The Hidden Risk of Commission Based Investment Sales
by Timothy Guthrie on Oct 5, 2017
When sitting down with an “investment professional” (hereafter referred to as ‘IP’), folks understand that the person across the desk, needs to be compensated something. Additionally, the IP’s firm has overhead, and keeping the doors open is expensive. You understand this principle is universal: The bagel shop sells you a bagel for $1.95 because their rent is $7,000 and month, the tire shop charges $900 for four new tires because the tires wholesale for $110 each and the new building cost $5.4 million.
While the IP’s method of compensation is an important topic; sales commissions vs. management fees (and I have strong opinions on this topic), many investors understand that there is a conflict of interest that is present when sitting across the desk from the IP. The sales commission based IP may recommend the ABC Tech Fund because it pays a 5% commission to the firm and he or she receives some portion of that. The management fee based IP does not receive a commission, but if you sign up for their services, they will not forget to bill your account for their services. I believe the management fee model is far superior to the commission model due to the greatly reduced conflicts of interest, but this article is on the “hidden dangers” of the commission based compensation model and this issue is not hidden. Below I explain several additional dangers to the investing public that you may not be aware of that are almost universally present when dealing with commission based organizations from Edward Jones, to the local bank investment rep, the national brokerage firm, or the insurance agent who also “does investments”.
Every such organization I have encountered has a ‘Preferred List’. The ‘Preferred list’ (hereafter referred to as ‘PL’) is a dangerous thing. It sounds nice, lists keep you organized and ‘preferred’ sounds good. In the context of retail investing though, the PL is a silent risk with many ill effects. What is a PL? The PL is a list of investment product companies (mutual fund companies, or annuity companies) that the local IP working for a commission based organization is forced to use when selling investments to the public. When I was in that world (prior to 2002) I was told that at least 80% of my sales needed to be from the companies on that list. I was told this at four different firms I worked at from 1991 to 2002. Edward Jones in their 2017 disclosure say this way: “Virtually all of Edward Jones’ transactions relating to mutual funds… and annuity products involve product partners” (emphasis added). “Product partners” is another name for the preferred list (PL).
How is this harmful? The ‘product partners’ list or PL severely limits the choices the IP can offer the client. I use mutual fund research software that tracks 31,000 mutual funds and ETFs. While some funds have multiple versions so the true number of unique mutual funds is not 31,000, the possible choices is still likely over 15,000. The commission based PL is usually 5-8 companies and maybe less than 100 choices. What are the odds the most attractive mutual funds for any given category is on that PL? very, very low. What are the odds that attractive sectors like robotics or biotech are not even represented on the PL? very high. The bottom line: the PL commission based IPs are forced to use limits your choices, reduces the likelihood you will be invested in an exceptional product, and keeps you from investing in the sectors of the economy with the most growth potential.
The PL system creates other problems. The regulatory environment the commission based firms operate in creates the need to at least try to reduce the sales commissions the client pays if the investment is reaches a certain threshold; $50,000 or $100,000 or more. Sales commission based mutual fund families offer discounts if your combined investment reaches those thresholds. The commission might drop from 5% to 4% if you invest $100,000 or drop to 2.5% if you invest $250,000. The result is when you rollover your 401k with these firms they often invest your entire $273,457.19 into one fund family. This is offered to you as a great benefit- the sales commission is reduced! This practice sounds wise. Save money (we are ignoring for now the fact that many IPs will advise you with no sales charges) by buying in bulk, all at one mutual fund family. What you may not realize at that time is that no mutual fund family is great or even good at everything. Think about it this way; no baseball player plays every position well. Most mutual fund families are only really good at one area, usually the investment theme that was the original focus of the company. Over time, they decided that they wanted to offer ‘all the flavors’, all the most popular mutual fund types, small cap, mid cap, international, junk bonds, muni bonds, government bonds, etc., The problem for the investor is that they are good at one thing, but you are using them for everything. So, to reduce the sales charge most of your money ends up in funds that are merely average or worse. This is not a bargain, and the sales commission based IP probably did not explain this conflict.
Now, suppose you invested with the commission based IP and ended up with a portfolio that you are happy with. The hidden danger now is time. Over time the investment markets change, from bullish to bearish and back again. The global economy slows down or speeds up. Maybe your once competitive fund is now at the back of the pack and new products are far better, or new sectors look attractive. Perhaps interest rates are rising and your traditional bond fund is doomed to lose value. The Euro is now higher or lower. What happens now? Often nothing. You see, the same compliance framework that put all your life savings into one mutual fund family to save you commission dollars is still at it, harming you to save you commission dollars. How? By mandating your IP keep your money at one fund company to avoid ‘churning’, the practice of maximizing sales commissions by switching products too often. How often is too often? Hard to say but usually 3-6 years. This means when you get that portfolio from a company on the PL (preferred list) where all your money is invested in one fund family to ‘save you money’ you end up with a static portfolio that will not change with the seasons or roll with the punches. Because you paid so much for it, it would be illegal or immoral to make you pay sales charges again and again when perhaps some account rebalacing is called for due natural changes that take place over time. Using a baseball analogy again, even the great players all age. They get slower, weaker and eventually retire. Financial products also move in and out of favor, great mutual funds can get too big, or legendary managers retire. With the sales commission based portfolios though you are often stuck, the IP afraid or prevented from changing direction even when it is clear a change is in order. The problem here is the sales commission based revenue model. The large upfront commissions (or deferred charges) lock you into a framework that can only be changed about as often as you paint your windows.
Additionally, the sales commission based IP is paid to sell, paid to close the deal. They are not paid to manage, they are not paid to watch your account every day. They are not even paid to re-shuffle your assets around that fund family you are invested in. Often, the IP makes contact when enough time has passed (according to their compliance department) that they can sell you something else and charge a new round of sales commissions. A new product is needed, with new commissions. This is not investment management, it is revenue management.
How did you end up with an inflexible portfolio 100% built with products on a PL (preferred list)? I can best answer that question by answering another question: How do products end up on the preferred list? Simple, they pay to be on the PL. That’s right, the sales commission based organization and IP that works for them put your life savings into a set of products not because they are risk/reward efficient, excellent, or have a lot of growth potential, but because the product company paid for product placement no different that Pepsi pays Kroger to place Doritos at eye level at the grocery store (Pepsi owns numerous snack brands). It works pretty much the same way at most organizations but Edward Jones, on their website explains it this way:” We want you to understand that Edward Jones’ receipt of revenue sharing payments creates a potential conflict of interest in the form of an additional financial incentive and financial benefit to the firm, … in connection with the sale of products from these product partners. For the year ended December 31, 2016, Edward Jones received revenue sharing payments of approximately $186.7 million from mutual fund and 529 product partners and $7.7 million from annuity product partners. For that same period, Edward Jones’ net income was $746.2 million.” Over 25% of this firm’s profits come from payments of product companies listed on the PL. This is in addition to the sales commissions these fund companies pay that are the bulk of the revenue at Edward Jones and similar firms. Sometimes the product companies pay in other ways, they pay for the annul compliance meeting, or the for trip to Italy for the top commission producers. Either way or even both ways, product companies pay to be on the menu, and brokerage firms take the money. Additionally, consider this, no matter how good, the commission based IP may not be able to offer a great product because the firm with great products can find plenty of customers without paying to be the preferred list. True professionals seek out the best options, and hate to be constricted and have their choices limited.
Contrast the above with how a ‘fee only’ (fee only means my only source of revenue is management fees, no sales commissions, no product based conflicts of interest) investment advisor like myself operates. I don’t select products from a PL that only contains products that paid real money just to be on the menu, I use expensive software and resources to seek out and find the best investment ideals, and products. I sort, filter and rate thousands of investments, and evaluate a sub set of these products to find what will work best in your portfolio. If a product disappoints it is replaced, if the investing weather changes we can adjust. I am paid to manage your account, to watch over it, to keep it on my mind. I even rebalance your account for no incentive other than good results so you stay ‘on the books’ for a small fee each year. When your account is rebalanced, you pay $7 each for a few transactions, not $5,500 in sales commissions. If you decide that my results are not sufficient, you take your money elsewhere, no penalties, no deferred sales charges. The fee only model is transparent, flexible and eliminates many conflicts of interest. It provides what clients really want, someone watching over their money.