ETF Investing Guide: My Broker's an Honest Fox

There are two bedrock assumptions underlying services for wealthy investors:

1. Your importance as a wealthy customer warrants a special - and for you a valuable - relationship with your broker.
2. Your wealth level requires and justifies financial products tailored specifically for you.

In practice, these two assumptions translate into the following. Most brokerage firms have specific units tailored for “high net worth” clients (presumably they mean “high net financial worth” clients, given that every human being is “high net worth”), as well as regular brokers who focus much of their time and effort on wealthy individuals. These firms offer you the ability to aggregate your assets in a single place, to discuss asset allocation and your overall financial situation, to receive the brokerage firm’s stock picks, to have an account managed by an outside money manager (or collection of managers), and generally to benefit from the broker’s attention and responsiveness to your needs.

Sounds good, right? Well, not so fast. Let’s start by analyzing the broker-client relationship that lies at the heart of these services.

As with most business relationships, there are many important aspects of the wealthy client/broker relationship. But undoubtedly the pivotal factor - the one that arguably trumps all the others in importance - is the underlying economic interests of broker and the client. And here the news is not good.

Put bluntly, your economic interests clash with your broker’s. This assertion does not stem from a jaundiced “you win/I lose” view of business relationships generally. Rather, it flows from the peculiarities of the way brokerage firms bill for their services. Here’s how. The client wants and expects two things: objective financial advice, and the most cost effective execution of that advice. The broker, however, receives no direct compensation for the advice, and all his compensation from the execution of the advice. The broker gets no direct payment for his time, and instead gets paid when the client transacts via his firm, and purchases products (such as mutual funds) which he is paid a sales commission for, including his firm’s own mutual funds.

This compensation framework sets up an intrinsic conflict of interest for the broker. (As a former sell-side analyst, I’m an expert in conflicts of interest...) The broker’s objectivity in giving advice is compromised by his desire to recommend products (or trades) that generate heavy fees. And these products (or trades) are precisely what the client should be avoiding, as one of the client’s key investing goals is to minimize fees.

Worse still, the fees that the broker receives are often invisible to the client. The broker makes money on the trading commission for a stock or bond, the buy-sell spread on a stock or bond (if he is also the market maker), the annual fee on a mutual fund if it’s his own fund, the load on anybody’s fund, and often a cut of the annual fee on a fund or managed account from another manager. In aggregate, the client is often unaware of many of the underlying fees involved, and the brokerage firm is highly incentivized to push certain products over others. On top of that, firms pay their brokers for pushing specific products, but they rarely (if ever) reveal these incentives to the clients who they are supposed to be advising. Goodbye objective advice.

To protect the client from this conflict of interest, the financial industry and legal regulations curb the behavior of brokerage firms and brokers. Firms, for example, are not allowed to (directly) compensate their brokers more for selling their own mutual funds than other firms’. But for most investors, the current system - of intrinsically conflicted brokers regulated by law and their own industry - is akin to hiring a fox to baby-sit the chickens, with a government agency appointed to ensure there are no non-vegetarian meals. And naturally this system leads to clients getting a raw deal, sometimes legally, and sometimes illegally.

The most egregious examples involve sales to unsuspecting clients of mutual funds and annuities with unnecessarily high fees. This can be by selling clients a high-fee class of mutual fund shares, not giving clients stipulated volume discounts, recommending that clients spread their assets among funds so they don’t warrant volume discounts, recommending high-fee, tax-free annuities in accounts which are already tax free, and putting clients who rarely trade into fixed-fee accounts designed for active traders. And - because their underlying financially interest dictates it - firms find ways to skew broker incentives towards their own mutual funds. Some tie branch managers’ pay to sales of in-house funds. This is technically within the rules barring special incentives to brokers but not managers; but you can guess the impact. Some pay brokers special credits for out-of-pocket marketing expenses for their own funds; again, not a technical violation but a clever way to economically incentivize brokers to sell their own funds. And some pay brokers higher commissions for selling funds on a “preferred” list. To get on the “preferred list”, a fund has to pay the broker a special distribution fee, or (you guessed it!) the fund has to be the brokers’ own fund. In aggregate, you get the idea. Despite the rules, the behavior of brokers is too often a function of their underlying economic interests. The fox ate a chicken or two???? Surprise, surprise!

As an aside, the rules governing broker behavior stipulate that brokers can only recommend investments that are “suitable” for their clients. Most law suits against brokers stem from allegations that brokers recommended investments that were unsuitable given the client’s risk tolerance and overall financial situation. Yet the “suitability” criterion seems oddly arbitrary. Brokers are not allowed to put retirees into risky investments, yet they are allowed to sell mutual funds to their clients that historically under-perform the market and have excessive fees. There is even a broker-sold S&P 500 index fund that charges an upfront load (!); yet I know of no suit that has been brought against a broker for promoting that fund and pocketing the load, when it clearly would have been more “suitable” for the broker to recommend that the client switch his account to an online brokerage and buy some ETFs instead, or at the very least purchase an S&P 500 index mutual fund without a load. In fact, given the general under-performance of actively managed mutual funds, you could easily argue that most of them are “unsuitable”.

As you can imagine, financial services firms like to play down these conflicts of interest. They describe their brokers as “financial advisors”, rather than salespeople or brokers. (In many cases, their brokers are trained financial advisors, but that doesn’t remove the conflict of interest.) They buy advertising featuring an employee earnestly advising a client. Their image is entirely vegetarian. But underneath it all, a fox is a fox.

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