Vanguard founder Jack Bogle said, “It’s amazing how difficult it is for a man to understand something if he’s paid a small fortune not to understand it.” This might be the most accurate description of what occurs in the investment industry. It explains the financial collapse in 2008 and why many financial advisors recommend and continue to recommend high fee investment products to their clients such as active mutual funds and variable annuities, despite the fact that they tend to underperform the market.
Revenue sharing agreements encourage advisors to recommend investment vehicles that underperform. To illustrate further, let’s examine a favored product, actively managed mutual funds. Actively managed mutual funds are investment vehicles that attempt to pick individual stocks with the goal of outperforming a given index (i.e. S&P 500). Over the last 5, 10 and 15 years (ending in 2019) 84%, 97% and 92% of large cap active mutual funds have underperformed their given benchmark. So why do advisors recommend these products? Well the answer is simple - FEES!
When your advisor makes an investment in a mutual fund on your behalf, the advisor and their firm generally receive financial compensation from the mutual fund company providing that product. These arrangements are costly to the investor since the mutual fund will charge a fee for the privilege to invest, which could be on top of the assets under management (AUM) fee you are already paying on the same investment dollars. The fees are then bundled together at the end of the day making it the investors (you) responsibility to spend the time and effort to find out exactly who is getting what portion of the fees. Not surprisingly, many investors do not have the time and/or knowledge to throw back the curtain and see who receives what portion of their fees. This calls into question an advisor’s motives for recommending that mutual fund product. Are they doing it because they will earn additional income or because it is the best investment option?
Why does this matter? Fees can have a devastating impact on your long-term investment health. To illustrate, let us assume that clients A & B invest $10,000 with financial advisors that both charge a 1% AUM fee. Client A’s advisor uses a low-cost index exchange traded fund (ETF) that charges 0.10% and client B’s advisor uses an active mutual fund that charges 1%. At the end of 45 years, if both advisors’ investments generated a 10% return before fees, client A whose advisor used the ETF will have 45.6% more for retirement after fees ($464,677) than client B ($319,204). It is important to also keep in mind that mutual funds can have front-end and back-end load fees that can be has high as 5%. The addition of back-end loaded fees (i.e. additional fees charged on your exit of the investment in the mutual fund) make the performance gap significantly larger.
Other types of expensive financial products to be aware of are variable annuities and unit investment trusts (UITs). Additionally, some financial advisory firms charge you for basic services such as dividend reinvestment and dollar cost averaging. Unless you have an advanced degree in mathematics to understand all the fees associated with your account, you should find an advisor that has: a simplified fee structure; doesn’t participate in revenue sharing and doesn’t utilize high fee investment vehicles.
Questions to ask. When meeting with your advisor or potential advisor, you should ask: (1) do they have any revenue sharing agreements; (2) what are the most common investment vehicles they use and if they make additional profits from them; (3) how the advisor determines which investments are best; (4) how the advisor mitigates potential conflicts of interests when it comes to making the right investment decision; and (5) how the advisor assesses the fees associated with an investment vehicle.
Next, let’s look at your advisor’s qualifications and determine if they have the skills and education required to successfully manage your money. For questions please contact me at firstname.lastname@example.org.