Fiduciary Fake Out

I take great pride in providing financial planning and investment advice on a fiduciary basis, so it pains me when I see the ‘fiduciary’ term abused.

Reuters uncovered an arrangement last week between a few large custodians and several Registered Investment Advisory firms that doesn’t appear to be in the best interest of clients.  The article starts off:

At least three wealth management firms that market themselves as objective financial advisers are getting payments for investing their clients’ money in certain mutual funds, a practice that even some of these firms say could create conflicts of interest.

On the surface this might not sound like a big deal, but it underlies a big secret in the industry, one that is even bigger than this abuse – the use of no-transaction-fee (NTF) mutual fund supermarkets.  An RIA who manages money for clients must “custody” those assets with a company, usually a broker-dealer.  The biggest custodians that RIA’s use are Charles Schwab, TD Ameritrade and Fidelity.

Custodians offer two sets of mutual funds that advisors may utilize, one set has no-transaction fee charged to the end client, the other does have a transaction fee.  In many cases the same mutual fund can be offered with or without a transaction fee.  Since mutual fund fees never show up on a client statement, but custodian transaction fees do, there is an appearance that no-transaction fee (NTF) mutual funds are cheaper – in fact, they almost never are.

I rarely use no-transaction fee funds because it usually costs my clients more money, way more money than a transaction fee fund.  The reason they cost more is because the custodians have negotiated for themselves a fee from the mutual fund companies ranging from .25 – .40% annually, a fee not collected from transaction fee funds.  There is a built in conflict of interest for the custodian to get the RIA to use their NTF network of funds.

I’ll provide a quick example.  If you have $100,000 to invest and an advisor recommends a set of NTF funds, the custodian will receive anywhere from $250 – $400 annually from the mutual funds you were recommended.  Had you purchased the same fund, but a different share class you might have instead paid a transaction fee of $25 per purchase.

Before I make my point, I do want to point out that I’ve never been pushed by any custodian (and I’ve used all three of the majors) to use the NTF funds over the transaction fee funds.  In addition, the custodians provide valuable services to both me and my clients and deserve to be paid for providing those services.  Lastly, NTF funds may in fact make much more sense than transaction-fee funds depending on the client’s portfolio needs.

Back to the example.  If you were buying four mutual funds and chose to buy the transaction fee version you end up paying $100 in fees (4 buys times $25).  The difference is those fees are only paid if you buy or sell, there is no ongoing annual fee (from the custodian, the advisor will charge a separate fee).  If there were no rebalances over a five year period, the person buying the NTF funds might pay anywhere from $1,250 – $2,000 in fees to the custodian while the transaction fee client only paid $100.  A huge difference.

In reality, most clients have numerous accounts and will rebalance at least once a year, which makes the fees for trading seem onerous.  This is where a true fiduciary shines.  A true fiduciary makes the determination up front which method of payment would work better for each client type.  A client that has a single account and a need for a single, balanced mutual fund would likely be recommended a transaction-fee fund (say from Vanguard).  If they buy and hold that fund for five years, a total of $25 is paid to the custodian, quite a deal.  But if the client has multiple accounts and will need to be rebalanced often, perhaps the NTF network of funds is best.

Of course the story I’m referring takes the NTF funds network to another level.  A few big firms have negotiated with a few of the big custodians to receive a portion of the .25 – .40% annual fees generated by their clients placed into the NTF network.  This practice is bothersome to me as I can think of no reason for the arrangement to be in place that would benefit the end client.  Disclosing this as a conflict is NOT enough, this is an easy conflict to avoid and thus should be avoided.  If there is a cost to the RIA firm for taking on of services that would otherwise be provided by the custodian, this cost should be charged directly to the end client via the advisor’s fee schedule, not buried in a mutual fund.

The firms mentioned in the above article have an extra incentive to recommend one set of mutual funds over another, I have a problem with this.  I think this practice puts the fiduciary industry in a bad light and hurts the message.

The difference in the fiduciary industry is that when true fiduciaries see these practices, they are called out.  I can’t say the same for majority of the non-fiduciary financial services industry.  None of us are perfect, even the best make mistakes, but the practice of negotiating a piece of the action on client assets from custodians should be stopped.

I do have one caveat. If the custodians offered to rebate back the fees they receive from the mutual funds to the actual client that generated those fees and then charged a transaction fee to cover their costs, I would be fine with such a practice.

Scott Dauenhauer, CFP, MSFP, AIF


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