In “Commission Based Advisors, Part 1”, we looked at the advantages of working with a commission based financial advisor. Today we will review some of the possible disadvantages or things to watch.
As I mentioned in Part 1, I run a fee only advisory service. I try to be objective in my analysis, but there may be some bias slipping through.
Disadvantages of Commission Based Advisors
The Free Lunch
There is no such thing as a free lunch, or so the story goes.
You usually get what you pay for.
If you intend on obtaining varied or comprehensive financial planning or wealth management advise, not just purchasing a specific investment product, make sure that the advisor is competent in your areas of need. I am not saying that commission based advisors are incompetent. But if their prime function is that of product salesman, financial expertise may be second, third, or further down their list of strengths.
Match your financial objectives and needs to the advisor skill set and experience. Do not accept lower quality advice simply because that advice is free. If you get weak advice and end up in an inefficient portfolio, there is a cost associated with that.
The Lunch May Be Free, But Watch the Charges for Plates, Cutlery, and Napkins
The advice may be free, but someone is paying the advisor.
Directly, it is the company behind the products being sold. Or the advisor’s employer.
Indirectly, it is always you. Whether you pay a sales charge for the product or are assessed higher annual operating expenses, you are paying the advisor’s wages.
Small investors may pay less than large investors. But everyone pays to some extent.
Length of time holding an investment can also impact how much one pays. With load products, the shorter the holding period, the higher the relative cost. With no-load products, the longer the holding period, the greater the cost paid back to the advisor.
For example, you invest $100,000 in a large cap, domestic equity fund charging a 2.1% annual fee. An actual average annual fee for large cap, Canadian equity funds, by the way! That equates to an annual expense deducted from your investment in the amount of $2100 per annum. Over 10 years, that is a lot of lost capital. Capital that is not being reinvested and growing on your behalf.
Note the 2.1% annual expense ratio includes expenses other than simply the “free” advice component. The linked Morningstar article indicates that the average difference between the identical investment fund is 1.0%. You pay a 2.1% annual expense for a fund purchased through a commission based advisor. Whereas you only average 1.1% in annual expense ratio for the same fund purchased via a fee only advisor.
In this case, the amount paid for “free” advice on the $100,000 investment is $1000 per annum.
Through the 10 years, that annual expense will increase. Say your fund returns 7.2% net of expenses (ignoring taxes), annually over the 10 years. Even with no additional investment, your fund will be worth $200,000. That means you pay more in annual fees each year. In fact, by year 10 your costs have risen to $4200 annually.
And for that initial advice that cost you nothing? You end up paying an additional $14,952 in fees versus buying the same fund through a few only advisor. That may be substantially more than you would have paid a fee only advisor up front. Even factoring in the discounted time value of money.
As an aside, I do not agree with Morningstar’s comparison of 2.1% versus 1.1% expense ratios. Morningstar is comparing mutual funds only. This makes sense as they want an apples to apples comparison between funds that commission based advisors sell and the exact same funds sold through fee only advisors.
However, in the real world, many fee based advisors will recommend exchange traded funds (ETFs) rather than mutual funds. There are many reasons why and I will discuss them in future posts. A key factor is that ETFs often have lower annual expense ratios than comparative mutual funds. That means the 1.1% ratio cited for funds sold through fee only advisors is higher than one would expect in purchasing an ETF.
For example, Vanguard offers two Canadian equity ETFs with annual expense ratios of 0.06%. iShares TSX Capped Composite ETF runs 0.06% per annum. BMO TSX Capped Composite ETF is 0.06%. These ETFs all target Canadian equities with emphasis on large cap. All will save you 1.04% annually versus similar mutual funds sold via a fee only advisor.
And do not get me started on the cost variance between a 2.1% commission based fund’s annual fees and an ETF at 0.06%.
Is it in Your Best Interest?
When I sit down with a professional – doctor, lawyer, accountant, etc. – I expect that they are acting in my best interests. I pay a fee and get their unbiased expertise in return.
With commission based advisors, I am always extremely leery as to whether they are looking out for me or for their own family. In my mind, I can hear them say:
“If he invests in this 5% front-load, 2.5% annual operating fee mutual fund, my son can get those braces. Don’t mention the excellent ETF that tracks the same market for a fraction of that fee.”
Maybe I just have a suspicious nature. But I am more comfortable dealing with someone I know will give me unbiased advice as to what is best for me. And not someone I hope will do so.
That said, there are commissioned salesmen that act in the clients’ interests. There are also fee only advisors that act unethically. But, on average, I have more confidence with a fee only advisor than with someone whose own income is linked to what he sells to me.
One question I would ask any potential advisor, commission or fee based, is whether they act as a fiduciary or not. That will assist in determining whose interests the advisor is acting for.
As I said, there are pros and cons to all manners of advisors. I am undoubtably less thrilled with commission based, but there are some very good ones out there. And, if you are starting out with very limited capital, deferring the advisor fee may be better than coming up with a cheque today.
Next we will review the pros and cons of working with a fee only financial advisor.
