Do most financial advisors know what they're talking about?

Napoleon Bonaparte famously said "Never ascribe malice to that which is adequately explained by incompetence". This is a way of thinking known as Hanlon’s Razor, and it can help us interact with the world more favourably.

There is an established body of evidence that high fees and active management are not in the best interest of investors. Commissions are often blamed for influencing the questionable advice that many financial advisors give, but there may be a much more innocent explanation.

As of December 2017, 89% of Canadian investment fund assets were invested in mutual funds, with the remaining 11% invested in ETFs. A 2017 Morningstar study of the Canadian mutual fund landscape showed that the majority of mutual fund assets in Canada are in commission-based products. These are typically actively managed mutual funds that pay a trailing commission to the financial advisor that sold them. It’s probably safe to conclude that many Canadians are still relying on the advice of financial advisors selling commission based products.

The lack of a fiduciary duty for most financial advisors is often blamed for the generally poor financial advice that many retail investors receive. A 2015 study commissioned by the Canadian Securities Administrators showed that Canadian financial advisors are likely influenced by commissions. Similar studies in other countries have concluded the same thing, leading some countries to ban mutual fund commissions altogether.

Commissions do seem like a sensible explanation for the bad financial advice that so many Canadians receive, but what if there is a bigger issue? We know that the barriers to entry for becoming a financial advisor are quite low. If financial advisors don’t necessarily have a great understanding of investing and portfolio management, it is feasible that their bad attempts at giving good advice are simply misguided.

A 2016 study titled The Misguided Beliefs of Financial Advisors looked at this exact issue. The study looked at more than 4,000 Canadian financial advisors, and almost 500,000 clients, between 1993 and 2013. By comparing the accounts of the advisors to the accounts of their clients, the study authors were able to test whether advisors were also acting on the advice given to their clients in their own personal accounts.

If, for example, financial advisors were selling expensive actively managed mutual funds to their clients while investing in low-cost index funds in their personal accounts, we would suspect a conflict of interest. If advisors were buying expensive actively managed funds in their own accounts, we would suspect that they really believed that to be a wise investment.

The data show that both advisors and their clients tend to exhibit performance chasing behaviour and an overwhelming preference for actively managed mutual funds. They also both had poorly diversified portfolios and owned funds with high fees, but the advisors own portfolios actually had worse diversification and higher fees than the clients. All of these tendencies are well documented as being detrimental to long-term returns. The study also shows that financial advisors typically continue with these behaviours once they have retired, ruling out the possibility that they hold expensive actively managed portfolios only to convince clients to do the same.

This evidence makes a strong case that the many financial advisors selling expensive actively managed investment products may be doing their best to give good advice based on their own misguided beliefs. None of this should come as a surprise. A license to sell mutual funds is not terribly difficult to obtain, and fund companies pour resources into convincing financial advisors that they should be selling actively managed products to their clients.

The possibility that many financial advisors are misguided in their beliefs has important implications for investors. A 2017 white paper from Vanguard titled Trust and financial advice shows that one of the most important factors that investors consider in assessing the trustworthiness of their financial advisor is the expectation that the advisor will act in their best interest at all times.

Of course having someone looking out for your best interests should be valued, but well-meaning advice from a misguided financial advisor is just as damaging as malicious advice. If you need financial advice, seeking out a financial advisor with advanced financial education and an understanding of the evidence supporting the use of index funds could be a sensible solution.

It is always a good idea to ask your financial advisor what they think about index funds. The right answer, and there is a right answer, is that index funds are the most sensible approach to investing for most people.