“The main thing about money, Bud, is that it makes you do things you don’t want to do.”
- Lou Manheim (Wall Street, 1987)
“See, they install that Tru-Coat at the factory. There’s nothing we can do about that.”
- Jerry Lundegaard (Fargo, 1996)
“Look, Jerry, you’re not selling me a damn car!”
- Wade Gustafson (Fargo, 1996)
Fees and high commissions, the lifeblood of the financial industry are alive and well. It is not quite the Wild West era of 1985 when Bud Fox was busy providing insider information to Gordon Gecko in the classic movie, Wall Street (1987). But asking your financial advisor about how the fees and commissions work on your account might make them squirm more than Jerry Lundegaard trying to sell Tru-Coat sealant for a 1987 Oldsmobile in the movie Fargo (1996). Here at Cypress Stone Capital, a fee-only Registered Investment Advisor, we believe that proper asset management using low-cost investment options and transparent fee structures are crucial. In this article, we will break down how all of this stuff works and take a look at the good, the bad, and the ugly when it comes to how you are charged for products and investment advice.
How a client is charged for investment advice can vary depending on the type of firm your advisor works for so it helps to discuss the different types. The two main types of firms that an advisor can work for are Broker/Dealers or Registered Investment Advisors (RIA’s). Most financial advisors are affiliated with a Broker/Dealer. The big, well-known brokerage firms and banks will fall under this category. Broker/Dealer firms are in the business of charging commissions on products although they may also offer fee-based products. The financial advisor’s job at these firms is to sell products in order to generate a commission/fee for the firm. These firms will usually take a large cut of those fees and commissions and many of these advisors will have a certain quota they are expected to meet on a quarterly/annual basis. There are also “Independent” advisors that are affiliated with some of these Broker/Dealer firms. There is no advantage here for the client as the advisor just gets a larger cut of commissions while having to pay their own office rent and expenses. They are also still incentivized to sell certain products so you could argue whether they are truly “Independent” or not. Broker/Dealer firms can also offer very large upfront payouts to recruit advisors based on their revenue production. The more commission and fees an advisor brings in annually, the bigger the upfront payout which can amount to 2-3x their annual revenue. You may already be wondering, how is any of this actually good for the client? Well, we will get to that!
Another type of advisor is one that works for a Registered Investment Advisor (RIA). These are usually your smaller, independent firms that charge a fee based on assets-under-management (AUM). RIA’s adhere to a more strict Fiduciary Standard and are regulated by either the Securities Exchange Commission (SEC) or the State(s) they operate in. Some of the RIA firms can also be a "hybrid" as they might also be affiliated with a Broker/Dealer so that they can sell commission-based products such as Annuities and 529 Plans (this must be disclosed in their Regulatory filing). RIA's will generally be more focused on the overall management of your investments as opposed to selling you products to earn a commission or fee.
Much of this discussion will deal with the hidden costs and high commissions charged by Broker/Dealers who are riddled with conflicts of interest and loath to any new regulation to make this subject more transparent to their clients. I will not be talking much about the standard management fees inside of Mutual Funds, Exchange-Traded Funds (ETF’s), etc. as these are always clearly disclosed and easy to find. We want to focus on how advisors charge fees and commissions, and some of the products to be wary of due to the way fees/commissions are embedded and charged. Sitting down with an advisor should not be like sitting in a car dealership only to later find out you were charged for Tru-Coat sealant!
The Good
No-load Mutual Funds: Popular with the do-it-yourself investor and RIA firms, these will not have any buried or hidden commissions. They will probably not be offered from a Broker/Dealer unless they are inside of a fee-based account. Institutional-Class funds would fall under this category as well since they have a similar low-cost structure.
Exchange-Traded Funds (ETF’s): Becoming more popular due to their low-cost and ease of trading, these are being utilized more, especially with RIA firms. A Broker/Dealer firm may offer these inside of a fee-based account or the advisor could sell them with a commission attached (be careful!). For the do-it-yourself investor, these can be traded for zero commission at most firms now. If you have an advisor that is still charging you a commission to buy/sell a stock or ETF, you should probably shop for a new Brokerage or Advisor.
The Bad
Mutual Fund (A-Shares): You might commonly see mutual funds sold that have a letter ‘A’ in the description. These A-shares have a high upfront cost, or “load” to the client and an equally high commission payout to the advisor. These can have upfront costs of 5%+ but can vary depending on the amount invested. In any case, you are going to be starting off in a hole due to these high upfront costs. These are not quite as bad when investing greater than $1 million, since you would qualify to get the A-shares at “net-asset-value” or “NAV”, which means you will not have a front-end "load". Although with a “NAV” transaction, you will have a restriction on when you can sell it, usually 18 months, since they paid the advisor a commission upfront and have to make sure they recoup that.
Mutual Fund (C-Shares): In this alphabet soup of Mutual Fund classes, there is something known as the C-share (I apologize if you now have the ABC song by the Jackson 5 stuck in your head). These are very popular with commissioned advisors since they are the epitome of opaqueness that brokers can easily tap dance around when explaining how they work. The usual sales technique is to tell the client there are no upfront fees (which is technically true). What tends to not be openly disclosed is how much is added to the internal expense of the fund in order for the advisor to make 1% upfront and a 1% annual commission for as long as you hold the fund. There is something called a “12b-1” fee buried in the prospectus that is described as a “marketing” or “distribution” cost. I will spell it out in more simple terms, it is the commission paid to the advisor. Many C-Share funds will have total expenses exceeding 2% annually. If the client sells the Fund within 12 months, they will be hit with a sales charge (CDSC) of 1% in most cases. There have been attempts to eliminate or reduce the C-Share offerings to the dismay of brokerage firms due to the lack of transparency and higher costs to own but they remain a popular product for commissioned advisors.
Model Portfolios: While not a bad thing in general, although this could be debated, it is a very cookie-cutter product that an advisor might sell to a client. These products eliminate the need for the advisor to do much of anything while taking a commission or fee on an annual basis. On top of the internal fees of whatever products are in the portfolio, the advisor will add an additional fee which could potentially be very high. The fee for these types of products should be well under 1% annually but many advisors charge excessively high annual fees, sometimes approaching 2%+. This needs to be properly disclosed, discussed, and understood by the client before signing the New Account Agreement! You must ask yourself what value the advisor is adding when selling you a static model portfolio that never changes. Unless these are offered by an advisor with a low fee, these portfolios would work much better for the do-it-yourself investor.
Mutual Fund (Target/Age-Based): While these particular products may be very useful in a 401(k) or in self-directed accounts, these should not be sold by an advisor in my opinion. These funds are designed to automatically shift the investment allocations over time. Why should you pay an advisor both an upfront and annual commission for this? This adds an additional expense to something that was designed to be very simple and low-cost.
529 Plan (C-Shares): While 529’s are a good product, it all goes slightly wrong when they are sold by a commissioned broker. These 529 Plans were designed to be a low-cost way to save for college, and originally were “sold-direct” to the client by the firms offering the product (you can still get a 529 directly). These gained traction with brokerage firms though, as there was now a new product to capitalize on and earn commissions. These 529 (C-Share) plans will have an additional 1% cost annually built-in since that is what the advisor is paid up front to sell them, and then receive on an annual basis thereafter. These will convert to the less expensive A-Shares after 8-10 years. 529’s are mostly age-based so nothing really has to be done, since by design they are basically on “autopilot” to make it easier and to reduce risk as college time nears. Even if you or the advisor choose to pick specific mutual funds within the 529 plan, the investment options are usually very limited.
Separately Managed Accounts (SMA): These are a managed portfolio of securities that are constructed by a 3rd-party Investment Manager. Managers are picked based on the investment allocations that are sought by the client. It will generally hold many individual securities (100’s in most cases) and have very high investment minimums ($100k+). The main issue with these accounts is the excessive fees charged by commissioned advisors. The 3rd-party Manager will take a cut and then the advisor can set and take a cut for being the "middleman" while continuing to get this commission annually. While there are certainly good SMA’s out there, many of these SMA’s will underperform their benchmarks due to the excessive fees that are implemented in many cases. An RIA firm can also offer these products and they will tend to have a much lower cost structure.
The Ugly
Mutual Fund (B-Shares): Fortunately for retail clients, but very unfortunate for commissioned advisors that were getting wined and dined by Mutual Fund wholesalers, B-Share Mutual Funds have mostly gone away. These were the “roach motels” of mutual funds, but the advisors loved them since they paid very high commissions and they could tell clients “There are no upfront fees!”. These paid upwards of 5%+ commissions to the advisor, but the client then had to hold it for sometimes 8-9 years! If the client sold it before then, they were charged a “back-end load”. I cannot even make up a logical reason as to why these were ever created or sold. Thankfully, it is unlikely anyone would still be sold this class of shares but they are still out there. If you had B-Shares sold to you in the past and you held them, they have likely converted to the lower cost A-share.
Annuities: Designed mainly as an insurance-wrapped investment that might guarantee a stream of income and offer other various features, annuities have some of the most excessive and opaque fee structures in existence. Popular with the commissioned advisors, many of these pay hefty commissions that would make a Real Estate Agent blush. When you have to sign a stack of documents that is thicker than those you get at a house closing, this particular investment must be questioned. They are usually sold as “safe” investments with “guarantees”, etc. The sales brochures with people walking on the beach and smiling aboard a sailboat are certainly inviting, but these products are bad for nearly everyone due to the excessive fees, expenses, and investment underperformance. There are numerous types of annuities, but Variable and Index annuities are some of the more grotesque variations. The internal expenses can easily exceed 4% annually, so seeing your annuity’s cash value erode on a quarterly basis is probably not a hallucination. That being said, some annuities may be appropriate for a very small segment of the population. In that case, it is probably better to seek out a fee-only version which is slowly becoming more popular and can be offered through an RIA firm. If you get one from a commissioned advisor, make sure the fees, expenses and surrender penalties are made very clear….although they might be buried on Page 72 of that paperwork.
Proprietary Mutual Funds: Many banks and brokerages have developed their own proprietary Mutual Funds. If you have investments with let’s say, the fictitious ‘Southern Tier Bank’, you might be sold a product that contains a bunch of Southern Tier Bank's Mutual Funds. The Bank/Brokerage is getting not only the management fees (typically much higher than average) for running the Mutual Funds, the advisor also charges a fee to sell them and the firm will take a cut of that as well. Why settle for one fee when you can get two at twice the price! They might make you believe their funds are somehow special or superior, but all you have to do is look at their performance against a proper benchmark to see that not only are they not superior, they can at times be downright atrocious. Many times these funds will be placed inside the firm’s proprietary Model Portfolios that are static portfolios and never really change other than some possible rebalancing each year. When would the bank or firm ever recommend for you to get out of their own funds? Likely never. This is a terrible conflict of interest and I am surprised that this is even allowed, but it has actually become more common. The other big drawback is that if you decide to move your account to another firm, those proprietary mutual funds likely cannot be transferred, as they can normally only be held at that particular firm! This means you will have to liquidate the funds and accept the tax gains or losses that might occur.
Unit Investment Trusts (UIT’s): A product that could only have been created in the darkest depths of Mordor by the evil Sauron in The Lord of The Rings. These are fixed portfolios of stocks or bonds that are built and issued with a fixed termination date, normally between 13 and 24 months although some may go out even longer. The securities inside of the UIT are fixed and never change but for this wonderful opportunity you are rewarded with sales charges and development fees of 3-4%+. Brokers make a nice commission as well selling these. The further out the termination date, the larger the commission. Once they are near the termination date, you will likely be advised to do a “rollover” to the newest version of the UIT and pay an additional set of imbedded fees along with the advisor getting another commission payout. The gift that keeps on giving! There is nothing a UIT can provide that a simple, low-cost ETF cannot. Even if you like the particular basket of stocks it holds, you could buy the stocks individually for zero commissions. UIT's are an outdated product that should have vanished faster than Frodo after putting on the Ring. A quick Google search of "UIT lawsuit settlements" will bring up some well known Brokerage firms that have been involved in the improper sales of this malignant product. Even if this product was free, I cannot come up with a good reason why anyone should hold a static basket of stocks that terminates on a specific date.
Structured Notes: A structured note is a Frankensteinian product that was developed in the 1980's, but became popular with retail investors in the early 2000's when Brokers started selling them since they offered very high commission payouts. These are constructed to be part bond and part stock using a mix of complicated derivatives that only a skilled Alchemist could assemble. Marketed as having very high yields, upside potential, and "limited downside", they have many risks. The average embedded fee is 3% which is hidden from the client and in addition to all of these bizarre characteristics, they have near-zero liquidity. If you had bought a structured note and then needed to sell it, best of luck. It might also be noted that the largest issuer of structured notes back in 2008 was...Lehman Brothers.
As you can see, even though it is no longer 1985, the Broker/Dealer firms in many ways are still acting as if it is. The majority of financial advisors with these firms are mostly still in the role of being a salesman and pushing products. The world has changed since the time Bud Fox was cold calling prospects at Jackson Steinem & Co. There are now lower cost options and choices available to clients as the overall fee and commission structures have come down significantly. Yet, many of the old tricks are still at play at these firms as they have just found more creative ways to bury these fees and commissions inside of products. A lot of lobbying effort is done to help keep this façade in place which is unfortunate for most of the retail clients of these firms. How would you feel about a prescription from your Family Doctor if his/her compensation was commission-based?
I hope this deep dive into the anatomy of fees and commissions was helpful. Being sold the wrong products and choosing the wrong type of Brokerage and/or Advisor can certainly end up being much more costly to clients than that Tru-Coat sealant…
- Eric
Cypress Stone Capital, LLC is a Registered Investment Adviser. This content is intended to provide general information about Cypress Stone. It is not intended to offer or deliver investment advice in any way. Information regarding investment services are provided solely to gain an understanding of our investment philosophy, our strategies and to be able to contact us for further information.
