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.

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 0.50% of the total investment per year. That is a significant amount, and it builds up year after year.

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.

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.