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If you're not careful, mutual funds can bleed your portfolio dry. Buy the wrong funds or play switcheroo with your holdings too often and your nest egg can get kneecapped in a heartbeat.
Paying too much for mutual funds is an issue that any investor can fall victim to, but investors that use brokers or financial advisors need to be especially careful. In The Motley Fool's recent special report on financial advisors, we highlighted the troublesome incentives that arise from brokers and advisors that make money from commissions. Because commission-based advisors' income stems from the fees from the funds they sell you, they're not necessarily incentivized to work in your best interests.
So how do you make sure that the funds you're being recommended aren't going to give your portfolio the vampire treatment? The three steps below are a great place to start.
1. Make sure you have the right advisor.
If you don't already have an advisor and you're starting from square one, finding an advisor that is fee-only and works under a fiduciary standard are two criteria you seek out.
A fee-only advisor is one that charges you a fee for services -- either based on the amount of assets they're managing for you or a fixed fee per hour that they spend working on your account -- and doesn't collect any commissions on top of that. Though there are still conflicts of interest that can arise in a fee-only relationship, because the advisor isn't relying on commissions, you can be more assured that they're not pushing a mutual fund simply because it will pay them a high fee.
Meanwhile, an advisor that's also a fiduciary means that they agree to act in their clients' best interests at all times. Because a fiduciary can get tangled up in court for failing this standard, they take the commitment very seriously.
But while looking for a fee-only fiduciary advisor may be ideal, it doesn't mean that every advisor that takes commissions is out to swindle you. In fact, there are a great many commission-taking advisors that are great assets to their clients. However, if your advisor or broker does receive commissions, it's even more essential to make sure that you have a transparent, trusting relationship with your advisor -- that, or you keep a very close eye on the funds that they're recommending.
2. Are your funds really beating the market?
Here's the bottom line: Most mutual fund managers don't beat the market.
In 2011, the situation was particularly bleak as Morningstar reported that 79% of large-cap mutual funds lost out to the S&P 500 (INDEX: ^GSPC ) index. That's pathetic.
Part of the reason is really simple -- actively managed funds often charge really high fees. For instance, the Columbia Acorn Emerging Markets A (CAGAX) fund charges a maximum front-end sales charge of 5.75% and then hits investors for 1.85% annually. The Oppenheimer Quest Opportunity Value A (QVOPX) hits investors with a similar maximum 5.75% front-end fee, while taking out another 1.52% annually.
Fees like that can easily make mincemeat of your portfolio, so if the returns that you're getting from your funds aren't beating appropriate benchmarks, then there's no reason that you should stand for expenses that high.
What's your other option? Go with the good ol' maxim: "If you can't beat 'em, join 'em." Aim to match the benchmarks through low-cost index funds or ETFs. The Vanguard S&P 500 ETF (NYSE: VOO ) will track the S&P 500 for you at the rock-bottom cost of 0.05% annually. The Vanguard Dividend Appreciation ETF (NYSE: VIG ) and the Vanguard MSCI Emerging Markets ETF (NYSE: VWO ) , meanwhile, track the Dividend Achievers Select Index and the MSCI Emerging Markets Index with respective annual fees of 0.13% and 0.2%.
3. Trading is harmful to your wealth.
Studies from the world of behavioral finance have shown that investors are often driven by overconfidence to trade excessively. And investors that trade excessively tend to underperform their more patient, plodding counterparts.
This applies to working with a financial advisor and mutual funds just as much -- if not more -- than sitting at home and day trading stocks on your own. When mutual funds -- particularly actively managed mutual funds -- are purchased or sold, they often trigger fees. If your advisor has a penchant for jumping in and out of funds, stacking fees on top of fees, you may end up feeling like your portfolio has sprung a leak.
So, as above, if your broker or advisor has a yen for trading and can prove that his outstanding level of ability is leading to benchmark-topping performance, then let him have at it (but continue to keep an eye on the results!). However, if that trading activity is full of sound and fury, but signifying nothing -- except racking up fees -- then tell your advisor in no uncertain terms that you'd rather settle your portfolio into some nice, long-term positions in low-cost index funds.
There's good reason for investors to use financial advisors. As behavioral finance expert Terrance Odean said to me, "Is there room for improvement for the behavior of individual investors on their own? Yes! Could someone that's well trained help them? Sure!" However, in order for clients to get the best experience possible from an advisor relationship, it's critical that they understand the basics of the business and how to find the right kind of advisor.
To supercharge your understanding of financial advisors, be sure to check out The Motley Fool's special report: "How to Thwart the Opaque, High-Fee, Underperforming Financial Advisors Who May Be Mismanaging Your Money."