By Financial Advisor Peter Egolf
The financial industry has a knack for creating inertia through complexity. Inertia transfers wealth from the average investor to Wall Street. Complexity can be exhibited through investment products and firm-level tactics, making it more difficult for investors to reverse their investment decisions. At One Day In July, we reject this notion. This article highlights a few of these areas to help investors identify and avoid these potentially costly situations that otherwise leave investors, saying, “I wish I had known that.”
Beware of anything sold based on fear, especially a product based on the fear of the future that locks-in would-be investors. Annuities are insurance products that are often offered to investors around the premise of “guaranteed” income. Guaranteed income can limit future income streams and wealth creation, a potential cost of the guarantee. Additionally, some annuities can charge stiff penalties to investors for exiting the plan, either through self-administered penalties (e.g., time or money) or through taxable events. For example, TIAA requires participants to roll-out of its Traditional Annuity plan within 120 days of ending employment or do so in annual installments over nine years.1 Your investments should not lock you in, especially not for diluted future income.
Mutual Funds come in three class varieties: Class A, B, and C shares.
Class A - Class A shares charge investors a front-end load or, in other words, a sales charge at the time of purchase. Thus, if you invest $1000 and purchase mutual fund Class A with a 5% sales charge, you will only be investing $950.2 Therefore, the sales charge for Class A shares penalizes investors before generating any investment returns. Class A shares tend to have lower 12b-1 (marketing and distribution) fees (than Class B or C).
Class B - Class B shares charge a back-end load or sales charge if the shares are sold within a specified time period. Class B shares charge a back-end load or sales charge at the time the investor sells the shares. Investors looking to avoid the upfront cost associated with Class A shares may choose Class B shares. However, Class B shares act as a looming charge that may diminish with time or be an investment exit cost.2 Therefore, investors may be inclined to hold a poorly performing Class B share investment for longer in hopes of minimizing the sales charge foregoing the opportunity to sell those shares for a superior investment, a form of loss aversion.
Class C - The middle child of mutual fund classes blends the sales charge evenly across ownership duration. Class C shares allow investors to focus strictly on the mutual fund’s yearly fees without feeling the effects of more complex psychologies associated with Class A and B shares. However, it is worth noting that Class C funds can still exhibit high fees to the investor’s detriment.Class C shares often have a small back-end load (sales charge).
No-load mutual funds and ETFs generally eliminate many of these self-imposed and fund-imposed consequences that otherwise keep investors from making a change in their best interest.
Firms can steer or even recommend investors towards investment products created and managed by their investment firm or an associated brokerage. These are known as proprietary products. There is an inherent conflict of interest when the advisor has a financial incentive to recommend funds that benefit their firm’s financial interests. It is even more problematic if these investments can only be held at one specific brokerage or firm. Thus, an investor can find themself invested in a fund that is non-transferable to another custodial firm. In this case, the investor has two choices: keep the fund and stay with the existing provider or liquidate the fund to cash. Both are suboptimal. The first choice removes the investor’s optionality. The second forces the investor to pay the penalty in the form of taxes upon liquidation to cash if the investment is held in a taxable account.
The prevalence of proprietary products can increase when investors reach higher wealth levels, such as qualifying as an accredited investor.3 Firms can leverage the misguided premise that increased wealth buys greater access to complex investment types, public or private, touting superior returns (One Day In July does not agree that complexity necessarily results in superior returns). Privately traded investments provide investors with the burdens of illiquidity, taxation complexities, and other potential hiccups upon exit. Private investments can benefit the firm in two ways. First, the firm can find accessible capital from existing clients to raise the fund. Second, the firm can charge potentially significant management fees deemed appropriate for the investment. The investor may see outsized returns but is more likely to feel the lack of optionality associated with proprietary products.
“Funds with a name suggesting an investment, industry, or geographic focus also must hold at least 80% of their assets in securities indicated by the name.”4 The fund name can also mislead investors if the fund does not name a specific investment type, industry, or geography. For example, the Obesity ETF required investors to review the prospectus to understand the fund’s objectives to determine whether the fund invests in tackling obesity, perpetuating obesity, or something completely different. Names range from confusing to downright odd, including a few recent but now defunct favorites (e.g., The Patriotic Fund, Bread and Butter, Arrow Dogs of the World).5
Separately, an investor may recognize a potential conflict of interest as an Average Brokerage Firm (ABF) client if the firm recommends their aptly named ABF Mutual Fund. On the other hand, should ABF recommend BAD Mutual Fund, the investor may falsely believe there is no relationship between the firm and the recommended investment. However, revenue sharing agreements allow brokerages, investment advisors, and funds with different names to remain related. For example, Morgan Stanley lists over 100+ fund families through which it has revenue-sharing relationships6, most of which do not carry the Morgan Stanley name.
Therefore, an investor should be mindful of the investments their advisor or broker has recommended. The investor should understand whether their advisor or broker meets the fiduciary standard to ensure advice regarding their investments is in their best interest.
At One Day In July, we are 100% independent. We do not use propriety products, insurance products, or revenue sharing relationships. We are fiduciary advisors who work to invest our clients primarily in low-cost, tax-efficient ETFs.
Our firm focuses on relationships. We begin by understanding the financial health of prospective clients. We can then break up with your existing brokerage/investment firm for you. You tell us which accounts you want to switch, and we will handle the rest hassle-free. Let us do the dirty work of saying, “It’s not you, it’s me,” while you do whatever else you like to do.
Based on your preferences, we pair you with a dedicated advisor. Your advisor will work directly with you to understand the current state of your financial health as well as your future needs and goals. Finally, your advisor will design a streamlined portfolio of diversified and liquid index fund ETFs.
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