It has often been stated that a cheap person knows the price of everything and the value of nothing. By contrast, wiser, more discerning individuals recognize that paying less does not always represent the best value. Discount brokerage houses and no-load mutual fund companies attempt to focus investors on cost. Read on to find out why your focus should be on value instead.
Primary Value Components
Investment services offered to individual investors come in many types of packaging and delivery. Discount brokerage houses, full-service brokerage houses, load mutual fund firms, no-load mutual fund firms, banks, insurance companies, private money management firms and fee-based advisors all attempt to convince investors that they can provide the best available alternatives when it comes to managing your money. Yet, despite their differences, each of these delivery channels is "fishing from the same pond." Each is largely using the same broad asset components—cash, bonds and stocks. The packaging may differ, but the components within the package are largely the same. More importantly, they are each providing all or part of three primary value components:
- Advice: The process of defining and implementing an appropriate investment strategy given an investor's objectives and particular constraints.
- Portfolio Management: The process of building and maintaining an investment portfolio that properly addresses the strategy that the advisory component has defined.
- Administration: All the trading, clearing and reporting functions required to effectively execute the portfolio management processes.
Interestingly, the pricing for these value components is remarkably similar regardless of the delivery channel selected.
The Old Model
Years ago, the retail investment landscape was dominated by full-service investment houses. Banks were not allowed to offer investments to individuals and insurance companies were limited to fixed annuities.
An investment product suggested by a broker comes in the form of individual stocks and bonds. The gradual accumulation of these various securities becomes an investment portfolio. As such, the broker is now providing portfolio management services. A variety of administrative functions are supplied as part of the service. When a client approves the purchase or sale of a security, the brokerage firm executes the trade and arranges proper settlements. Confirmations and statements are generated. Dividends and income are accounted for, and year-end tax data is supplied.
The cost to the client for this full service of advice, portfolio management and administration is a substantial commission every time a security is bought or sold. (See also: Don't Let Brokerage Fees Undermine Your Returns.)
The Advent of the Discount Brokerage
Out of the deregulation of commission charges in the mid-'80s came the discount brokerage houses. Why pay a high commission to buy or sell a stock when you can execute the same transaction more cheaply? With discount brokers, you decide for yourself what your overall strategy should be and you can choose your own stocks and bonds (portfolio management), and the discount brokerage will execute and settle the trades, provide you with confirmations and statements and all of the other reporting that you require (administration).
Many people who are unaware of the three primary value components will think, "Yes, why should I pay my full-service broker a large commission to buy or sell a stock when this discount broker can do the same thing for a much cheaper fee?" However, the discount broker is not exactly providing a comparable service. What has happened is that the investor has decided to stop outsourcing—and thus paying for—the service of advice and portfolio management. Rightly or wrongly, investors feel they are competent enough to do these things themselves. The only function investors cannot do for themselves is administration; this is what investors pay for in the form of a reduced commission. (See also: Brokers and Online Trading: Full Service or Discount?)
Panic in Full-Service Land
In response to discount brokers' inexpensive rates, the typical full-service broker panics and begins discounting commission charges because he or she was unable to articulate the value of the other services provided. The fact that the old model is fraught with inherent weaknesses does not make the task any easier. The trading-based commission compensation structure has a built-in conflict of interest. Is the advice given truly in the best interest of the client or is it tainted by the need to generate income for the broker? Aside from some knowledge of stocks and bonds, what qualifications does the broker have to give strategic investment advice? Is he or she a Certified Financial Planner (CFP)? In the area of security selection, what qualifications does the broker have to develop an effective overall portfolio? Is he or she a Chartered Financial Analyst (CFA)? You may feel like you could do as good a job as your broker in these areas. (See also: Is Your Broker Acting In Your Best Interest? and Evaluating Your Broker.)
Maybe it's because the typical full-service broker recognizes that he or she isn't best qualified to professionally manage client funds or maybe it's because there is now less income opportunity in transacting individual securities, but soon there is a turn toward load mutual funds—funds sold with a sales charge. This has become a growing trend, the pitch being that the broker focuses on guiding you (advice) and a professional money management firm manages the funds. Annual charges for administration and professional money management are drawn from the client's fund assets by the fund company. Soon, however, investors discover no-load mutual funds. They wonder: Why pay a load to a full-service broker, when I can access the same professional management without paying a sales charge? Again, this means that the investor must act as his or her own advisor. (See also: Choosing a Compatible Broker.)
Pricing Value Components
The old full-service, "stock-of-the-day" model is largely a relic of the past. Individual investors trading individual securities are primarily doing it themselves through discount brokerage houses. Other investors have gravitated toward mutual funds, variable annuities, and private money managers. Despite the various approaches, however, the pricing of the three value components is remarkably similar.
Mutual funds and variable annuities provide the best insight into this pricing. A review of funds indicates administration charges of about 0.5% per year. The average embedded fee for portfolio management in mutual funds also runs around 0.5% per year. The charge for advice is reflected in the sales charges. Mutual funds come in a variety of sales charge structures including front-end loads, back-end loads, and level loads. Factoring in the typical hold time of a mutual fund, you'll find that the average sales charge runs about 1% per year.
Total average annual pricing for all three value components averages around 2% per year and charges may not always be fully transparent, but whether you are aware of them or not, you are still paying them. (See also: Stop Paying High Mutual Fund Fees.)
The Charges Paid by Various Investors
An individual trading stocks through a discount broker is acting as his or her own advisor and money manager. Outside charges are strictly administrative, so we can assume an annual cost of 0.5% per year, though it could be more or less depending on account size and trading volume.
An investor selecting no-load mutual funds is acting as his or her own advisor as well, so outside charges are limited to professional management and administration. The annual cost is around 1%.
An investor selecting load funds from a broker is outsourcing all three value components. Annual cost is around 2%. If this client is using a fee-based advisor who allocates funds between no-load funds, the advisor is typically charging a 1% annual advisor fee, and the internal expense of the funds runs 1%, so the total cost to the client is the same: 2%.
Clients accessing private money managers through professional advisors pay at least 2% annually and often more, based on the belief that these managers offer a more personalized service.
Variable annuities cost about the same 2% annually, but with an additional 1.25% or so tacked on to cover death benefit guarantee insurance.
The Bottom Line
Anything of value has a cost. Pricing within the financial services industry is not gratuitous—it is tied to services rendered. As an investor, you must assess whether you are getting your money's worth. If you decide to take on some of the value components yourself, you will reduce your price, but at what cost? Take care not to follow the cheap man's folly. You may make mistakes that end up costing you more than you save. If you feel you can act as an effective self-advisor and save 1% annually, go with no-load funds. If you believe you can also manage your money as well as the professionals, then buy your own stocks and bonds and save another 0.5%. Whatever route you choose, consider the essential value components, how they are priced and whether you are getting what you pay for.