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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.

Author Bio

Total Articles: 1083
Rob founded the Dough Roller in 2007. A litigation attorney in the securities industry, he lives in Northern Virginia with his wife, their two teenagers, and the family mascot, a shih tzu named Sophie.

Article comments

Kyle says:

“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.”

This is true if you change fund families. If I bought an American Funds A share, sold it years later and bought a Templeton A Share there would be two front loads.

Once I’m “in the building” with American Funds I can switch between any of their A share funds without paying the load again.

This isn’t true with every fund company, but it’s standard operating procedure for most fund families.

Rob Berger says:

Kyle, thanks for pointing out this nuance. Very important if you can stay within the same fund family.

Rob Drury says:

Lot’s of good information here, along with a lot of misnomer. As the article points out but not strongly enough, everything must be viewed net of fees. First of all, let’s agree that one’s advisor deserves to get paid, and paid well. The question is what compensation structure is most appropriate.

Contrary to today’s popular wisdom, I strongly prefer commission-based compensation to fees for the typical individual. High net worth individuals and business owners need extensive advice and active management of their affairs as well as their portfolios. They need someone getting paid to “be there.” The rest are primarily product buyers. Fees in no way promote objectivity or integrity. In fact, they ensure that the advisor gets paid even for accomplishing absolutely nothing.

I’m in agreement that mutual funds are usually the way to go for most of us saving for retirement; but because of taxation issues, I only recommend they be used within tax qualified plans (IRAs, 401k, etc.) so that transactions within the funds don’t create taxable events. Over the long haul, and contrary to some implications in this article, loaded funds are usually the least expensive, as no-load shares normally have significantly higher expense ratios due to vast marketing costs not incurred using brokers. A-shares have the lowest expense ratios, and offer price breaks based on balance. For many, B- shares (deferred sales charge) fees are the best option. To be fair, there are a very few fund families that have low enough expenses to justify their no-loads; but again, one’s advisor deserves to get paid. If one chooses no-load or exchange traded funds, one doesn’t deserve the assistance of an advisor; and most need that assistance.

Finally, while the “expensive annuity” reference was subtle and only slightly germaine, I keyed in on it right away. A particular stick in my craw, there is nothing “expensive” about annuities. They are insurance products, and as such, charge premiums for protections that may or may not be appropriate for a particular individual. Annuity commissions, while seemingly high, address the fact they are paid only once for the life of the account. There is no incentive for the churning of transactions within. Of course, recommendations to move out of an annuity may be suspect, but inappropriate advice of this type is extremely rare, and is the topic an entirely different discussion.

Chris says:


I like what you are doing with the podcast, particularly with regards to educating people on the importance of understanding their investment choices and the effects of costs associated. I wish I would have had this information 10 years ago when starting investing.

One reason that I think people make mistakes and don’t bother to understand these things is they go into advisors with their guards down because most people are referred to their advisors by family or friends who they trust and assume know what they’re doing with their money. I know this was our case.

I have reviewed your blog in my most recent post on my blog about working towards financial independence and early retirement. Check it out if you get a minute.


Thanks again for what you’re doing,