Dan Solin: Dirty Tricks Brokers Use to Get Your Business

Brokers and advisors like to describe their activities in terms indicating the benefits they bestow upon their clients. "Wealth manager" is one of my favorites, because it conveys the impression that using them is likely to increase your wealth. Using the wrong adviser can have the opposite effect. They can "manage" to transfer your wealth into their pockets.

I also find the titles bestowed on brokers interesting. They refer to themselves as "financial consultants" and "Vice-President." Mutual funds play the same game. "Absolute return fund" implies a fund that always has positive returns. According to an article in The Wall Street Journal, while most (but not all) of these funds posted positive returns in the 2008-2009 time frame, "many were lackluster in comparison with the index returns and just two funds outpaced the S&P 500's gains."

The clever name game is part of a larger strategy geared to get your business. It includes massive advertising (often using celebrities to enhance credibility), the availability of "trading programs" and niche marketing, like hosting seminars for women investors.

While these pitches for your business are fairly subtle, the gloves come off when brokers or advisers are competing for your business. It gets really ugly when one of the contenders is recommending an index based portfolio, which is what I believe should be the strategy followed by all investors. Here are some of the dirty tricks some brokers and advisers use to dissuade investors from index based investing:

Hiding Expenses

Since expenses are deducted from returns, it makes sense to be aware of the expenses of the funds in your portfolio. A study by Morningstar found the management fee charged by mutual funds (called "expense ratios") are "strong predictors" of performance.

It is important to understand wrap fees, transaction costs, adviser fees, brokerage commissions and account management fees when computing the real cost of your investments. Transaction costs are easy to hide. Ask for the "turnover ratio" of the funds you are considering. A high turnover means higher trading costs. Index funds typically have lower turnover ratios than actively managed funds.

To get an overall understanding of expenses, ask for the "weighted expense ratio" of the recommended investments.

Higher Taxes

The returns of actively managed funds are typically reported pre-tax, which can be very misleading. One study (discussed here) looked at the 10 year pre-tax and after-tax returns of index funds and actively managed funds. It found that, on an after-tax basis, index funds outperformed 86% of active mutual funds.

Ask for the after-tax returns of the recommend funds.

Misleading tilt

There is significant research supporting the value of tilting the stock portion of a portfolio towards small and value stocks. Tilting towards these riskier asset classes can increase expected returns, albeit with increased risk. However, there are periods of time when large and growth stocks outperform small and value. For example, in 2011, large cap stocks outperformed small cap stocks.

By tilting the stock portion of a portfolio towards the asset class that outperformed in the past year or two, advisers can make it appear they have the ability to increase returns in the future. Don't be fooled. If your adviser is recommending a tilt towards any asset class, ask to see long term data supporting this recommendation.

Using long term and lower quality bonds

By using long term (maturity dates more than 5 years) bonds, and bonds with ratings below investment grade, brokers and advisers can make it appear they are generating higher returns. Many investors don't understand these returns come with higher risk. Historically, according to research done by Dimensional Fund Advisors, long term bonds are more volatile than shorter term bonds, but have not provided consistently greater returns. The same research indicated that bonds lower in credit quality have earned higher returns, but there is a greater risk of default.

You would be better advised to limit your bond holdings to maturities of five years or less and to insist that all of these holdings be rated investment grade or higher. You can increase your expected return (and your risk) by allocating a greater portion of your portfolio to stocks, assuming that would be suitable for you.

Using short term returns

Short term data can be extremely misleading. Some brokers and advisers cherry pick funds for inclusion in a recommended portfolio that have impressive three year returns. The implied message is that these funds are likely to outperform in the future. You can find a discussion of the benefit of longer term data here.

You should insist on seeing at least a 10-year history of returns and preferably longer.

There's an old Chinese Proverb that says: "If you must play, decide upon three things at the start: the rules of the game, the stakes, and the quitting time."

You now know some of the rules of the game.

Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, The Smartest Retirement Book You'll Ever Read and The Smartest Portfolio You'll Ever Own. His new book, The Smartest Money Book You'll Ever Read, was published December 27, 2011.The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.

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Source: http://www.huffingtonpost.com/dan-solin/dirty-tricks-advisors-use_b_1220607.html

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