This month, we return to our financial “stop doing” list with another top stop: STOP heeding transaction-based investment advice. When you go to buy a new car, you already know that a Ford dealer is unlikely to recommend a Toyota, even if it’s the better vehicle for you. It’s widely understood that this is the salesperson’s role, so you consider the advice accordingly.
Things are different in the investment world. While the quality of advice you receive can vary widely, it’s often unclear how to differentiate the solid from the suspect recommendations. The first step toward clarity is to understand the differences between transaction- and fee-based advice.
We’d like to see this change, but most of the investment advice currently available comes from financial representatives who are ultimately earning their living in ways very similar to any other salesperson.
To begin with, most of them are affiliated with a large bank, insurance agency or similar financial institution, which means that the advice they offer is highly likely to be influenced by a desire to promote their firm’s offerings over anyone else’s.
Transaction-based financiers also typically have conflicting agendas of their own, coming from sales commissions, company promotions, marketing quotas and similar incentives that have little to do with whether the advice they are offering is best for you and your financial goals.
In contrast, there is another kind of investment advice out there. It comes from independent, fee-based advisers like yours truly. In our portfolio manager model, we are compensated exclusively by you, our client for dedicating our financial know-how to deeply understanding you and the full range of your unique financial objectives. We then offer objective, product-neutral advice optimized to advance your best interests. Rejecting any other sources of compensation helps keep our mind clear and focused on this higher cause.
I commented on these conflicting kinds of advice several years ago when I described why I have embraced evidence-based investing as a way to help reduce some of Bay Street’s otherwise entrenched conflicts of interest. More than a decade ago, I also established a fee-based practice, to further reduce any temptations to make recommendations that did not first and foremost serve my clients’ best interests.
I’m not alone in casting a skeptical eye toward less-than-obvious financial incentives feeding the financial industry. A recent Globe and Mail piece shared the results of a study on mutual fund trailer fees paid to financial advisers who recommend these commission-laden funds to their clients. The fees are paid out annually as long as the investor holds the fund, and are often relatively buried in the disclosure fine print. Unsurprisingly (to cynics like us, anyway), the study found:
- The incentives “worked” for the financial industry. Trailer fees (can you say “kick-backs?”) generated increased average monthly inflows of investor funds regardless of past performance. The higher the trailer fee, the more funds flowed in.
- The incentives didn’t work for investors. Adding insult to injury, the article disclosed: “The report also finds that mutual funds that pay higher trailer fees have a far worse performance over all than those that don’t pay trailer fees.”
Conducted by a York University finance professor, the report was commissioned by provincial regulators who have been looking into financial industry reforms related to the second phase of IIROC’s Client Relationship Model (CRM2). But the issues aren’t exclusive to our home turf. The UK and Australia already have banned such transaction-based commissions, based on similar concerns. As reported here, following the UK ban, the sale of the highest-cost funds plummeted within a year, “from 60 per cent of all products sold by advisers in the three months before to just 20 per cent six months later.”
Wow, actions speak louder than words, don’t they? As long as trailer fees and similar sales incentives remain common in our industry, we would recommend the best action for investors is to STOP heeding transaction-based investment advice … or at least understand the context in which it is being offered. If you step into a Ford dealership, don’t be surprised if you end up buying a Ford.