A 48-year-old plumber recently came to me for investment advice. For a man with only a high school education, he had an incredible mind for business: he knew how to serve clients, please customers and keep them coming back and recommending him to their family and friends.
The man built a very profitable business. In addition to his keen business sense, he was very smart with money and exercised great discipline when it came to spending and saving. He and his wife made their purchases with cash, never credit. They paid off their house in under 15 years. With no business or personal debt, they were able to save every cent from his wife’s job for their retirement.
But as smart as he was regarding money, the personal investment market is often designed to keep investors in the dark. There was always a reason, always an elaborate explanation, and some intricate complication that impacted his returns. Still, this plumber knew he was not getting the returns that he should in his retirement account and he was wise enough to know what he didn’t know. So, a friend gave him my name and he stopped by with his paperwork.
The problem was immediately clear. The Plumber’s advisor was selling him actively managed mutual funds with a 5% upfront commission and expense ratios of 1.95%. In addition, there were a number of other hidden pyramid fees that were not stated on his statements. These are exactly the types of abusive fees that the U.S. Dept. of Labor seeks to eliminate. Instead, the Plumber could have been invested in exactly the same investments with no upfront commissions (No commissions at all in fact) and an annual expense ratio of only 0.09%. That’s right, exactly the same holdings with annual expense ratio of only 0.09%.
Some might ask what harm can an extra 1%-2% per year cause? The reality is the compound effect of forfeiting 1% per year can rob you of immense profits. The Plumber’s broker gave him the usual story about why he needed a fund with such a large load: The “load,” or fee, covered various expenses such as administration of the account, distribution fees, compensation for a transaction intermediary of some kind—perhaps the broker, financial planner, or investment advisor–for their time and investing experience. He added that “everyone else is doing it too”. Well, we know that this is not the case. Many advisors do engage in this practice, but it’s not for the client’s benefit. The goal here is to fatten their own bank accounts and the profitability of the many corporate entities embedded in the chain.
In the same way that actively managed investments do not outperform passive index investments, mutual funds with loads do not outperform “no-load” mutual funds.
One of the first things that I do with new clients is look up the Securities and Exchange Commission (SEC) registration of their previous broker or advisor. I was not surprised to see that the plumber’s broker was not listed. In fact, after some digging, it was discovered that the firm was actually registered with the regulators under a different name and doing business under an unrelated name altogether.
Now I ask you, if you did not have anything to hide, why would you operate under a different name?
Full disclosure of all of the advisor’s charges, assessments and fee-sharing arrangements must be included in the SEC registration documents. Further, some advisors work under a franchise arrangement with large firms that have well-established brands in the investment community and thus owe a variety of “franchise-like” fees to the mother firm. This creates the stacking that I have referred to in prior posts. This pyramid of parties all needing to get paid their slice of your fees creates the incentive for advisors to recommend high priced products: everyone in the chain needs to get their piece of your profit.
But this comes at a price. These independent advisors have to pay the big-brand to operate under that name. This is one common way that fees start to stack. There are often multiple layers or intermediaries between an investor and investment—and each charges something for management, brokerage, transactions, etc. It could be a half a point or less, but this adds up quickly if there are many middlemen.
The advisor also told the Plumber that, while the fees were high, his risk was low. The account was set up with a protective mechanism so that even if the market suffered a sharp downturn, the Plumber’s principal would be protected. Of course, the broker didn’t tell the Plumber the whole story.
The only way to guarantee downside protection is to cannibalize upside gains. The various ways to ensure that principal is never eroded beyond a certain point all involve cutting into profits during the good years to hedge against losses in the bad. As everyone knows, there is no such thing as a free lunch. If it sounds too good to be true, it probably is. These are very expensive, high fee “insurance-like” products that prey on fear. They pay only marginally more than the comparable CD rate when equity markets are up and no interest at all when markets are down. In the end, they ensure handsome profits for the issuer and greatly depress your investment returns. If you are going to give up almost all of the equity upside, it would be wiser to buy bonds or straight CDs where you at least get interest payments every year and where you’re not paying dozens of stacked fees and commissions.
Come back on Sept. 21, 2015 for the next post in this series: The General Surgeon. See how the system is designed to take advantage of everyone, including those who are analytical and well educated.