By John Wasik
CHICAGO, July 9 A recent New York Times story
quoting a former JP Morgan broker who said the company urged its
financial advisers to sell its own commissioned funds over
less-expensive outside products should not have surprised any
educated investors. It has been well-known in academic finance
circles for years that when you add up the fees that brokers
layer on, the value proposition often evaporates.
I have yet to find independent evidence that shows that
broker-sold products outperform noncommissioned index funds over
time on a regular basis. There are, of course, exceptions from
year to year. And of course, some brokers may provide a useful
service if the funds they recommend can equal or top market
returns and meet investors' needs and goals. But generally the
opposite is true over the long haul.
A comprehensive study conducted by researchers Daniel
Bergstresser, John Chalmers and Peter Tufano, published in 2007,
examined broker- and direct-sold (when no broker was involved in
the transaction) funds from 1996 through 2004. The broker-sold
funds delivered lower risk-adjusted returns - even before
"distribution" costs were subtracted. The results were
consistent across different fund objectives, with the exception
of foreign-stock funds (see).
Investors pay far too much for these underperforming
broker-recommended funds - more than 4.5 percentage points over
direct-sold funds, the researchers found. They even offered a
less-charitable interpretation that brokers "put clients'
interests behind their own interests and the interests of the
fund companies that pay them."
Building upon this research, one of the largest studies on
this topic ever conducted examined 524 mutual fund families for
the National Bureau of Economic Research, which was published in
2010 (see). The researchers
found that broker-sold funds not only needed to charge higher
fees to cover compensation, they invested less in portfolio
management and earned lower before-fee returns. Could it be that
brokers pitch these funds because they are paid more to sell
them than off-the-shelf, commission-free index funds?
To pour even more salt on investors' wounds, high-fee,
broker-sold funds may diminish total returns over time. Say you
invested $10,000 in a fund charging 1.5 percent in annual
expenses. If that fund returned 10 percent, you would have
roughly $50,000 after 20 years. Cut the fees down to 0.50
percent, which is easily doable with an exchange-traded or index
mutual fund? You would have about $10,000 more in the same
period. But don't take my word for it. Run a comparison with the
SEC's online mutual fund cost calculator ().
If it's a badly kept secret that broker-sold funds are
unlikely to outperform their direct-sold cousins, why do
investors still buy them? In the July 2 New York Times story
quoting the former JP Morgan broker (see),
the bank defended its strategy, stating it has "an in-house
But in reality, the reason likely has more to do with the
handholding and perceived peace of mind in a broker/adviser
relationship. Our need for a human connection and assurance
overrides our rationality. Trusted advisers can form an
invaluable buffer between our financial goals and the madness of
markets, but we can place too much trust in them.
Jason Hsu, a finance professor at the University of
California, Los Angeles, who also oversees investment management
for Research Affiliates in Pasadena, California, put it nicely
in the company's June newsletter: "We nonetheless sleep easier
knowing we have employed a high priest. And for sure, the high
priest will charge, and charge dearly."
GO YOUR OWN WAY
There are so many alternatives to the high-priest syndrome
that there is no need to be snookered by broker-sold funds.
Consider a host of direct-sold fund families that charge no
commissions. There are hundreds of funds that fit this bill from
the Fidelity, Schwab, T. Rowe Price and Vanguard Groups.
For self-directed investors, it would be worthwhile to spend
the time to create ready-made portfolios from direct-sold funds.
You can build a portfolio with investment-ready funds suggested
by Folioinvesting.com, MyPlanIQ.com and 7Twelveportfolio.com.
You not only eliminate conflicts of interest - you build the
lowest-cost portfolio that is right for you - there are no
Don't want to fly solo on fund selection? If you choose to
work with an adviser, ensure that they operate as a fiduciary
and place your interests above those of their firm. Until
brokers are forced to abide by these principles - the U.S.
Securities and Exchange Commission is currently sitting on a
rule that would force them to do this - you will be subject to
endless broker conflicts of interest.