You have choices when it comes to investing. You can go directly to a mutual fund company (such as Vanguard or T. Rowe Price) and choose investments yourself, or you can use a fee-only financial advisor to assist you in choosing investments. But by far the most common method is to work with a broker. Brokers are companies like Edward Jones, Ameriprise, and AG Edwards Wachovia Wells Fargo, plus many, many other companies, including insurance company brokerage divisions, banks, and the like.
What’s the Difference?
You’re probably wondering – what’s the difference between a broker and, for example, a fee-only advisor? You’re right to be confused, because until you start working with one or the other and you know what the difference is, they look pretty much the same from the outside. Here’s the difference:
Brokers are salesmen. It is their job to sell you an investment product, and that’s how they get paid. They are required by law to ensure that the product is “suitable” to your situation.
Fee-only advisors are advisors. Fee-only advisors are bound by law to act as a fiduciary. It is their job to advise you on the appropriate strategies and tactics – investment moves that are in your best interest.
That’s a pretty big difference in itself – but since that differential makes the fee-only advisor look SO much better (and since this writer is a fee-only advisor), I wanted to point out what research has born out to be true about the recommendations that you get from a broker.
What Can a Broker Do For You?
There is a study done by researchers at Harvard and the University of Oregon (Bergstresser, Chalmers, and Tufano), which strives to identify the possible benefits to the consumer of financial services in purchasing investments via a broker. They looked at five possible benefits:
- Assistance in selecting funds that are harder to find or evaluate.
- Access to funds with lower costs excluding distribution costs.
- Access to higher performing funds.
- Superior asset allocation.
- Attenuation of behavioral investor biases (in other words, saving the investor from himself)
Ultimately, the researchers “found it difficult to identify the tangible benefits delivered by brokers.” But that’s getting ahead of ourselves. We’ll take each category separately and briefly describe the findings.
Assistance in selecting funds that are harder to find or evaluate
It is true that brokers often direct investors into smaller, younger funds that have less track record or are not covered by major rating services. The costs (especially in time) to the individual would be enormous in researching these funds. If the other benefits are brought about by utilizing these harder to find or evaluate funds, then there would be a benefit to working with the brokerage. What we’ll see is that the rest of the evidence doesn’t bring that conclusion.
Access to funds with lower costs excluding distribution costs
The researchers found that the funds sold through the broker channel do not have lower costs excluding distribution fees. In other words, even if funds exist that are of a lower cost, the brokers are not (in general) directing investors to those funds. Across the board, the annual cost of a brokered stock fund was on average 2 basis points (bp) higher (.02%), not including commissions or 12(b)1 fees. And the average annual cost of a bond fund was an amazing 23bp higher, and money market funds were on average 4bp greater.
Access to higher performing funds
The overall return, as well as the risk-adjusted return, is lower for the funds that the broker chooses, versus funds that are directly purchased via other channels (e.g., a fee-only advisor or through personal research by the investor). Stock funds underperformed direct-purchased funds by an average of 7.5bp (.075%) – and using risk adjustments caused these figures to get even worse. Bond funds underperformed as well, but money market funds did provide a slightly better return, by a total of 18bp on average.
Superior asset allocation
While a broker’s asset allocation recommendation is different from that of other investment channels, over time the outcome is pretty much the same for either type of investor. The difference is that, on average, the broker tends to direct a higher percentage of investors into bonds (as opposed to stocks). Since stocks, over a long run, outperform bonds and bonds demonstrate lower risk (as measured by standard deviation), this difference in allocation weights tends to even out between the two.
Attenuation of behavioral investor biases
Lastly, the research shows that most broker-driven investors are much more sensitive to short-term performance in the market than other investors. This leads to “performance chasing”, which in general does not bear greater returns, while at the same time increases incremental transaction costs. Transaction costs benefit the broker, of course.
But wait, there’s more!
In addition to the research summarized above, you need to know about how a broker is typically paid. I already mentioned that the broker is paid to sell the investor products – how does that work? There are many types of fees which can impact an investor’s account:
- Front end loads: this is a commission charged when you purchase the fund. Typically these can be anywhere from 3% to 5% or more of the purchase, although at much higher balances the fees can be reduced and even eliminated.
- Back end loads: this is a commission charged when you sell the fund. Often, this is used to keep an investor in a fund for a specific period of time, during which other fees can be transacted from the account. After a period of time, these back end loads are waived.
- Annual loads: this is an annual commission based on the holdings in the account, and can be one of the most expensive ways to hold investments.
- 12(b)1 fees: this is also an annual fee based on the holdings in the account, and often is the most elusive to identify – while representing the greatest drain to the investor. This fee is usually pretty small in relation to other fees (sub 1%) but it is charged across all classes of funds, whether a front-end, back-end, or annual load. What really hurts is that the 12(b)1 fee is specifically for marketing the underlying investment. In other words, as an investor in the fund, you’re paying to help bring in more investors.
While it’s not conclusive, some of the results found in the research paper indicate what you might expect: that brokers sell the investments that pay them the most. For example, as the front-end load or 12(b)1 fee increases for a particular fund, there is an attendant increase in the sales of the fund. Not unexpected, it’s basic human nature.
Conclusion
The research shows no tangible benefit to working with a broker – in fact, results are often worse with a broker. Add to that the costs of working with a broker, above and beyond the dismal results that you achieve, a conclusion isn’t hard to come by: it makes more sense to either do the research on your own and purchase funds directly, or to work with a fee-only financial advisor who will do the research and operate as a fiduciary to ensure that the investment choices you make are in your best interests.
Photo #1 by Marcin Wichary
Photo #2 by kevin_oneill
Yet another taxpayer-friendly provision in the tax code that will be expiring at the end of 2009 is the increase in standard deduction for real estate taxes paid. (If you’ve been following these posts, you’ll realize that this is another “stealth increase” in taxes, beginning in 2010.)
Here’s a very good idea to consider – if you have a teenager who has a part-time job, rather than putting those earnings solely into a savings account (or worse, a car), open a Roth IRA. The money contributed to this account will mostly be tax free, since the first $5,700 (2010 figures) of earned income is not taxed for a single filer that is a dependent of another.
12/17/2010 – with the passage of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010, the rate changes formerly discussed in this article have been superseded.
12/19/2010 – with the passage of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, the provision for an IRA owner who is at least age 70½ to make a direct charitable contribution of up to $100,000 from his or her IRA has been extended through the end of 2011. Such a direct contribution can be used to satisfy the IRA owner’s Required Minimum Distribution.
Did you know that you could deduct losses in your IRA accounts? It’s not as simple as it sounds… but it is available and can be a sort of consolation prize for the poor individual that fits the circumstances.
But wait! Doesn’t the IRS treat all IRAs as one account? Hold on, there – before you get all dressed up and jump off a chair: You’re making the assumption that there is consistency in the rules… and consistency in the rules would be a huge departure from the IRS’ proud, nearly 150-year track record. Besides, if the rules were consistent and made sense, then what would guys like me write about?
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