I have read many posts and articles about Financial Advisor’s conflict of interest when it comes to clients investments, so I thought give a glimpse as an insider.
Although I do not sell investment to clients currently I have in the past and I have talked and analyzed many full service brokerage firms as they have tried to recruit me, for the most part they are all the same with some minor differences. So here is a look at how the brokers are generally trained and paid and how this could affect you negatively.
NOTE: We are talking about full service commission based investment brokers.
Brokers prefer Mutual Funds over individual Stocks
It is true that most brokers prefer mutual funds over individual securities.
Better pay
The main reason brokers prefer Mutual Funds is because of commission, yes this does come very close to unethical. Mutual funds usually pay higher commission to the firm and therefore higher commission to the broker plus there are the trailer fees.
Example at a firm I used to work at:
If you had $100,000 and we would buy stocks, 10 stocks each $10,000 with it the total commission would be about $2500 to the firm and $1000 to the broker, however if this was in a mutual fund the commission would be about $5000 to the firm and $2000 to the broker. You see the conflict of interest?
As an added bonus brokers also get “servicing” fees as long as the client holds the fund, in stocks there would be no further commission until sold. These servicing fees range from 0.25% to 1% depending on the fund type.
The firms I have worked with always have some type of justification as to why mutual funds are good better options for clients; we receive “objection overcoming” training on how to deal with those questioning mutual funds.
Unethical: YES
Diversification
The second and a more legitimate reason for preferring mutual funds is that investors usually do not have enough funds to have a diversified enough portfolio. If you have $50,000 there are only a few good stocks you can buy and you will lack proper diversification, however in a mutual fund you would be well diversified.
However one could buy ETF’s to get the diversification needed at a much lower cost. But this is not really encouraged by firms because of lower revenue. Whenever I would ask a trainer or supervisor about ETF’s they would say “oh no ETF’s are not good, nobody manages them” not a good enough reason for me.
Unethical: POTENTIALLY
No time to monitor stocks
Another important reason is that brokers do not have enough time to monitor each stock for clients. With mutual funds thing are much easier, generally brokers choose several mutual funds they will use for clients so monitoring it would not be as time consuming and even if it was time consuming there is an incentive, the trailer fees.
Unethical: NO
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Investment Banking Client
Sometimes the firm maybe involved in underwriting of an issue or maybe involved in a private placement, and their brokers maybe asked to sell the investments to clients. The product may not always be a good investment for the client.
If the company is an investment banking client of an investment firm, the firm will be reluctant to issue unfavorable opinions about the company as they might lose the investment banking client. This can cost the investor large sums of money.
Unethical: YES
Full service brokerage is not for everyone, it is expensive. However not everyone has the time or knowledge or even motivation to do their own investing. If you are with a full service broker I hope you remember these points when discussing your investments. The firms and advisors are suppose to disclose most of the information, however by you asking questions you will make it clear that you are aware of potential conflicts of interest.
Note: This is a very general overview not all advisors are the same, I have worked with some great advisors who truly care about their clients unfortunately they are the exceptions.
Do you think Full Service Brokerage houses s put their needs before their clients? Any experience with any?
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For the money you don’t have in the markets, you’re probably going to want to find the best savings account interest rates that you can. An online bank will typically be able to offer better bank deals than your local bank because of their small operating costs. You should make sure to research the list of bigger online banks to make sure you find the best rate for your cash.
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{ 6 comments… read them below or add one }
When you ask about full service brokerage, you mean the ones that can offer insurance as well?
I would stay away from a full service brokerage, because the brokers do not have fiduciary duty to their clients. For people who need financial planning, fee only or fee based is much better and more transparent.
I am just wondering what full service brokerage perspective on Claymore Advisor ETFs that do pay a trailing commission and does generate trading commissions as well. I would expect that Claymore Advisor ETFs would be less profitable than deferred sales charge mutual funds, but significantly more profitable for stocks due to trailing commissions.
By the way, how much up front commission does the mutual fund company pay to the brokerage for a 2 yr deferred sales charge mutual fund? I know that brokerage is being paid .5% trailing commission with a deferred sales charge equities mutual fund annually, but I have not found the exact number for the initial up front commission that the mutual fund company gets. My guess is either 2% or 2.5%. Can you confirm the amount for me?
Yes almost all full service brokerage firms now offer insurance, the brokers actually do have a fiduciary duty to their clients and there is extensive training for it as well as the securities commission pay very close attention to them, however there is the law and than there is the real world. There are some very good and honest commission based advisors, you just have to do a lot of work.
Fee-based advisors can be very expensive for those with small portfolios and not complex needs.
for a 2 yr DSC fund generally it is between 2 and 2.5%, the trailer fees will increase after the 2 year period for equity funds trailer fees are generally about 1%. but there arent many 2 yr low load funds, most are usually 3 yrs.
The topic of fiduciary duty is a very complicated one. According to Four Pillars of Investing, US brokers do not have fiduciary duty to their clients. US brokers only need to find somewhat suitable solutions for their clients and maximizing commissions is allowed. Due to the things that I have read about Canadian brokers, I assumed that Canadian brokers do not have fiduciary duty.
I think a 2% or 2.5% for a 2 yr deferred sales charge is ridiculously high. For example, holding a 2.5% MER fund for 2 years would give the fund company a 5% of invested assets assuming there is very little fluctuation in the fund price. The two yr deferred sales charge with .5% annual trailing commission means that a total of 3% to 3.5% of invested assets is paid to the brokerage, translating to 1.5% to 1.75% annually of invested assets. while the fund company only get 1.5% to 2% of invested assets, translating to .75% to 1% annually. I always thought that the Canadian mutual fund industry is greedy, but by this analysis, it is the brokerage firms who are greedy.
The way I see it, there are very few good commission based investment solutions in Canada. The ones that I think off my head is Philip Hager & North C series, Claymore Advisor Series, some of the big bank’s funds like RBC Monthly Income A series, and CIBC Index Funds (for those who has 150,000 to invest in them). Do you have any other good ones to add?
I think a good fee based approach is to charge .5% asset management fee and using the F series fund or ETF for the clients. Philip Hager & North has a very good F series from my own analysis. On top of .5% asset management fee, the broker should be able to make money off insurance commissions. As a result, this scenario still allows the broker to make decent money.
I am interesting in hearing what they taught you at “objection overcoming” courses to deal with those who question the system.
advisors who charge fees for Asset under management usually have a high threshold to accept clients, generally its from $250k to $500k and i dnt know many who do it for 250K mostly its around 500K. You see the issue for the small investor?
As for the objection overcoming training haha, there have been many session spend on that maybe i’ll have a post on this topic.
I have not been a broker, but I have been in business examining portfolios of brokerage clients. Some of what I found are mind-boggling. This article
The staggering cost of conflict of interest
is based on a true story.
This is the reason why I shop for better or best commission based investment brokers who can offer and suggest me with different investment opportunities rather than stick to mutual funds. I like mutual funds and I would love to invest in it but I also like to diversify my portfolio (it is a basic rule in investing).
That is why I have chosen etrade. Since I joined them I was able to take control of my investment and I get more value for my money. I also got to join a trading network where I gained useful unbiased market insights and analysis from the pros for free!
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