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Big Fees. Bad Advice

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The investment world is really bizzaro world. Everything is the opposite.

You would think wealthy people would get world-class financial advice from their high powered advisors. You would be wrong.

A recent study looked at $50 billion in assets held in approximately 50,000 individual accounts. The average account size was $900,000, but the study focused on the largest accounts, with an average size of $3.5 million. Here is what it found:

* The ultra rich have a strong preference for ETFs over index funds;
* They hold less than a third of their portfolios in either index funds or ETFs.
* They hold "very little" broad-based marked index funds.

Why is this a perfect example of bizzaro world? Well, the overwhelming credible, peer reviewed, financial data would advise the opposite. Specifically:

* Index funds are superior to ETFs for most investors
* 100% of their portfolios should be in index or passively managed funds; and
* A broad based market index fund should be an integral part of every portfolio.

Here is the bottom line on ETFs:

* You incur a hidden fee because of the ETFs "bid-ask" spread;
* You have to pay a brokerage commission to buy or sell them;
* They may not be as tax efficient as index funds;
* Many ETFs do not track indexes as well as index funds.

Here is Warren Buffet's take on the ETF/index fund debate:

I have nothing against ETFs, but I really think an index fund that just charges a few basis points for management is pretty hard to beat... You put it away, you have nobody encouraging you to trade it next week or next month ... your broker isn't going to be on you.

And what about the advice given to the ultra rich that encourages them to pick outperforming mutual funds?

Jonathan Clements, the highly respected financial journalist for The Wall Street Journal, summarized it best:

Santa Claus and the Easter Bunny should take a few pointers from the mutual-fund industry [and it's fund managers]. All three are trying to pull off elaborate hoaxes. But while Santa and the bunny suffer the derision of eight year olds everywhere, actively-managed stock funds still have an ardent following among otherwise clear-thinking adults. This continued loyalty amazes me. Reams of statistics prove that most of the fund industry's stock pickers fail to beat the market. For instance, over the 10 years through 2001, U.S. stock funds returned 12.4% a year, vs. 12.9% for the Standard & Poor's 500 stock index.

The failure of RIA's to the ultra rich to include a broad based index fund in their portfolios is a rookie error and a fatal flaw. Here is what John Bogle, the founder of Vanguard, observed:

...a Wilshire 5000 index fund will likely outperform most actively-managed stock mutual funds over the long run.

There is ample support for Bogle's views. One study tracked the performance of mutual funds that received the much hyped "five star" rating from Morningstar from 1993-2000. These funds had a total return of 106%. Not bad, until you compare it to the total return of 222% for an index fund that tracked the Wilshire 5000.

Why fight bizzaro world?

Just do the opposite of advice given by advisors to the ultra-rich.

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