge sums of government and corporate retirement money. Arguably, they're the best of the best. If your local financial planner applied for the job of managing the pension for Pennsylvania's teachers or New Jersey's state-pension system, he or she would likely get laughed off the table.

Pension fund managers have their pulses on the stock markets and the economy. They can invest where they want. Typically, they don't have to focus on a particular geographic region or type of stock. The world is their oyster. If they want to jump into European stocks, they do it. If they think the new opportunities are in small stocks, they load up on those. If they feel the stock market is going to take a short-term beating, they might sell off some of their stocks, buying more bonds or holding cash instead.

Your typical financial planner isn't as knowledgeable as the average pension fund manager. But most advisers will try and “sell” you on the idea that (like the pension fund manager) they have their pulse on the economy and that they can find you hot mutual funds to buy. They might try telling you that they know when the economy is going to self-destruct, which stock market is going to fly, and whether gold, silver, small stocks, large stocks, oil stocks, or retail stocks are going to do well this quarter, this year, or this decade.

But they are full of hot air.

Pension fund managers are more likely to know oodles more about making money in the markets than financial advisers or brokers.

Knowing that pension fund managers are like the gods of the industry, how do their results stack up against a diversified portfolio of index funds?

Most pension funds have their money in a 60/40 split: 60 percent stocks and 40 percent bonds. They also have advantages that retail investors don't have: large company pension funds pay significantly lower fees than retail investors like you or I would, and they don't have to pay taxes on capital gains that are incurred.

Considering the financial acumen of the average pension fund manager, coupled with the lower cost and tax benefits, you would assume that the average American pension fund would easily beat an indexed portfolio allocated similarly to most pension funds: 60 percent stocks and 40 percent bonds. But that isn't the case.

U.S. consulting firm, FutureMetrics, studied the performance of 192 U.S. major corporate pension plans between 1988 and 2005. Fewer than 30 percent of the pension funds outperformed a portfolio of 60 percent S&P 500 index and 40 percent intermediate corporate bond index.⁷

If most pension fund managers can't beat an indexed portfolio, what chance does your financial planner have?

The best odds to win

If you told most financial advisers this, they would either begin talking in circles to confuse you, or they would desperately be battling with their ego.

If it's the latter, you might hear this: If it were so easy, why wouldn't every pension fund be indexed?

Pension fund managers are as optimistic as the rest of us. Many of them will try to beat portfolios comprised of a 60 percent stock index and a 40 percent bond index.

But they aren't stupid, and many pension funds maximize their returns by indexing.

According to U.S. financial adviser Bill Schultheis, author of The New Coffeehouse Investor, the Washington state pension fund, for example, has 100 percent of its stock market assets in indexes, California has 86 percent indexed, New York has 75 percent indexed, and Connecticut has 84 percent of its stock market money in indexes.⁸

The vast majority of regular, everyday investors, however, (about 95 percent of individual investors) buy actively managed mutual funds instead.⁹ Unaware of the data, their financial advisers distort realities to keep their gravy trains flowing. It will cost most people more than half of their retirement portfolios—thanks to fees, taxes, and dumb “market timing” mistakes.

Sticking with index funds might be boring. But it beats winding up as shark bait, and it gives you the best odds of eventually growing rich through the stock and bond markets.

Is Government Action Required?

David Swensen, Yale University's endowment fund manager, suggests the U.S. government needs to stop the mutual fund industry's exploitation of individual investors.¹⁰ The U.S. has some of the lowest cost actively managed funds in the world. I wonder what he would think of Canada's costs, Great Britain's costs, or Singapore's costs, all of which are significantly higher.

You can't wait for government regulation. The best weapon against exploitation is education. You might not have learned this in high school, but you're learning it now.

Among those hearing the call to arms and taking action to educate others is Google's vice president, Jonathan Rosenberg.

In August 2004, Google shares <www.google.com/intl/en/about/corporate/company> became available on public stock exchanges and many Google employees (who already held Google shares privately) became overnight millionaires when the stock price soared.

The waves of cascading wealth on Google's employees attracted streams of financial planners from firms such as JPMorgan Chase <www.jpmorgan.com>, UBS <www.ubs.com>, Morgan Stanley <www.morganstanley.com>, and Presidio Financial Partners <www.thepresidiogroupllc.com>. Drawn like sharks to blood, they circled Google, wanting to enter the company's headquarters so they could sell actively managed mutual funds to the newly rich employees.

Google's top brass put the financial planners on hold. Employees were then presented with a series of guest lecturers before the financial planners were allowed on company turf.

According to Mark Dowie who wrote about the story for San Francisco magazine in 2008, the first to arrive was Stanford University's William Sharpe, the 1990 Nobel laureate economist. He advised the staff to avoid actively managed mutual funds:“Don't try to beat the market. Put your money in some indexed mutual funds.”¹¹

A week later, Burton Malkiel arrived. The professor of economics at Princeton University urged the employees to build portfolios of index funds. He has been studying mutual fund investing since the early 1970s, and he vehemently believes it's not possible to choose actively managed funds that will beat a total stock market index over the long term. Don't believe anyone (a broker, adviser, friend, or magazine) suggesting otherwise.

Next, the staff was fortunate enough to hear John Bogle speak. A champion for the “little guy,” John Bogle is the financial genius who founded the nonprofit investment group, Vanguard. His message was the same: The brokers and financial advisers swimming around Google's massive raft have a single purpose. They're a giant fleecing machine wanting to take your money through high fees—and you may not realize what is happening until it's too late.

When the sharks finally approached the raft, staff members at Google were armed to the teeth, easily fending off the well-dressed, well-spoken, charming advisers.¹²

I hope that you'll be able to do the same as the crew at Google. But don't forget that for most financial advisers, index funds are pariahs. If you have an adviser today, and you're not invested in index funds, then you already know (based on their absence in your portfolio) that your adviser has a conflict of interest. In that case, asking your adviser how he feels about indexes is going to be a waste of time.

After one of my seminars on index funds, I often hear someone say: “I'm going to ask my adviser about index funds.” That's like asking the owner of a McDonald's restaurant to tell you all about Burger King. They won't want you stepping anywhere near the Whopper.

And they certainly won't want you paying attention to the leader of Harvard University's Endowment Fund, Jack Meyer. When interviewed by William C. Symonds in 2004 for Bloomberg Businessweek, he said:

Clearly, investing in index funds is a way to statistically ensure the highest odds of investment success. Doing so, however, means that you will need to stand your ground and perhaps take the road less traveled, while most people succumb to the impressive sales rhetoric that leads them toward—at the very least—investment mediocrity with actively managed mutual funds. If you want to grow rich on an average salary, you can't afford to invest in the expensive products sold by most financial advisers.

A huge risk, however, is when investors start looking at options to enhance their investment returns even further than what an indexed portfolio would provide. The following chapter outlines some common mistakes that people make, with a strong message to avoid the same mistakes yourself.

Notes