Trailing Commission: Definition, Percentage Range, Ways To Avoid

A trailing commission is a fee that you pay a financial advisor each year that you own an investment. The purpose of a trailing commission is to give an advisor an incentive to review a client's holdings and provide advice. It is essentially a reward for keeping you with a particular fund.

Key Takeaways

  • Trailing commissions are fees paid to financial advisors every year that an investment is owned.
  • Trailing commissions are paid in order for a financial advisor to have an incentive to review a client's investment holdings and provide advice.
  • To know if you are paying trailing commissions and how much they are, you can ask your financial advisor or check the fund's prospectus.
  • Trailing commissions vary but can range between 0.25% to 1% of the total investment per year.
  • Avoiding trailing commissions is possible, by investing in low-cost mutual funds, exchange traded funds (ETFs), which typically have lower costs, or using robo-advisors.

Are You Paying a Trailing Commission?

Asking your advisor is the most obvious way to find out. An ethical advisor will probably answer the question directly. If you would prefer to do your homework and find out on your own, consider reading the investment prospectus. Be sure to look carefully at the footnotes under any section that says "Management Fees." The highest fees are usually the best hidden.

How Much Do Trailing Commissions Cost Investors?

Fees vary depending upon the fund; however, it is not uncommon for a trailing commission to range between 0.25% to 1% of the total investment per year. That is a significant amount and builds up year after year as the value of the asset grows.

As the asset grows in value over time, the advisor that initially sold you the investment makes more money off the trailing commission. That actually gives your advisor an excellent incentive to grow your investments.

Justifications for Trailing Commissions

Trailing commissions appear unfair to many investors, but there are some justifications. A trailing commission is not supposed to give an advisor income in perpetuity in exchange for doing nothing. The advisor should be reviewing your investments and providing you with advice.

In theory, trailing commissions give the advisor an incentive to keep you in successful funds. It can be easy to become discouraged during bear markets, and trailing commissions give your advisor a reason to keep you fully invested.

A trailing commission is usually much better than giving your advisor a share of a load fee. When the advisor gets a percentage of the load fee, the advisor has an incentive to move you in and out of mutual funds. That type of overtrading can reduce returns.

Trailing commissions encourage your advisor to invest for long-term growth and avoid overtrading.

Avoiding Trailing Commissions

As markets continue to develop, trailing commissions are becoming less justified and easier to avoid. Many mutual funds do not have trailing commissions, and a large number of exchange traded funds (ETFs) with low fees are also available. There are even a few low-cost mutual funds with high returns.

When investing in exchange traded funds (ETFs), take a look at the expense ratio, which will be the cost of investing in that fund.

Avoiding trailing commissions is just one way to stop paying high mutual fund fees. Reducing fees is the only sure way to improve returns, so mutual funds and hedge funds must do something special to justify extra fees.

Trailing Commissions and Liquidity

Trailing commissions can still make sense for funds focused on illiquid investments, such as direct real estate holdings, unlisted companies, and frontier markets. These investments are not available in the U.S. stock market and can have higher returns, but it costs more to buy and sell them.

Funds focused on illiquid investments have a good reason for using trailing commissions to keep advisors loyal and their clients invested.

How Are Trailing Commissions Calculated?

In equity-based mutual funds, trailing commissions are typically calculated per day and paid quarterly. This can vary by fund. A trailing commission is always calculated as a percentage of the total investment made into a fund and its value as it grows/declines. The percentage will also depend on the specific fund.

Who Pays Trailing Commissions?

Depending on how your investment is set up, trailing commissions are usually paid by the mutual fund to your advisor/dealer for the ongoing services of managing your account. These commissions are a percentage charge of your investment value.

Can You Claim Trailing Commissions on Your Taxes?

Trailing commissions are not tax-deductible. Trailing commissions are automatically withheld from the income generated in your account and are, therefore, not reported to you and cannot be deducted.

The Bottom Line

Trailing commissions can be a good way to keep an advisor incentivized to manage your money and earn strong returns, though it's important to analyze your cost-benefit ratio to determine if it's worth it to keep paying these costs.

Today, there are many ways to invest your money and earn a strong return without having to pay high trailing commissions; low-cost mutual funds, robo-advisors, and ETFs are some good options.

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