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Why Are Investors Paying So Much For Index Fund Selection?

The financial service industry is shrinking - bankers, traders, and brokers are losing jobs en masse - but, remarkably, assets-under-management and fees for independent investment advisors have continued to grow steadily throughout the financial carnage of the past 5 years; as noted by the title of this article in last week's Wall Street Journal - "It's an RIA (Registered Investment Adviser) World, Everyone Else Just Lives in it"

Why are investors increasingly relying on investment advisors?
2011 was another dreadful year for actively managed funds (funds which seek to select individual winners and losers). Equity mutual funds had their worst year since 1997 relative to the Standard & Poor's 500 Index, as record-high correlation and price swings made it harder for money managers to pick stocks according to The 50-day correlation of S&P 500 stocks to gains or losses in the full index increased to a record 0.86 in October.

What this means is that investors were better to put their money in broad index funds which track asset classes such as large-cap stocks, municipal bonds, or commodities. These asset classes soared and plummeted over the course of the year in tandem with the latest financial headlines, and with so much turmoil, most investors felt more comfortable going to bed at night knowing they were paying a professional to select and re-balance their portfolio of index funds.

Dilbert Comic

But isn't 1% still an awful lot to pay for asset allocation and a little hand-holding when markets are crashing?

There is no question that experienced professional advice can be extraordinarily valuable for building a long-term financial plan and avoiding the behavioral finance pitfalls that plague the vast majority of individual investors. Most investors are likely to benefit from some form of outside financial assistance. But a fee based on 1% of your assets can add up to a staggering amount of your wealth over time (especially in today's low-yield environment).

Asset allocation can be challenging (and those index funds aren't going to pick themselves). But in 2012, with asset allocation models (ours and others) available on the internet, it is a very, very do-able task for the average investor to manage their own portfolio. Investors can accomplish much of the fund management services provided by investment advisors by following the set-up and re-balancing instructions from these web-based models and then making the suggested low-cost index fund trades through an online brokerage account or mutual fund company like Vanguard. Investment Advisors can then be consulted on an hourly fee basis for periodic strategic planning and advice.

Americans are zealously pursuing value in other areas of their lives from online coupons to do-it-yourself home repair. So it is surprising how well the traditional investment adviser business and fee structure is holding up.