Investors using a traditional investment management company usually sign up because they want a professional advisor or firm who will pick investments that maximize their chances of achieving their financial goals.
But, too often, buried beneath the financial rep’s slick sales pitch, is another reality. It’s the world of commissions, kickbacks, expensive funds, trading costs, and built-in conflicts of interest that take a bite out of the investor’s wealth.
Where Do Conflicts of Interests Live in Financial Services?
When it comes to understanding conflicts of interest in investing, just follow the money. How are the professionals and services you are working with getting paid? What are they incentivized to do that might not be in your best interest? And who are the various “middle men” making a profit?
In today’s world, it’s still not uncommon for investment professionals who work at large brokerages to rely on commissions as their main way of making money. Many of us in the industry are pushing investment professionals toward more transparent fee structures, but it’s not yet enough. Unfortunately, it’s up to everyday investors to be aware of the conflicts of interest that exist in the financial services industry. Investors need to think critically about how the way(s) their investment managers get paid might influence the investments they end up with and ultimately their real return over time.
With commission-based pay, your broker might receive a cut each time you trade, and a percentage each time they steer your money into certain investment companies’ financial products. You can see how a conflict arises when that broker recommends you invest in a fund that pays them a high commission but doesn’t necessarily better your financial strategy as a client. Also, they’re generally incentivized to have you trade, regardless of whether or not it will make you better off.
By suggesting products with high commissions, a broker can easily pad their pocket year after year, while your investments produce returns, net of those fees, which impede on your ability to reach your financial goals. And it’s not just that commissions come out of your fund’s assets and therefore shareholders’ pockets; research shows that mutual funds that have higher expense ratios tend to be poorer performers too. It’s a correlation that unfortunately demonstrates the rampant conflict of interest hurting many unwitting investors.
Today’s Mutual Funds are Rife with Commissions and Conflicts
A 2012 study led by Susan Christoffersen of the University of Toronto found that for each extra dollar of commission paid, the average fund acquired $14 worth of assets. But what’s shocking is that each percentage point of commission paid corresponded to a reduction of half a percentage point in annual net returns to shareholders. It’s that kind of scenario that should have investors feeling suspicious.
A 2011 study went so far as to suggest that commissions may, in fact, be the cause of poor performance. The study, reported in a National Bureau of Economic Research working paper by Diane Del Guercio and Jonathan Reuter, found that actively managed mutual funds don’t always do worse than index funds but that they do underperform in the case of funds sold through brokers. The authors concluded that the management companies had little incentive to improve fund performance because the commissions they were paid already gave them access to investors that they otherwise might have had to gain by providing superior returns.
The potential for conflict and the resulting harm to investors prompted the Obama administration—via the Department of Labor—to propose a wider-reaching fiduciary standard, which went into partial effect this month. This means that brokers and advisors serving retirement accounts explicitly and legally have to put their clients’ interests above their own, rather than selecting products that they deem “suitable,” the weaker standard in effect today.
Just how prevalent and substantial the conflicts are in the provision of financial advice is unclear, but a report published in February 2015 by the Council of Economic Advisors, a research agency within the White House, took a stab at quantifying it. It estimated that $1.7 trillion of assets in individual retirement accounts (IRAs) are “invested in products that generally provide payments that generate conflicts of interest” and that the conflicted advice reduces annual returns by 1%, or $17 billion.
The CEA report is based on a survey of academic research, and the authors acknowledged that their estimates are just ballpark figures. Still, there are ample reasons for concern as to whether retirement savers can access quality advice at a reasonable price, and they emphasize that “conflicted advice leads to large and economically meaningful costs for Americans’ retirement savings.”
Another common cost is extracted through funds’ front-end sales loads. These are charges tacked onto the purchase price of a mutual fund and often shared between the buyer’s advisor and the advisor’s firm. You might be surprised by this, and it’s because you aren’t given a bill explicitly listing this cost, instead, it’s often buried somewhere in the fine print, and treated like a negative return. You invest $100 and actually start with $97. As of March 2015, loads are assessed on funds with upwards of $2.5 trillion in assets, or 17.5% of all funds sold, according to Morningstar.
That does not include funds with sales charges that are camouflaged by structuring them as trailing commissions, in which a smaller amount, perhaps 1%, is deducted from a fund’s returns and paid to the advisor for every year that a shareholder remains invested. These ongoing payments are often part of a fund’s 12b-1 fees, a catchall category that encompasses various marketing expenses. Firms can charge up to 0.25% per year and still list it as a ‘no load fee’ fund.
Some brokers rebate sales charges to their clients, charging instead by the hour or as a percentage of the assets they manage. There is far less potential for conflict in a fee-based system because the advisor generally makes more money when the client’s assets grow, so their interests are more closely aligned. ETFs don’t have load fees, so we generally consider them more transparent.
Be a Proactive Investment Shopper
With so much money at stake, the best way to ensure that your investment manager is working in your best interest is to do your homework and shop around for good advice. Verify that your professional is getting paid to meet your needs, not the needs of a broker, fund or external portfolio strategy. Investment professionals can be a great resource for investors, but finding the right one takes more than a passing glance at credentials. You can be a more proactive shopper by asking these questions:
- “I’d love to learn about how you’re paid in this arrangement. How do you make money?”
- “How do you protect your clients from your own biases? Can you tell me about potential conflicts of interest in this arrangement?”
- “What’s the philosophy behind the advice you give? What are the aspects of investment management that you focus on most?”
- “What would you say is your point of differentiation from other advisors?”
You should also know what the costs are for your current investments, and you should compare those costs with other options in the marketplace as time goes on. If alternatives seem more attractive, ask your advisor why they haven’t suggested making a switch, and if the explanation you get seems inadequate, ask yourself why you’re still with your investment professional.