06/18/2013 06:55 pm ET | Updated Aug 18, 2013

Slick Tricks to Separate You From Your Money

These are tough days for "market beating" brokers and advisors. Investors are using the Internet to do their own research. They are finding support for a view I have been advocating for years: "Market beating" brokers and advisors are emperors with no clothes, touting an expertise they don't have and taking advantage of their naive clients.

These clients are no longer easy marks. They are taking action, and Wall Street is plenty unhappy about it. Low-cost index and passively managed funds had net inflows of over $442 billion over the past decade. Higher-cost, actively managed funds (where the fund manager attempts to "beat" a designated benchmark) had outflows of $368 billion. Ouch!

Wall Street is not taking this drubbing without a fight. Watch out for these slick tricks:

Worthless Predictions: Self-styled market seers continue to make predictions about the direction of the market in an effort to convince investors that they have the ability to peer into the future with accuracy. I am unaware of any peer-reviewed data indicating this is an expertise that exists, once you exclude luck as a factor. Here's one example, among many others: I wrote a blog post on August 14 titled: Two Silly Predictions You Should Ignore. I discussed a prediction by Bill Gross, the "King of Bonds," at PIMCO. Mr. Gross stated "the cult of stocks was dying." He related the way stocks operate to a Ponzi scheme.

The other prediction was by Mark Yusko, the CEO of Morgan Creek Capital. He told advisors not to expect any significant returns from stocks through 2021 and derided the contrary views of John Bogle, the founder of Vanguard.

According to Yahoo! Finance, the DJIA closed at 12,976 on August 1. It closed at 15,070 on June 14.

Undeterred, both Mr. Gross and Mr. Yusko continue to make predictions about the markets. Sometimes they are right, and sometimes they are wrong. Relying on their predictions, or those of their colleagues, is gambling and not investing.

Underestimating Your Intelligence: Wall Street hopes you won't discover evidence-based investing. The entire premise of the brokerage industry -- its predictive "expertise" -- is flawed. There is a much better way, backed by peer-reviewed data. It does not rely on financial astrologers or other hype. It targets expected returns of the capital markets. Two leaders of this intelligent and responsible investing strategy are Dimensional Fund Advisors and Vanguard. Both are thriving as investors abandon actively managed funds. DFA explains how it invests in this excellent white paper. [Full disclosure: I am a wealth advisor with Buckingham Asset Management. Buckingham recommends DFA funds to its clients]. John Bogle, the founder of Vanguard, explains the benefits of evidence-based investing in this lucid talk he gave in 2001.

Misleading Data: Most troubling to Wall Street has been the dismal performance of hedge funds. For the period 2003-2012, the HFRX Global Hedge Fund Index had an annualized return of a puny 1.6 percent. For the same period, the S&P 500 Index had an annualized return of 7.1 percent. If these all-star managers can't pick stocks or time the market, Wall Street is concerned you might figure out that your local broker doesn't have much of a chance of doing so either.

J.P. Morgan to the rescue. It compiled a chart purporting to show that during the 16 years from 1997 to 2012, hedge funds delivered superior cumulative returns over common benchmarks by "substantial margins." Before you rush out and buy a hedge fund, you should read an excellent blog post by Harriet Agnew in Financial News. Ms. Agnew notes the problems with this chart, which "may exaggerate the actual performance of hedge funds."

The most misleading aspect of this chart is its use of time-weighted returns instead of asset-weighted returns. Assets of hedge funds have increased dramatically over the time period measured. By using time-weighted returns, the chart gives the same weight to positive returns on a smaller asset base as it gives to losses on a higher asset base. Although hedge funds are not responsible for the amount of assets flowing into their funds, the use of time-weighted returns is a misleading indicator of returns actually earned by investors in those funds. Ms. Agnew provides an example of a 19 percent loss on $1.9 trillion in assets, which would equal $360 billion. Even if the hedge fund industry had a 20 percent gain the following year, it would not make up for the prior year's losses, because the gains were on a smaller asset base.

As my colleague Larry Swedroe noted in this blog post, there is compelling evidence that "alpha" (outperformance) is a limited resource. There is greater alpha available when the asset base is smaller, but it gets diluted as assets increase, making it far more difficult to generate alpha. As more funds chase market mispricings, those opportunities tend to disappear. Investors late to the game who poured assets into hedge funds, in expectation of generating the same level of alpha as the early money, paid obscene fees for underperformance.

The chart also ignores the performance of hedge funds that did not survive or stopped reporting their returns to the database.

Finally, the chart ignores dividends from the S&P 500 return. Dividends represent approximately two percentage points a year for the S&P 500, or about 40 percent of the total returns over the long term. Is it just a coincidence that the J.P. Morgan chart shows the "outperformance" of hedge funds over the S&P 500 is a little more than two percentage points annualized?

The lesson is clear: They don't have reliable data supporting their "expertise" so they use smoke and mirrors instead.

Don't be fooled.

Dan Solin is the director of investor advocacy for The BAM ALLIANCE and a wealth adviser with Buckingham Asset Management. He is a New York Times best-selling author of the Smartest series of books.

The views of the author are his alone and may not represent the views of his affiliated firms. Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisory services.