What Can a Broker Do For You?

You have choices when it comes to investing.  You can go directly to a mutual fund company (such as Vanguard or T. Rowe Price) and choose investments yourself, or you can use a fee-only financial advisor to assist you in choosing investments.  But by far the most common method is to work with a broker.  Brokers are companies like Edward Jones, Ameriprise, and AG Edwards Wachovia Wells Fargo, plus many, many other companies, including insurance company brokerage divisions, banks, and the like.

What’s the Difference?

the difference engine_marcin wichary usedYou’re probably wondering – what’s the difference between a broker and, for example, a fee-only advisor?  You’re right to be confused, because until you start working with one or the other and you know what the difference is, they look pretty much the same from the outside.  Here’s the difference: Brokers are salesmen. It is their job to sell you an investment product, and that’s how they get paid.  They are required by law to ensure that the product is “suitable” to your situation. Fee-only advisors are advisors. Fee-only advisors are bound by law to act as a fiduciary.  It is their job to advise you on the appropriate strategies and tactics – investment moves that are in your best interest. That’s a pretty big difference in itself – but since that differential makes the fee-only advisor look SO much better (and since this writer is a fee-only advisor), I wanted to point out what research has born out to be true about the recommendations that you get from a broker.

What Can a Broker Do For You?

There is a study done by researchers at Harvard and the University of Oregon (Bergstresser, Chalmers, and Tufano), which strives to identify the possible benefits to the consumer of financial services in purchasing investments via a broker. They looked at five possible benefits:
  1. Assistance in selecting funds that are harder to find or evaluate.
  2. Access to funds with lower costs excluding distribution costs.
  3. Access to higher performing funds.
  4. Superior asset allocation.
  5. Attenuation of behavioral investor biases (in other words, saving the investor from himself)
Ultimately, the researchers “found it difficult to identify the tangible benefits delivered by brokers.”  But that’s getting ahead of ourselves.  We’ll take each category separately and briefly describe the findings. Assistance in selecting funds that are harder to find or evaluate It is true that brokers often direct investors into smaller, younger funds that have less track record or are not covered by major rating services.  The costs (especially in time) to the individual would be enormous in researching these funds. If the other benefits are brought about by utilizing these harder to find or evaluate funds, then there would be a benefit to working with the brokerage.  What we’ll see is that the rest of the evidence doesn’t bring that conclusion. Access to funds with lower costs excluding distribution costs The researchers found that the funds sold through the broker channel do not have lower costs excluding distribution fees.  In other words, even if funds exist that are of a lower cost, the brokers are not (in general) directing investors to those funds.  Across the board, the annual cost of a brokered stock fund was on average 2 basis points (bp) higher (.02%), not including commissions or 12(b)1 fees.  And the average annual cost of a bond fund was an amazing 23bp higher, and money market funds were on average 4bp greater. Access to higher performing funds The overall return, as well as the risk-adjusted return, is lower for the funds that the broker chooses, versus funds that are directly purchased via other channels (e.g., a fee-only advisor or through personal research by the investor).  Stock funds underperformed direct-purchased funds by an average of 7.5bp (.075%) – and using risk adjustments caused these figures to get even worse.  Bond funds underperformed as well, but money market funds did provide a slightly better return, by a total of 18bp on average. Superior asset allocation While a broker’s asset allocation recommendation is different from that of other investment channels, over time the outcome is pretty much the same for either type of investor.  The difference is that, on average, the broker tends to direct a higher percentage of investors into bonds (as opposed to stocks).  Since stocks, over a long run, outperform bonds and bonds demonstrate lower risk (as measured by standard deviation), this difference in allocation weights tends to even out between the two. Attenuation of behavioral investor biases Lastly, the research shows that most broker-driven investors are much more sensitive to short-term performance in the market than other investors.  This leads to “performance chasing”, which in general does not bear greater returns, while at the same time increases incremental transaction costs.  Transaction costs benefit the broker, of course.

But wait, there’s more!

In addition to the research summarized above, What Can a Broker Do For You?you need to know about how a broker is typically paid.  I already mentioned that the broker is paid to sell the investor products – how does that work?  There are many types of fees which can impact an investor’s account:
  • Front end loads: this is a commission charged when you purchase the fund.  Typically these can be anywhere from 3% to 5% or more of the purchase, although at much higher balances the fees can be reduced and even eliminated.
  • Back end loads: this is a commission charged when you sell the fund.  Often, this is used to keep an investor in a fund for a specific period of time, during which other fees can be transacted from the account.  After a period of time, these back end loads are waived.
  • Annual loads:  this is an annual commission based on the holdings in the account, and can be one of the most expensive ways to hold investments.
  • 12(b)1 fees: this is also an annual fee based on the holdings in the account, and often is the most elusive to identify – while representing the greatest drain to the investor.  This fee is usually pretty small in relation to other fees (sub 1%) but it is charged across all classes of funds, whether a front-end, back-end, or annual load.  What really hurts is that the 12(b)1 fee is specifically for marketing the underlying investment.  In other words, as an investor in the fund, you’re paying to help bring in more investors.
While it’s not conclusive, some of the results found in the research paper indicate what you might expect:  that brokers sell the investments that pay them the most.  For example, as the front-end load or 12(b)1 fee increases for a particular fund, there is an attendant increase in the sales of the fund.  Not unexpected, it’s basic human nature.

Conclusion

The research shows no tangible benefit to working with a broker – in fact, results are often worse with a broker.  Add to that the costs of working with a broker, above and beyond the dismal results that you achieve, a conclusion isn’t hard to come by:  it makes more sense to either do the research on your own and purchase funds directly, or to work with a fee-only financial advisor who will do the research and operate as a fiduciary to ensure that the investment choices you make are in your best interests.
Photo #1 by Marcin Wichary
Photo #2 by kevin_oneill
IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).

About the author

Jim Blankenship, CFP®, EA

Jim Blankenship is the founder and principal of Blankenship Financial Planning, Ltd., a financial planning firm providing hourly, as-needed financial planning and advice. A financial services professional for over 25 years, Jim is a CFP professional and has earned the Enrolled Agent designation, a designation that qualifies him as enrolled to practice before the IRS. Jim is also a NAPFA-registered financial advisor, which designates him as a Fee-Only Financial Advisor.

An IRA Owner's Manual
A Social Security Owner's Manual

Leave a Reply

Your email address will not be published.

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <s> <strike> <strong>

Copyright 2014 FiGuide.com   About Us   Contact Us   Our Advisors       Login