August 2004
We've been in the investment business long enough to have seen many of the ways the investment public gets burned. And we aren't talking about corporate executives defrauding shareholders or even mutual funds skimming off profits to entice big institutions to invest large sums. Instead, we're talking about how the investment business works every day in cities across the country. This is the business that employs literally tens of thousands of "brokers", "financial advisors", "investment counselors", "financial planners", "investment managers" and "financial consultants" that surround us every day. With all the titles and initials thrown about in our industry, it isn't surprising to us that most people assume that we all must be the same. But one way in which professionals in our industry truly differ is in how they get paid for what they do. It isn't the only difference but it's a very good place to start and how mutual funds are sold is a prime example of what we mean.
The Alphabet Soup of Mutual Funds
Even though we've never once sold a mutual fund, it didn't take us much time to figure out exactly how those that do sell them make their money. Don't get us wrong, making money isn't a sin, but we do believe that professionals in the investment industry should only get paid for doing something, not selling something. In addition to the thousands of funds to choose from, investors should know that there are three main share classes to choose from, too. Here's how the different share classes work and how brokers get paid depending on which you choose.
A mutual fund is offered in multiple share classes, commonly known as A, B and C shares. Mutual funds of the A share variety are very commonly sold and an up-front commission is charged before your money is put to work. This huge fee runs almost 6% for some of the most well-known mutual funds, like the very popular American Funds family. The mutual fund industry craves investors and the brokerage firms through their army of brokers are there to deliver them. In the case of the A shares being sold, the mutual fund collects the 6% up-front commission, hands it all over to the brokerage firm, who in turn passes on about 40% of it to the broker who sold it. Put into real life dollars, if a broker sells $1,000,000 worth of some mutual fund's class A shares during the year, the brokerage firm keeps about $35,000, the selling broker takes home about $25,000 and the investors are left with only $940,000 invested from day one.
We've heard that at least part of the sales pitch is to tell the potential client that this is a one-time commission and they won't have to pay anything else for as long as they own the fund. This isn't the whole story. Of course you will pay more that just the commission. The mutual fund company has to employ at least one portfolio manager, provide that person with some office space and computer systems and so the fund naturally charges an ongoing investment management fee. It comes directly out of the fund itself every day - hidden from plain view because you never get an invoice in the mail. This is known as the "expense ratio" of a mutual fund and it isn't a small amount - with the average stock fund charging about 1.5% annually.
On the other hand, purchasing a mutual fund's B shares impose a back-end fee if you later decide to sell the fund - unless you hold the fund for about five years. The back-end sales charge often starts at around 5% and then grades down to nothing over 5 years or so. We've talked with people who own mutual fund B shares and often they were generally unaware of the back end fee.
B Shares Add Insult To Injury
Interestingly, mutual fund companies charge B shareholders a lot more in annual expenses than they do those with A shares. The same fund, the same portfolio managers, everything exactly the same - only higher expenses. In fact, the broker gets around the same commission - and it is still paid to them right away. So why would a broker sell the B shares over the A shares? Perhaps it is because they were unsuccessful in selling the A share variety due to investors natural aversion to losing money right off the bat. Possibly it creates a very sticky client who won't be likely to leave them because of the threat of throwing away money on the way out the door. That is no way to keep client.
Lastly, there are the C shares that impose neither a front-end or back-end load. Instead the broker gets a smaller upfront commission of around 1% every year for a long time. Unfortunately, that commission results in the fund carrying the highest ongoing annual expenses of them all. Nonetheless, the C share type would seem to be the easiest of the three classes to sell, but since the broker doesn't get a big payday up-front the incentive to sell it is far less.
To be fair, different brokers use different mutual fund share classes. These differences may reflect their bias against front-end fees or back-end fees. Others may feel that over the long term, A shares come out ahead due to their lower ongoing expense ratio. A lot of the arguments over which share class is best are mostly a game of justifying the way a broker wants to get paid - it isn't really much at all about what is best for the client. By buying them through a broker or insurance agent, it just costs way too much.
Follow The Money - Those Who Pay Get Served
If the mutual fund route is taken - and we aren't, in any way, advocating that route - why not simply buy low expense, no-load mutual funds or index funds? By skipping the broker altogether and purchasing shares directly from the fund company itself people would then be able to afford to pay for unbiased investment advice. We think it makes good sense for consumers to insist that their professionals only get paid by them - not by a mutual fund company, a brokerage firm or an insurance company. There should be no products to push, no commissions to earn and absolutely no incentive for them to offer one solution over another. Our advice is to simply follow the money. If you are the only one paying the bills, then you will likely be the only one getting served.
"Money is better than poverty, if only for financial reasons." - Woody Allen
"When I was young I used to think that money was the most
important thing in life; now that I am old, I know it is." - Oscar Wilde
Jason P. Tank, CFA
jason@frontstreet.com