You’ve moved to a new city and are interviewing primary care physicians.  You are escorted into the doctor’s office and are surprised to see that he is grossly obese and smoking a cigarette!

Is he the person you would choose to keep you healthy?  I doubt it.

Let’s change the scenario.  You are looking for an investment advisor to provide comprehensive wealth management services.

According to a recent study, here’s what you’re likely to find.

Many advisors don’t know how to invest

The study looked at trading and portfolio information for more than 4,000 advisors and almost 500,000 clients located in Canada between 1999 and 2013. The data also included the personal trading and account information for the majority of the advisors.

Previously, the prevailing view was that conflicts of interest caused advisors to recommend expensive, actively managed funds likely to underperform comparable index funds.  That would be bad enough.

What the study found is worse – much worse.

Advisors don’t recommend actively managed funds because they make higher commissions doing so.  They hold the same funds themselves.  These funds have high expense ratios (over 2%).  The portfolios of the advisors and their clients both earned “negative alpha” (the difference between the returns they could have achieved by investing in comparable index funds and what they actually earned) of a shocking -3% annually.

The study found the misguided beliefs of advisors is what drove their recommendations to their clients.

The study summarizes the investing behavior of these advisors as follows:  They underdiversify, trade frequently, and favor expensive, actively managed mutual funds with high past returns, despite evidence that these strategies often underperform.

The authors conclude: …advisors have the wrong beliefs rather than the wrong incentives.

The takeaway

This study leads to the inescapable conclusion that these advisors are incompetent and negligent.  You wouldn’t rely on a doctor with unhealthy habits. You should avoid advisors who invest their personal funds in expensive, actively managed mutual funds.

Resource of the week

The findings of this study (discussed above) are so important, I recommend you read it yourself.  While it is based on data from Canadian financial institutions, it’s likely U.S. based data would yield similar results.

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