The traditional value proposition for most advisors and money managers has been based on their prospects for delivering better returns than those of the markets. Yet years of sound academic research and empirical results show that, rather than adding value, active management typically detracts from long-term market returns.
It is this overwhelming evidence that leads Truepoint to construct portfolios employing passive or indexed investment vehicles. However, this brings us back to a more specific version of the original question: “Can an advisor add value simply investing in index funds?”
While we believe our track record reflects the value added through close attention to portfolio construction and opportunistic rebalancing, it is more difficult to measure the benefit of providing an external source of discipline. A recent study published in The Journal of Wealth Management attempted to do just that.
Philip Maymin, an assistant professor of finance and risk engineering at NYU-Polytechnic Institute, studied 17 years of client contact records at Gerstein Fisher, a New York City investment management firm. Maymin used the comprehensive records to gauge the ability of an investment advisor to add value by restraining clients from their own tendencies to aggressively trade.
Maymin compared his findings to that of a 1978 study on “night eating.” In the study, a client wishing to minimize his night eating pursued increasingly physical behavioral strategies. He began with a “Stop! Think!” note on his refrigerator, eventually progressing to tying the door shut with twine. Finally, the client discovered what turned out to be the only effective strategy: completely removing the option.
Every night, he would lock the refrigerator and give the key to a roommate. Importantly however, while this did end his night eating, it did not remove the desire to eat. Similarly, Maymin argues, emotions of fear, regret and greed lead investors to feel constant urges to trade; simply telling themselves to abstain does not work. The best path is removing the option – in this sense, the investment advisor acts in the role of the roommate keeping the key.
“The urge never goes to zero,” states Maymin in a New York Times article (“When to Buy or Sell? Don’t Trust Your Instincts”) profiling the study. “People who want to trade aggressively, it will never go away. If the market is volatile, it increases.”
A prior Barber, Lee, Liu and Odean (2009) study concluded that aggressive trading by individuals reduces returns by about 4% per year. In Maymin’s words, “enlightened behavioral investors ought to be more willing to pay on the order of 1% to an investment manager who will prohibit or at least impede aggressive orders than pay nearly four times as much for the privilege of excessively and detrimentally trading their own account.”