If you use a financial advisor, you've probably been approached to invest in a diversified group of funds or a mutual fund advisory program. But be careful before you accept -- they may cost you more than your portfolio can afford.
Several large financial companies offer these programs. For example, UBS (NYSE: UBS ) offers a program called PACE (Personalized Asset Consulting and Evaluation), while Wachovia (NYSE: WB ) offers something called Fund Choice. Merrill Lynch (NYSE: MER ) and JPMorgan Chase (NYSE: JPM ) provide similar vehicles.
Asset allocation with funds
Although each program is different, typically, your advisor will ask you several investing-related questions. Based on your answers, you'll get a recommended allocation of several mutual funds that cover different investment styles, such as large-cap growth funds and international bond funds. Your advisor may offer proprietary managers for each style, or you and your advisor may select appropriate choices from hundreds of funds. The allocation takes your risk tolerance and investment time frame into account, along with other prudent considerations.
The usual up-front or back-end sales charges associated with certain funds are waived, in favor of an overall quarterly or yearly fee. Although the fund's sales charges are waived, the client pays the regular ongoing fees associated with the funds, in addition to an overall account fee.
So what's wrong with that?
Unfortunately, these accounts serve your financial advisor's interests much better than your own.
Look at this from your advisor's point of view. First, mutual fund advisory programs provide a dependable income stream. While commissions on individual trades are sporadic and unpredictable, fee-based accounts provide a highly desirable and stable cash flow year in and year out. Even when you make no changes to your investments, your advisor still gets paid.
Second, they provide a defense against litigation. When advisors recommend higher-risk strategies, they expose themselves to lawsuit risk if their advice goes sour. In contrast, these programs have a written strategy and a rationale for investing that the client accepts up front.
Last, these programs reward financial advisors for investor apathy. Even if clients don't like the program's results, they'll typically wait a while before doing anything about it. Meanwhile, financial companies continue to collect fees for years, until you finally decide to fire them.
Too much diversification, too high a price
Meanwhile, you typically end up with more funds than you really need. Diversification can be a great way to reduce risk and volatility. But if your recommended allocation includes seven different stock funds, each with hundreds of holdings, you'll often end up with stocks like AT&T (NYSE: T ) , Procter & Gamble (NYSE: PG ) , and Apple (Nasdaq: AAPL ) -- a portfolio that looks a lot like the overall market.
Also, fees eat away at your account. Rather than using low-cost index funds, these programs often use managed funds that charge more -- closer to the overall average fund fee of more than 1.3%. And the costs don't stop there. In many cases, those fund costs are on top of overall program management fees, which can add another 0.5% to 1.5% annually.
Consider that the overall market has been lackluster lately, and you can see how those fees take a bite out of your personal returns. With a 10-year average return of just 2% on the S&P 500, a fund fee of more than 1% plus a 1% management fee would eat up all your gains. And that doesn't even take inflation and taxes into account.
Count your costs
Used properly, a diversified portfolio of mutual funds can lower your risk and actually increase returns over time. But with the costs of these programs, earning good returns is quite difficult.
A down market doesn't afford the luxuries of a bull market. If you diversify, you need to do it much cheaper than mutual fund advisory programs. A better way is with index funds or ETFs. These vehicles will enable you to achieve the same level of diversification at much lower cost. To give yourself a chance against the bear, you simply must avoid paying 2% or more in unnecessary fees.