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 expertise."
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 commissions involved.
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.