The views presented here do not necessarily represent those of Advisor Perspectives.
I talk to a lot of advisors and often see what I believe are misunderstandings that end up costing their clients (and themselves) a lot of money. Many of these advisors disagree that they are misunderstanding, but hopefully you will at least consider the arguments I have. Here are seven examples of the misunderstandings I often hear.
1. Index fund. This is, of course, a mutual fund or ETF that tracks a market index. Index funds like the iShares Core S&P Total U.S. Stock Market ETF (ITOT) and the Vanguard Total Stock Market ETF (VTI) do track the U.S. stock market. But so many advisors think they are indexing when they put their clients into multiple index funds.
There are nearly 3.3 million stock market indexes around the world, according to new research from the Index Industry Association. There are thousands of index funds we can put our clients into. These can include smart beta, levered, triple levered, and even triple levered inverse index funds. Some of these may be low cost and less concentrated, but understand they are all active as they are picking parts of the market to under or overweight.
2. Alpha. This is the excess return over the market index. Alpha, by definition, must be zero in the aggregate before costs and negative after costs. Benchmarking is part art and requires judgment to select an index to use as a benchmark from a field of 3.3 million choices. There are a few that will purposely compare the total return of a portfolio to an index stripped of dividends.
For the most part, people in the financial services industry try to be fair, but there is so much discretion involved. Do I compare a small-cap value fund to small-cap value index? I argue no – compare it to a total stock index. The narrower we benchmark, the less valuable it becomes. Eventually, one could compare a single stock to a single stock index, which would make benchmarking worthless.
Nobel Laureate William Sharpe wrote, “Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.”
In my view, most mismeasurement is not intentional. We are all human and want to show we are adding value. A better strategy is to avoid alpha.
3. Stock or stock fund yield. Most advisors think this is the dividend yield. For example, the dividend yield of the S&P 500 was 1.25% annually for the quarter ending September 30, 2024. However, this captures less than half of the total return. S&P also reports the buyback yield for the index was 1.82% for a total yield of 3.06% (difference is rounding). If the companies paid out the 1.82% in dividends, all would be taxable. But if you sold 1.82% of your S&P 500 index fund, you’d own the same proportion of S&P 500 companies as if they had paid it all out in dividends. I work through the math here. But now the part of that 1.82% returned is not taxable since only part of that amount is a taxable gain. Of course you have to hold the shares for more than a year to get the long-term capital gains tax rate.
Companies have learned that it’s far more tax efficient to return money to shareholders in a stock buyback than with dividends and so have changed their strategy. Accordingly, stock buybacks have been increasing far faster than dividends.
To illustrate this point, Rob Arnott, chair of Research Affiliates, recently calculated there was actually a small amount of negative share dilution – stock buybacks – over the past 10 years. Arnott told me, “Instead of paying high dividends, while diluting the shareholders with a steady flow of new share issuance, they have been doing the opposite – paying smaller dividends and buying back some stock.” If you want the most tax-efficient income fund, perhaps a low-cost total stock or S&P 500 index fund is the best choice.
4. Commodities. Many advisors include commodity funds as part of a diversified portfolio. Here’s a secret: Outside of precious metals, there are no commodity funds. No fund families that I know of have storage tanks that hold commodities like oil or grain. There are only funds that buy commodity futures.
Another secret is that, in the aggregate, not a penny has ever been made in the futures market before costs. The futures market helps companies smooth out cash flows such as ExxonMobil selling oil futures to Southwest Airlines.
I agree that commodities can have low to negative correlations to a standard stock and bond portfolio. But the same goes for gambling part of a portfolio in Las Vegas. At least you’d have more fun in Las Vegas.
5. Yield-to-worst. The technical definition is that it’s the minimum yield a client can expect from a bond under various scenarios. I see this most often in a muni bond portfolio. It assumes that, under current rates, bonds paying more than market rates will be called when the call date is reached. I tell advisors and clients that this is actually the best-case scenario.
One recent client had a muni bond portfolio where the advisor thought he was getting over a 4.5% tax-free current yield on a high-quality portfolio of individual munis. His broker declined to provide supporting data such as the yield-to-worst. In reality, he was buying bonds at a premium and that 4.5% yield was in large part, a return of principal. The yield-to-worst was less than 3.2%. I call this the muni bond illusion.
Why is that the best-case scenario? One bond, for example, would be called in a matter of weeks if rates stayed where they currently are. But if rates rose just a bit, the client would be stuck with below-market interest rates for another 18 years until the bond matured. So, in reality, the 3.2% yield-to-worst was part interest income and part insurance premium. If rates increased, the municipality wouldn’t call the bonds, leaving the investor stuck with a below-market interest rate and a bond with a much longer duration.
6. Phantom income tax. This is tax on income that you or your client hasn’t actually received. Mentioning this to clients and advisors usually evokes an immediate, negative, emotional response. That can cause a rejection of some good products like individual TIPS and TIPS ladders.
While I don’t love phantom income tax, it’s not a deal breaker for me. Say I open a certificate of deposit at a bank or credit union that pays an attractive rate. I want interest to compound but the IRS taxes me each year, even though I didn’t yet receive the cash. That’s phantom income tax as well. The same goes for TIPS in a taxable account. Regardless, I love my TIPS and am happy to let the interest compound.
7. Fee-only. Many advisors tell me they give “unbiased advice” because they are not incentivized to recommend certain financial products over others. Spoiler alert: We are all biased because we are human. Can we really develop a simple portfolio and keep charging for the occasional rebalance or would the client balk? Telling a client to pay off their mortgage leaves less assets in the portfolio to charge a fee on. And what if a product – such as cash paying far more elsewhere – isn’t available on our platform?
Be aware of all of these conflicts. In my experience, those that refuse to even consider the fact that they exist are typically the advisors abusing client the most.
Conclusion
Though you may not agree with my view on all seven of these terms, it may be beneficial for you and your clients to at least consider them. Use indexing to own the entire market (U.S. and international) and work to minimize alpha which, in the aggregate, is negative after costs. Look at the total yield of a stock or stock fund rather than only a part of it. Avoid commodity funds since they don’t own commodities. Don’t fall for the muni bond illusion, and understand that phantom income tax is not always a deal breaker. Finally, understand that we all have biases, because we are human and always question whether your incentives are aligned with your clients’. Fiduciary is such an easy word to say.
Allan Roth is the founder of Wealth Logic, LLC, a Colorado-based fee-only registered investment advisory firm. He has been working in the investment world of corporate finance for over 25 years. Allan has served as corporate finance officer of two multibillion-dollar companies and has consulted with many others while at McKinsey & Company.
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The views presented here do not necessarily represent those of Advisor Perspectives.