Financial Advisors - Advantages and Disadvantages of Using Them

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1 Financial Institutions Push Products? I am stunned, amazed, and find it all very hard to believe*. A lawsuit in the United States alleges that JPMorgan Chase steered clients to overpriced, underperforming funds to boost the bank s fees and profits. Say it ain t so. Next you ll tell me (spoiler alert) that there is no Santa Claus nor Easter Bunny. The linked article makes some important points that individuals should always remember. First, let me say that this is just a lawsuit at this point. And JPMorgan may be innocent of the accusations. However, the general points still hold. Caveat Emptor Caveat emptor and common sense, people. JPMorgan falsely represented its financial advisers were operating under fiduciary duty to clients, while its bonuses encouraged the sale of proprietary funds, according to the lawsuit, which seeks class action status. Unless there clearly is a legal, fiduciary relationship between you and another party, do not assume there is one. Never assume that your counterparty has your best interests at heart. No matter how nice the person is, at the end of the day it is his or her interests that come before yours. Always put yourself in a position to safeguard your interests. Companies Sell In-House Products

2 Some financial institutions sell best of breed products from a variety of sources. That said, anytime you are dealing with a company that also sells proprietary products, you need to exercise caution. JPMorgan, the largest U.S. bank, turned to proprietary funds and investments to make up for declining profits after the housing boom burst, according to the lawsuit. The strategy allowed JPMorgan to collect double fees for management and sales, it said. JPMorgan is in the business to turn a profit. JPMorgan makes money selling JPMorgan products. They make much less selling you Citibank or Vanguard products. Companies Market Their Products Companies normally attempt to put a positive spin on their products and services in order to make a sale. Some people think that banks, brokerages, and other financial institutions are more above board than the traditional used car salesman. According to the lawsuit, JPMorgan s marketing materials highlighted inflated, hypothetical returns, while suppressing a much less rosy picture of performance. Nope. Financial institutions can be just as sneaky as any other business. Free Lunches are Never Free I have personal experience with financial institutions and advisors who push products. If your bank, broker, or financial planner is not charging you for their services, you need to ask yourself how they are making their money. It has to come from somewhere. And that somewhere is in product fees, retrocessions on

3 product sales, bonuses for in-house product sales, selling complementary products and services, etc. There is no such thing as a free lunch. In my experience, the cumulative price you pay in higher fees more than offsets any free advice you receive. Learn to understand the true cost and benefits of any financial products you consider purchasing. Ask questions until you are satisfied and get it in writing to avoid misunderstandings later on. If you do, you will improve your probability of successful wealth accumulation. If you do not, you will only create wealth for advisors and financial institutions. * If you could not guess, that was a heavy dose of sarcasm. Brokers Versus Fiduciaries HighTower Advisors has created a great video comparing investment brokers with fiduciaries. A broker is someone who takes a fee in exchange for executing a transaction. They provide a service in return for compensation. For the most part, a broker is not a fiduciary. However, brokers depending on where they reside, professional qualifications, company, regulatory oversight, etc. may have certain duties of care to their clients. A fiduciary is someone with a legal duty of care to the client. It is more than simply executing transactions. More as if the fiduciary steps into your shoes to try and best meet your needs.

4 It is an important distinction. Make certain that you always know whether you are dealing with a fiduciary or not. I am not saying never to deal with a non-fiduciary. Only that you know the difference between the two. And, if appropriate, take steps to safeguard your best interests over those of your representative (agent, banker, broker, financial planner, etc.). Now to the HighTower video. Butcher Versus Dietician In the video, the broker is a meat butcher. The butcher knows meats and if you want meat will (hopefully) sell you the best meat for your needs. I say hopefully as there must be elements of competence and honesty in the butcher. Not to mention trust between the customer and vendor. If any of those are missing, major problems can arise. The butcher is not going to sell you fruits or vegetables. Nor tell you that you should cut back on your intake of red meat for health reasons. The fiduciary is more a dietician. A dietician should take a holistic view of your life based on your unique situation (using an Investor Profile and Investment Policy Statement). Then provide the best recommendations for you. Not what the dietician prefers for him/herself, or based upon what is in his/her best interest to sell. Only what is right for your specific needs. Never Forget As the video nicely states: Broker are butchers selling you product. Fiduciaries are dieticians looking after your health. The problem is most people think their butcher is a dietician. The world needs both butchers and dieticians. As well as

5 brokers and fiduciaries. Use each in their place and do not confuse the two. Otherwise, it will end badly. httpv://youtu.be/dg5rrmac1gy Commission Based Financial Advisors I mentioned in an earlier post that I would say a few words on financial advisors. Mainly, my thoughts on commission versus fee based advisors. I shall split this into two parts. Today, the pros and cons of commission based financial advisors. First, some disclosure. I run my business on a fee only basis, so there may be some unintentional bias in my analysis. I try to be fair, as there are undoubtably excellent commission only advisors, but please keep this in mind as you read the post. Commission Based Advisors Commission based financial advisors do not directly charge clients for their services. These advisors earn their income through salaries, commissions, or retrocessions paid by their employer and/or third parties.

6 There are potential advantages and disadvantages for investors. Advantages Nothing Out of Pocket When getting investment or financial planning advice, the investor is not charged directly for the service. Instead, advisors are compensated by the companies who issue the financial products purchased by their clients. Perhaps you have $5000 to invest. It may take a commission based advisor 1 hour to determine an investment strategy to pursue. Or it may take 5, 10, or 15 hours. Regardless, you do not directly pay a cent to the advisor. With no money paid directly by the client to the advisor, these may seem a cost-effective solution for investors. And, in many instances, I am certain the client believes he does receive value for the service. For small investors, this may be the key reason to choose a commission based advisor. Possibly Useful for Small Investors Why small investors? An argument may be made that the advisor s fees are spread out over all the commission product sold. Let s say that you and your sister invest through a commission based advisor. You plan to invest $5000, your sister will invest $50,000. You meet separately with the advisor for 3 hours and arrive at an investment strategy. The strategy involves either purchasing mutual funds with 5% front-end loads or the no-load funds having an extra 0.25% annual operating cost (reflecting retrocession payments to the salesmen by the fund). With the front-end load funds, you will pay $250 in a sales

7 charge. Your sister will pay $2500. With the no-load funds, you will pay (through higher total expense ratios) an extra $12.50 annually on your initial capital. Your sister will end up paying $125 annually. Even though you and your sister required the same amount of time from the advisor and are investing in identical products, she will end up paying more. With commissions and operating costs, the investor with greater capital invested always pays higher fees. Note that often there is room for negotiation for those bringing in substantial assets. Not everyone pays retail for investing services. Be sure to ask about any discounts. Even if you are just starting out. Improved Service Quality in Commission Based Advisors With so much competition in the financial planning industry, it aids product sales to have knowledgeable salesmen. Today, many commission based advisors possess the proper technical training and experience with which to advise investors. If you can find an advisor with top credentials and not pay a full price for financial planning assistance, then you may save money in the long run. As to whether there is a potential saving, I think this differs from investor to investor and advisor to advisor. If you find an excellent advisor (or you force the advisor to follow a low-cost strategy), the money paid by you through higher product costs may be worth the quality of service you receive. But if you end up with someone pushing high margin products, well Best of Breed Products Some investment firms and commission based advisors now offer

8 best of breed product sales. They do not automatically push clients towards in-house solutions. Instead, the advisors attempt to find the best product in the market for the client s needs. This may result in less commissions for the advisor and less revenue for the investment firm. But better results and lower costs for clients. No, these are not Mother Teresa firms. Rather, the belief is that a satisfied customer will generate more wealth over the long-run than unhappy clients. Studies show that satisfied clients have much longer relationships with the investment firm, which results in longer revenue streams. The firms are trading short term profits from investors who leave after experiencing high costs and/or poor performance for lower margins on clients that stay for long periods. Secondly, satisfied clients bring additional wealth to the firm. Most investors maintain multiple investment and banking relationships. Yes, the eggs in one basket concern. But, over time, if one investment firm or advisor achieves a high level of customer loyalty, assets are normally shifted in from other institutions. Assets under management is a key driver for the value of investment firms and banks. In most cases, these companies reward employees based on generating net new money to the same degree as product sales figures. Third, word of mouth advertising is an excellent way to generate new customers. Do you like getting a cold call at home or work from someone trying to sell you something? Probably not. But what about if you are at a party with friends and you mention that you intend to buy a house and are looking for a realtor? A friend tells you that she just bought a home and the realtor did an excellent job. You likely want to know more and may end up calling the realtor yourself. That

9 is the principle here. While a satisfied client may produce less short term revenue, they will assist in generating new customers over time. Disadvantages The Free Lunch There is no such thing as a free lunch, or so the story goes. Often you get what you pay for. If you intend on obtaining financial planning or wealth management advise, make sure that the individual is competent. I am not saying that commission based advisors are incompetent. But their key function is that of product salesman, financial expertise may be second, third, or further down their list of strengths. If you get poor advice and end up in an inefficient portfolio, there is a cost associated with that. The Lunch May Be Free, But Watch the Charges for Plates, Cutlery, and Napkins The advice may be free, but someone is paying the advisor. Directly, it is the company behind the products being sold. Indirectly, it is you. Whether you pay a sales charge or are assessed higher annual operating expenses, you are paying the advisor s wages. Small investors may pay less than large investors. But everyone pays to some extent. Length of time holding an investment can also impact how much one pays. With load products, the shorter the holding period, the higher the relative cost. With no-load products, the longer the holding period, the greater the cost paid back to the advisor.

10 Is it in Your Best Interest? When I sit down with a professional doctor, lawyer, accountant, etc. I expect that they are acting in my best interests. I pay a fee and get their unbiased expertise in return. With commission based advisors, I am always extremely leery as to whether they are looking out for me or for their own family. In my mind, I can hear them say: If he invests in this 5% front-load, 2.5% annual operating fee mutual fund, my son can get those braces. Try not mention the excellent no-load index fund and ETF that track the same market. I feel much more comfortable dealing with someone that will give me unbiased advice as to what is best for me. That said, there are commissioned salesmen that act in the clients interests. There are also fee only advisors that act unethically. But, on average, I have more confidence with a fee only advisor than with someone whose own income is linked to what he sells to me. To make your own comparison, we will look at fee only advisors next.