Millions of Americans invest in mutual funds as their primary vehicle for retirement savings. These funds hold trillions of dollars of wealth, constituting a vital part of our economy.
Yet although I think mutual funds are the greatest thing since sliced bread, you'd have to be blind not to notice that the industry is rife with conflicts of interest, self-dealing, and special treatment for institutional clients, at the expense of retail investors. While we may not ever be able to completely eliminate all of these problems, a new change is under way that will benefit fund investors immensely -- and possibly redeem some of the fund industry's lost luster.
A sea change
No, the fund industry hasn't decided to spontaneously lower its fees across the board -- keep dreaming! However, an ongoing change in how many financial advisors get paid is having broad implications for the business. In the old model, advisors would make fund recommendations for their clients, and typically direct client money into certain funds that would kick back a commission to the advisor. A typical "load" on a fund like this can run as much as 5.75%, which means that before your investment even got to the fund, you'd take a sizable haircut just as the price of entry.
Despite the popularity of the commission-based approach, many people felt there was something unseemly about the practice. How could investors be sure that their advisor was directing them into the most appropriate fund for their needs, and not just the fund that offered the best payout to the advisor? Furthermore, this left the door open for less scrupulous advisors to churn an investor's account by frequently moving into and out of funds, garnering another commission with each move.
The fee's the thing
Fortunately, more and more investment professionals have seen the light and begun to ditch a commission-based pay structure. Eager to avoid the appearance of impropriety, advisors are eschewing the traditional broker model, instead charging clients an annual asset-based fee, regardless of how they are invested. According to data from consulting firm Cerulli Associates, as of 2008, 17% of all advisors were fee-only, and another 48% were "fee-based." That combined total of 65% is up from 46% just five years ago.
I think this move to more of a fee-based model is a terrific move for investors. While a fee-based model may end up costing investors roughly the same as a commission-based model, it better aligns the interests of the advisor and the client, and it eliminates a huge potential area of conflict of interest -- something the fund industry desperately needs to improve its image on Main Street.
Another significant benefit for folks who invest through financial advisors is a greater selection of investment options. Once the advisor is no longer limited to load funds, a whole new world of fund choices opens up for the investor. Now investors can have access to top-notch fund companies such as Vanguard and T. Rowe Price (NASDAQ:TROW), which offer low-cost, no-load funds.
If you are thinking about employing a financial advisor to get your fiscal future on track, I would highly recommend a fee-only or fee-based professional, rather than a traditional commission-based broker, for all of the above reasons.
Advice for do-it-yourselfers
Of course, even if you don't employ a financial advisor to invest your money, there are some important lessons you can take away from this ongoing change. First and foremost, never buy a load-bearing mutual fund. There's no reason to pony up 6% of your money up front just to buy a fund. There's always a better option. For example, American Funds AMCAP (AMCPX) is a terrific fund -- but it comes with a load of as much as 5.75%, in addition to its 0.74% annual expense ratio. Instead, you could buy T. Rowe Price Blue Chip Growth (TRBCX) for zero load and a mere 0.80% price tag. Both funds offer exposure to big-name growth stocks such as Microsoft (NASDAQ:MSFT), Apple (NASDAQ:AAPL), and Google (NASDAQ:GOOG), but the T. Rowe fund comes without the onerous load.
Secondly, remember that just as fund commissions can earn financial advisors a hefty paycheck, so, too, can trading commissions in your own account on stocks and ETFs make your broker rich at your expense. If you are an ETF investor, I advise minimizing your costs by sticking to well-diversified, broad-market funds such as SPDRs (NYSE:SPY), PowerShares QQQ Trust (NASDAQ:QQQQ), or Vanguard Total Stock Market ETF (NYSE:VTI). Once you've bought in, remember to think of these as long-term investments, not day trading vehicles. Don't rack up charges by making frequent short-term trades.
Ultimately, if the mutual fund industry can better align the interests of investors and the professionals who give advice and make recommendations, it will go a long way toward rebuilding trust in the business. After the many black eyes the fund industry has endured in the past decade, that little bit of extra trust is sorely needed.
