A reader we’ll call Frank recently emailed me about his advisor (we covered part of his email about dividends here). She had placed him in A shares of American Fund mutual funds. This told me he was working with a commissioned-based broker, as these mutual funds charge a sales fee of 5.75% to compensate the broker for referring a client to their funds.
Here’s the critical part of Frank’s email:
Currently I’m invested in various American Funds and I’ve been thinking about reinvesting in a few Vanguard index funds. After explaining my reasons to my financial advisor, she is quick to point out that while the fees of let’s say VTSMX (.17% expenses) are low, the total reinvestment isn’t as great as that of for example ANCFX (.63% expenses) which I’m currently invested in. She is basically saying that even though the fees are higher I will still make more money in the long term. As a listener of your podcast this idea raises a red flag.
I’ve heard this argument frequently from investment advisors that charge heavy fees. They try to convince us that they can produce higher after fee returns, although they never extend a guarantee with their promise. Frankly, I’ve heard the same argument from fee-only advisors who charge ridiculously high fees.
We’ve dealt with this issue in the past when looking at Dave Ramsey’s Endorsed Local Provider program. ELP, as he calls it, refers individuals to commissioned-based brokers. Dave has taken a lot of heat for this, with some wondering if his recommendations are motivated by money. I’ll leave that assessment to you for now.
Today we are going to cover 5 gotchas you should keep in mind if you are either working with a broker or considering working with one.
1. Confusing Terminology
What’s the difference between a fee-only advisor and one that is fee-based. At first glance, they may appear to be the same thing. They are not. A fee-based advisor is the same thing as a commissioned broker. Don’t be confused by the fact that fee-based seems similar to fee-only.
To be certain, question a potential advisor to understand exactly how he or she makes money. You may find that for investment management the are fee-only, but they get paid commissions on insurance and annuity products. The key is to do your due diligence before deciding whether to work with an advisor.
2. Sales Charges
Commissioned brokers typically recommend actively managed mutual funds that come with a 5.75% sales charge. If you were to invest $100,000 in such a fund, $5,750 would immediately come out of the fund to pay your broker. You’d have $94,250 left in the fund.
The downside to this transaction is obvious. So why do some people continue to use commission-based brokers. There are a couple of reasons, including the “Total Return” argument we’ll cover below. But one argument often put forth is that commission-based brokers are actually less expensive than fee-only investment advisors over the long run.
The argument goes that while you pay 5.75% up front, that’s the only fee you’ll pay the broker for that investment. In contrast, with a fee-only advisor you continue to pay out a percentage of your portfolio each and every year. Given enough time, the commission-based broker can be significantly less expensive.
There is absolute truth to this argument. Add to that the fact that some fee-only advisors charge absurdly high fees, and the argument becomes even strong.
There are, however, a few problems with this argument.
First, it assumes you never (or at least rarely) change investments. If you were to move your investments from one mutual fund to another with sales charges, you’d be hit with a 5.75% fee again. So when your broker recommends a change a few years down the road, you’ll have the unpleasant choice between ignoring the advice or paying more in fees. And that says nothing of the inherent conflict of interest–is the recommendation motivated, at least in part, by the fees the advisor will receive if you follow their advice?
Second, not all fee-only advisors charge exorbitant fees. While 1% of AUM (assets under management) appears to be the standard, some charge less depending on account size.
Third, actively managed funds recommended by commission-based brokers come with higher expense ratios. The American Funds mutual fund in Frank’s email charges 0.63% annually in fees and has a turnover ratio that suggests high transaction costs. In contrast, an index fund has low turnover and charges less than 0.20% in fees.
3. Fund Selection
Commission-based brokers recommend funds with sales charges. These fees are how the broker gets paid. As a result, these brokers won’t recommend index funds or other investment products that don’t pay commissions. In short, these brokers ignore investments that may be in your best interest simply because they are not in the broker’s best interest.
4. Product Selection
I was talking to a friend of mine the other day who worked for a commission-based broker a few years ago. My friend, who is a Chartered Financial Analysis, is very knowledgeable about the business. I asked if his former employer made most of its money by charging a few of AUM. He smiled, and immediately I realized just how naive my question was.
He explained that his former employer made money selling expensive annuities and non-traded REITs. These investment products typically put 7% of the amount invested in the broker’s pocket. As a result, they pushed these investments on unsuspecting clients. They preferred the “quick win” over a long relationship that truly benefited the client. Indeed, many fee-only advisors have to get new clients out of these expensive investment vehicles just a few years later.
5. The “Total Return” Myth
Lastly we turn to the total return argument. It goes like this–yes your fees may be higher with me, but your total return after fees will also be higher. Expensive fee-only advisors have been known to make the same argument. Even Dave Ramsey falls into this trap with his claim of a 12% return in the stock market.
There is an element of truth to this argument. Indeed, it is total return after fees and taxes that is most important. If higher fees result in even higher returns, who cares about the fees? So what’s the problem?
First, over the long term very few actively managed funds beat the indexes after fees and taxes.
Second, even if we knew that some actively managed funds would beat the market over say the next 35 years, there’s no way to know today which fund would achieve this feat.
Third, even if we were lucky enough to pick the right fund, it’s doubtful we could stick with it over the next 35 years. Why? Because the future, yet currently unknown, winner would have some really bad years. Even Warren Buffett has had some bad years. How likely are we to stick with active management through think and thin?
Fourth, taxes are a significant issue with actively managed investments. Turnover of assets tends to be higher as managers try to sell the losers and buy the winners.
And finally, a note of caution. Performance numbers of mutual funds typically do not account for the sales charge. While they are listed net of other fees, taking into account the front load is challenging because it’s effect depends on how long the investor holds the fund. So be very careful when comparing performance numbers between funds that levy a sales charge and those that do not.