$4.95 trading commissions: a good deal?

Yes, both for you and me and for Fidelity, which initiated the move down from $7.95.  Fidelity has quickly been followed by other discount brokers.

The reason for the reduction is the increasing popularity of ETFs with individuals who have been traditional buyers of no-load mutual funds–and who, because of this, aren’t used to paying commissions.  (Yes, the functional equivalent of trade commissions end up being deducted from mutual fund results through administrative expense charges, but people generally don’t notice this.)   Apparently, though, $4.95 is an acceptable number.

Fidelity, as a market maker in ETFs, will also earn a bid-asked spread on transactions.   In addition, the reports I’ve read suggest that the sponsor of an ETF can earn as much as 0.5% of assets annually through stock lending.  So forfeiting $3 on each trade won’t dent Fidelity’s bottom line, especially if this stimulates sales of in-house ETFs.

I think the main results of the move will be to lower our costs modestly and to hasten a bit the demise of traditional brokers.

 

 

 

 

 

candidate Trump vs. President Trump on banks

During his presidential campaign, Donald Trump repeatedly accused Hillary Clinton of being in the pocket of the big banks and brokerage houses.  He suggested that, unlike himself, she would act as president in the banks’ favor and against the interests of ordinary Americans.  That made her “Crooked Hillary.”

So it’s at least very surprising that in his first flurry of activity as President, Trump is advocating changes in government policy that are very favorable for big bank profits, while potentially harming customers and the financial system as a whole.

eliminating fiduciary responsibility

His first action has been to derail implementation of the mandate, recently instituted by President Obama, that financial advisers handling individuals’ retirement investments act as “fiduciaries.”  Put in the simplest terms, fiduciaries have a legal obligation to act in the client’s best interest rather than in their own.  This implies not recommending products that have a history of bad performance, but which pay high sales commissions to the salesman.  Apart from the Obama exception about pension assets, stockbrokers and insurance salesmen have no such requirement today.  (Congress has repeatedly refused to enact the necessary legislation.)

an example

Donsider three investment products:

–Product A is a Vanguard index fund.  It charges 0.08% of the assets per year as a management fee.

–Product B is an XYZ brand fund that is for all practical purposes the same as an index fund. Buyers pay a commission of 5% of the assets invested to acquire shares. The fund charges 1% of assets as a management and pays your broker 0.50% of your assets yearly as what amounts to a retention fee.

–Product C is just like Product B, except that its managers have underperformed the index by 2 percentage points for each of the past ten years.

Of these three, a fiduciary can legally only recommend A.  Because a broker or other financial adviser must only do things that are good for you, not what’s best for you, he can likely recommend both B and C if he believes you won’t lose money from them.  That’s even though C will likely perform 3.5 percentage points worse than A each year.

In a world where stocks gain an average of 8% a year, the holder of C makes 4.5%.   In nine years, the holder of A will have   doubled his money.  The holder of C will probably be up by 40%.

the Trump rationale

Trump administration official Gary Cohn, formerly a high executive at Goldman Sachs, explains that Mr. Trump believes the Obama rule is bad.  Why?  …because it may reduce consumer choice by potentially driving the purveyors of high-cost, poor performance products out of business.  That is, the Obama rule somehow “hurts” people by increasing the amount of money they’ll have at retirement.  This is sort of like saying we should eliminate car safety inspections because they prevent used car dealers from selling autos with no brakes–thereby limiting consumer choice.  Media reports say the analogy Cohn actually used is that the Obama rule is like having supermarkets that can only sell food that’s good for you.  Huh?

More tomorrow.

 

brokers, IRAs and the fiduciary standard

a fiduciary

Being a fiduciary basically means putting your client’s financial interest ahead of your own.

A practical example:  

…given the choice between two products, one with a checkered performance record and high costs, but which makes payments (cash or trips or dinners…) to a financial adviser for selling the product, and a second with stellar performance and lower costs, and which makes no such payments, a fiduciary is required to recommend the second over the first.  At the very least, the fiduciary is required to disclose the facts of the situation, including the payoff from product #1, and allow the client to choose.

A brokerage firm registered representative, on the other hand, is not a fiduciary.  So he’s not required to alert the customer in advance if he’s recommending an inferior product, which is ok, but not great for the client and which–oh, by the way–pays him more.

For a long time consumer advocates have been trying to get Congress to change the laws so that brokers are redefined as fiduciaries.  Their push has intensified since the financial crisis.  But, although the change seems to me to be just common sense, and is in line with the standard of service customers already assume they are receiving, the financial industry lobby is still strong enough to have stymied these efforts.

retirement funds

The Labor Department, however, has recently used its administrative authority to issue guidelines for retirement investments which require advisers to act as fiduciaries, that is, to give investment advice that is in the client’s best interest.

Today, I heard the first reaction to these guidelines–other than general disapproval–from the brokerage industry.  According to the Wall Street Journal, the Edward Jones brokerage firm is withdrawing its mutual funds from retirement products affected by the Labor Department rules.  I looked on the Edward Jones website for clarification, but there’s no press release I can find.

To me, this means one of two things:

–EJ thinks its business practices run afoul of DOL guidelines and it is choosing to withdraw from this market rather than change them, and/or

–it thinks that 401k/IRA providers that sell Edward Jones products have potential compliance issues and prefers not to be involved.

Either way, this all seems to me evidence of how reliant the traditional brokerage profit model must be to offering investment “advice” that can’t pass the fiduciary test.

 

 

12b-1 fees: what they are

fiduciary

The recent Labor Department determination that all financial advisors making recommendations for individuals’ retirement savings must act as fiduciaries is reviving interest in the topic of mutual fund/ETF fees and expenses.

Being a fiduciary means that the advisor has to place the client’s interest ahead of his own.  It isn’t permissible, for example, for a fiduciary to recommend an investment that is likely to return 5% per year, for selling which he gets a large commission, over a virtually identical one that will return 8%, but which pays a small commission.  For a non-fiduciary, which is what brokers/financial planners are when dealing with non-retirement assets, pushing the low return/high commission alternative is still ok legally.

Personally, I don’t like it that the fiduciary standard doesn’t apply to non-retirement investments.  I also don’t understand why individual investors don’t appear to be worked up about this.  I do understand why the big banks are opposed to fiduciariness, since applying the fiduciary standard to all advice to individuals strikes at the heart of the profits of the traditional “full service” brokerage industry.

12b-1 fees

The 12b-1 part refers to the section of the Investment Company Act of 1940 that governs how an open end mutual fund is allowed to pay for fund distribution and servicing.  It covers things like advertising, sending materials to prospective shareholders or having a call center to answer questions about the fund.

The general idea is that a fund benefits from retaining existing shareholders and adding new ones, so it’s a legitimate use of shareholder money to promote both objectives.

But the most common use of funds under the 12b-1 rule–and the least well understood, in my view–is periodic payments to financial advisors by a fund while clients continue to hold shares.   In the industry, these payments are called “trailing commissions,” or “trailers.”

The SEC doesn’t limit the amount of this fee, although FINRA (the Financial Industry Regulatory Authority, the investment industry trade group) rules set an effective  cap of 1.0% of fund assets yearly.  My sense is that the most common fee percentage for an equity fund is 0.25% – 0.50%.  The best hard data I can find come from the ICI (Investment Company Institute, a mutual fund trade group), and are from 2003.  At that time, aggregate 12b-1 fees amounted to just under half the total administrative expenses, at 0.43% of assets annually.  The rest were old-fashioned (more clearly understood by customers) sales charges.

why is 12b-1 a current issue?

Historically, disclosure of these fees has been exactly crystal clear.  Try finding information about them on the ICI website, if you don’t believe me.  In fact, I can’t recall having met anyone not involved in selling mutual funds who was aware these fees exist.

So, does a broker/financial planner who advises a client on retirement investments in mutual funds have to make sure the customer understands that 12b-1 fees are being subtracted from NAV on a regular basis?  Once he gets that, does the customer put two and two together and realize he’s subject to these fees on non-retirement investments, too–and has been from day one?

How does he react?

The difficulty I’ve experienced in gathering factual data for this post tells me that fund companies think the reaction will be strongly negative.

 

investment advisers as fiduciaries: a new Labor Department proposal

The Labor Department proposed new rules today that would require that brokers or financial planners or other professionals giving advice to individuals on their retirement savings act as fiduciaries.

what a fiduciary is

Being a fiduciary means being legally bound to give advice that’s best for the client, without regard for any benefits the adviser might get for recommending one investment over another.

Strangely, in my view, the fiduciary standard is not the rule advisers work under now.  Rather, advisers are only required to recommend products that are “suitable” for customers, meaning they fit the client’s goals, financial circumstances and risk tolerances.

The difference?

Another way of saying the same thing, the fiduciary is required to do what’s best for the client; under the old standard the adviser has simply got to avoid products that damage the customer.

For example:

A broker/planner has two general equity fund offerings:

–Fund A has a long history of strong investment management, consistently beating the S&P 500, and charges low fees

–Fund B has weak managers and an equally long record of sub-par investment performance, consistently losing to the S&P.  It also charges fees that are double the size of Fund A’s.  However, Fund B offers higher commissions to brokers who sell its product, plus trips to weekend informational seminars at resort locations to those who sell the most of it.

Under current rules, a broker/planner is permitted to recommend B over A, even though B is only better for the broker, and will presumably be considerably worse for the client.

costs are the smoking gun

Other than in hindsight, it may be hard to say whether manager X is better than manager Y.  And managers who consistently underperform are eventually culled, even in retail brokerage houses, where the emphasis is typically on strengthening the sales force, not the portfolio management team.

But I think it would be hard for a fiduciary to defend recommending one so-so product over another that costs half as much, and for selling which the fiduciary gets gifts, trips or a corner office and a secretary.

traditional brokers will be hurt the worst by these rules

That’s because they charge the most–partly to compensate highly-paid salesmen, partly to fund an expensive network of retail sales offices.

The traditional retail brokerage business has been dying a slow death since the advent of discount brokerage services in the 1970s.  Imposing a requirement that brokers do the best for their clients is another nail in the coffin.

for now, the rules only affect retirement savings accounts,

…not general savings/investments.  I presume this limitation is the result of fierce lobbying by financial advice providers opposed to the fiduciary standard.  But we may just be seeing the thin edge of the wedge.

Stockpile.com and stocks

A couple of days ago my California son sent me a picture of a Stockpile kiosk in an office supply store.  I’d known about the company, a subsidiary of stock market clearing house Apex, for a while but hadn’t looked into it before this.

The idea is that you can buy or gift small fixed dollar amounts of high profile stocks, like Amazon, Nexflix or Tesla, or index ETFs for that matter, either using a gift card you buy in office supply stores, supermarkets etc. or find online (gift card or e-card) at stockpile.com.  The recipient can either redeem the card for cash or use it to purchase fractional shares of the stock whose name is on the card.

My son’s first reaction is that this is a symptom of the kind of craziness that marks the top of a stock market cycle, like when strangers on the subway start to trade stock tips or when a cab driver does the same thing, explaining he’s a day trader who now drives as a hobby.  (I was a cab driver in Manhattan once and I can’t imagine anyone doing this who doesn’t have to.)

My hunch is that this isn’t a sign of the market topping, however (I’d be more worried if the kiosk offered bonds).  Of course, I think I’m pretty good at recognizing bottoms, but I know I’m bad at seeing tops.

Rather, I think this is another step in the evolution of stock investing away from the traditional brokerage model.  That model has three main defects:  the prices are outrageously high; the brokerage salesperson (around 90% are men) has no legal responsibility to do what’s best for the client; and in my experience the service and advice are poor.

Stockpile.com, in contrast, is bare bones.  No advice.  All trades are done at the day’s closing price.  Commissions are $.99 a trade.  And, of course, you can buy and sell fractional shares.

Target customers appear to be either impulse buyers, desperate gift givers or younger investors without much money to spare.  It’s hard to know how long the service will stay this way or how it will evolve.

I remember speaking with traditional brokers when marketing my mutual funds who believed (correctly, I think) that many clients kept most of their investment assets with Fidelity or Charles Schwab.  That way they would get advice from their brokers but only do, say a third of their trading at several hundred dollars  pop and the rest for $7 or $8 with a discount broker.

Maybe Millennials will end up keeping a third of their money with Fidelity or Schwab to get access to the statistical information they have available but do most of their trading for $.99 with Stockpile.  Maybe retiring Boomers, now more money-conscious, will do the same thing.

My overall reaction:  another evolutionary step, another nail in the coffin of traditional brokers.

 

 

 

 

the Supreme Court and 401k plans

On Monday, the Supreme Court made a narrow ruling on a technical point that may have far-reaching implications.

Participants in the 401k plan offered by Edison International, a California utility, sued the company claiming that it stocked the plan with “retail” versions of investment products that charge higher management fees than the lower-cost  “institutional” versions that it could have chosen instead.

The company defended itself by successfully arguing in a lower court that the statute of limitations for bringing such a lawsuit had expired.  The Supreme Court said the lower courts were mistaken.  An employer has a continuing duty to supervise its 401k offerings.  So even though years had passed since the 401k offerings were placed in the plan, the statute of limitations had not expired.

So the case goes back to the lower court, where presumably the question of whether Edison was right to offer a higher cost product than it might otherwise have.

Was this a mistake?

Why wouldn’t any company have the lowest cost share possible in the 401k plan?

The short answer is that the company receives a portion of the management fee in return for allowing the higher charges.

Typically the company argues that the fee-splitting helps cover the costs of administering the 401k plan.  In practical terms,thought, the move doesn’t eliminate the costs.  It shifts them from the company to the plan participants.

If the Wall Street Journal is correct, this is the case with Edison, which is reported as pointing out that the fee-splitting is disclosed in plan documents.

I have two thoughts:

–the sales pitch from the investment company providing the 401k services probably sounded good at the time.  The 401k would be inexpensive (free?) to Edison.  High fees would shift the cost onto employees instead–which makes sense, the seller might argue, since employees are the beneficiaries of the plan.

On the other hand, to anyone without a tin ear, this sounds bad.  The amounts of money are likely relatively small.  Edison is probably spending more on legal bills than it “saved” by choosing the plan structure it did.  And if it turns out that Edison is profiting from the arrangement rather than just covering costs, the reputational damage could be very great.

–fee-splitting arrangements on Wall Street are far more common than I think most people realize.  This case could have wide ramifications for the investment management industry if the courts ultimately decide that Edison acted improperly.