Buy investment funds through low cost channels

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Do not buy mutual funds and ETFs through high cost vendors

All mutual funds and ETFs are not created equally. Most are created to serve the business interests of the financial industry rather than to deliver investment vehicles that are likely to serve the best interests of individual investors.

Do not purchase any mutual funds or ETFs through high cost brokers and financial advisors

You can easily invest directly with low cost mutual fund firms, and you can easily buy ETFs through discount brokers. You simply do no need to pay a third-party broker, financial, or investment advisor to do this for you, when you can do this yourself directly. Your “hourly wage” for taking the personal initiative to invest your money directly in mutual funds and ETFs is usually very high versus what you pay when you buy funds through an third-party financial advisor.

Purchasing mutual funds through an advisor or ETFs through a “full service broker” can be very expensive over your lifetime. Your costs tend to be much higher and your investment risk exposure tends to increase with advisor recommended mutual funds and ETFs.

Third-party brokers and financial advisors may not place you in the lowest cost funds, in part, because higher cost funds also provide these advisors and their firms with higher compensation. Consistently, commissioned brokers and fee-based advisors recommend more expensive, actively-managed funds in an effort to justify their own cost. Of course, it only makes sense that individual investors would expect their advisors to justify their fees through superior performance. Why pay an advisor extra, if he is not going to beat the market for you and “earn his keep?”

Unfortunately, such an advisor will take extra and unnecessary investment risk using your money and not his. The historical record for actively managed investment strategies indicates that on average long-term results are more likely to be worse rather than better.

Almost uniformly, brokers now call themselves “financial advisors.” However, brokers have used loopholes to skirt and largely escape any legal obligation to act in your best fiduciary interests, as would be expected under the Investment Advisers Act of 1940, as amended. In fact, the US brokerage industry, with the long-term complicity of regulators, has muddied the differences between securities brokers and investment advisers and their differing legal obligations regarding the interests of investors. Recent survey research demonstrates that the investing public has little clue that there is supposed to be any legal difference in the standard of professional care between brokers and real financial advisers.

Just as unfortunate, however, is the very wide range of investment product expenses that characterize investment funds selected and promoted by real financial advisers. Financial advisers regulated under the Investors Advisers Act of 1940 are supposed to act in the “fiduciary” or best interests of  their clients. Yet, there has been little restriction on the fees that they assess or the cost of the products that they recommend. Far too many financial advisers place their clients in expensive actively managed investment funds, when the historical record indicates that inferior outcomes are to be expected. In my opinion, when you consider the results of the study below, both brokers and investment advisers who recommend expensive investment funds seem far more similar than dis-similar. Are the best interests of the client being served by either group? You decide.

Investment research contradicts financial industry claims to help individual investors do better

There is no need to guess about this. Just read the research. You might like to read a very enlightening study that covers the problems mentioned above and others. After reading this study, you might change your mutual fund buying habits and save yourself substantial sums of money for the rest of your life.

In this Harvard Business School finance working paper, “Assessing the costs and benefits of brokers in the mutual fund industry,” Professors Bergstresser, Chalmers, and Tufano analyze the value-added of the broker sales channel for mutual funds.

In the conclusion of this research, Professors Bergstresser, Chalmers, and Tufano state that:

“We begin with a positive hypothesis: the prominence of funds sold through brokers implies that brokers provide consumers with valued services. Our study has identified few, if any, of these benefits.” (1)

This is a rather stark conclusion, when you consider that the great majority of mutual funds are sold through brokers and other third-party financial advisors.

In buying mutual funds through brokers and advisors rather than purchasing them directly from fund companies, individuals incur very substantial front-end or back-end sales load charges, and they pay substantially higher ongoing fund management and marketing expenses. Individual investors unnecessarily waste billions of dollars every year by purchasing mutual funds through brokers and advisors rather than buying directly.

Higher cost brokers and financial advisors have no special insights about the future

Regarding the future, high cost brokers and financial advisors do not know anything special compared to any other reasonably informed investor. However, they do seem to be quite good at suggesting that they do have superior insights. In addition, they are especially good at taking a larger portion of other people’s money on a regular basis.

Professors Bergstresser, Chalmers, and Tufano used a database that allowed them to compare the performance and other characteristics of broker sold mutual funds versus directly purchased mutual funds. Here are some additional quotations from this research study.

“Do brokers offer and sell higher performing funds?  … summing up across broad equity, bond, and foreign equity investment categories leads us to estimate the annual underperformance of the broker-sold funds at $4.6 billion dollars in 2004. This underperformance is before the payment of $9.8 billion in 12b-1 fees paid in 2004 and the payment of other distribution fees such as loads.” … (pages 7 to 9)

“Do brokers provide better asset allocation and timing abilities? … We find no evidence that, in aggregate, brokers provide superior asset allocation advice that helps their investors time the market.” … (pages 10 to 12)

“Putting a brake on behavioral biases? … Another behavioral bias is the tendency to chase past returns, measured by the flows into and out of mutual funds as a function of prior fund performance. … While in theory, brokers could reduce the behavioral bias to chase returns, we find no consistent evidence in practice that return chasing is substantially weaker among broker-sold funds.” … (pages 15 to 16)

“Do brokers merely sell what they are paid to sell? … Relative to the direct channel, brokers’ clients select asset allocations that perform no better, and invest in funds that perform worse even before any distribution fees are considered. For these non-benefits, they pay front-end loads that are as much as 417 basis points (4.17%) higher and annual distribution charges that are up to 40 basis points (.4% per year) larger.” … (page 17)

“An optimistic interpretation would be that brokers are indeed acting in their clients’ interests, but, as researchers, we have simply not been able to measure the many substantial intangible benefits that brokered clients receive. … A less charitable interpretation of our results is that financial intermediaries may not always act in their clients’ interest, but rather put clients’ interests behind their own interests and the interests of the fund companies that pay them.” …  (page 17)

“In summary, we find a reasonably clear pattern of results. We find that the brokered channel sells funds with inferior pre-distribution-fee returns. The channel does not show any evidence of superior aggregate market timing ability, and shows the same return-chasing behavior as observed among direct channel funds. Finally, more sales are directed to funds whose distribution fees are richer. This work leaves us with the puzzle of why investors continue to purchase funds that appear to be no better at substantially higher costs. The answer could be that we, as researchers, failed to measure important intangible benefits, or that consumers of brokers fail to consider the costs and benefits of this relationship.”   (page 18)

If you purchase mutual funds through brokers and other financial advisors, you might want to reconsider your investment purchasing practices. To understand more about the lack of value provided by brokers and advisors in selecting mutual funds for investors, I suggest that you download and read this important and rather disheartening research paper on broker sold mutual funds versus directly purchased mutual funds.

Read for yourself this study about the costs and benefits of brokers in the mutual fund industry

Read for yourself this study about the costs and benefits of brokers in the mutual fund industry. Then, decide whether, in the future, you will ever just give your money away to financial professionals who state or imply that they know how to help you get better investment results. Understand this industry for what it is, which is simply a sales channel for more expensive investment funds. More expensive investment funds are better for the industry, but worse for you.

Reading this study requires your reasonably careful attention, but it is not difficult to read in less than an hour. If you still need convincing that you should purchase mutual funds directly and cut out the middleman, this could be a very profitable hour of reading for you.

I maintain a permanent link to “Assessing the Costs and Benefits of Brokers in the Mutual Fund Industry” by Bergstresser, Chalmers, and Tufano, on one of my websites. Go to:

This link will take you to the Social Science Research Network website where you can download a free copy of this study in Adobe Acrobat .pdf format. When you get to the SSRN site, just click on the “One-Click Download” link, save the file to your local disk, open, and read.

1) Bergstresser, Daniel B., Chalmers, John M.R. and Tufano, Peter, “Assessing the Costs and Benefits of Brokers in the Mutual Fund Industry” (January 16, 2006). AFA 2006 Boston Meetings

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