| This week's question is not directly related to 401(k)s,
but it is relevant to those of you who have some retirement money invested outside of your
401(k) plan. Why are some investors, whose advisors
recommended load funds, seemingly doing so well, while the rest of us in no loads are
barely making headway?
There are really two parts to this question:
- Do load funds (those with sales charges) earn higher returns
than no-load funds (funds without sales charges), and
- Do advised investors do better than investors who go it
alone?
A "load" on a fund is purely a sales commission.
It compensates the "advisor" (or broker) who sold you the fund. Most loads are
"front-end" (typically 4.5 percent), which means the commission is taken from
you when you buy the fund. So if you invest $20,000 in a fund, nearly $1,000 immediately
goes to the advisor. Some loads are "back-end," which means the load is paid
when you sell the fund. Either way, the money comes out of your pocket and does not
represent an investment in the fund. None of the load goes to the people who manage the
fund and make the investment decisions.
Do Load Funds Perform Better?
Well, suppose your neighbors bought a Chevy Monte Carlo for $20,000 direct from a dealer,
paying a $1,000 commission. You go online and buy the same car (with identical add-ons,
color, and floor mats) direct — for $19,000. Would you expect different performance
from the two cars? Of course not. Your neighbors merely paid a sales person to help
convince them that the Monte Carlo would make them the envy of the subdivision. You needed
no such convincing.
Despite what brokers might like you to believe, there is
absolutely no logic or evidence to suggest that load funds outperform no-load funds, even
if you ignore the cost of the load. But do consider what the load itself takes away from
your fund returns. Although the calculation is slightly more complex, a fund with a 4.5
percent load, held for three years, reduces annual return by about 1.5 percent per year.
The Value of Advice
The second part of the question dealt with whether paying for advice is worthwhile. First
of all, recognize that I am biased. I am an investment advisor. If I said that investment
advice had no tangible value, I would immediately be fired and would have to return to my
prior career as a ballet dancer. But speaking very frankly, the value of investment advice
depends on the person seeking it, and of course on the quality of the advice. Two aspects
cause advice to have value: competency and effort.
Most advisors are relatively astute when it comes to
investing. They understand the economic factors at play in the market, the risks posed by
different types of funds, and the likely rewards for taking those risks. More importantly,
advisors usually practice a solid investing discipline that convinces their clients not to
sell in a panic, and buy at inflated values. Of course, as an individual you may believe
that you have the understanding and discipline to make such services unnecessary.
With respect to their effort, it is hard to replicate the
effort that goes into analyses provided by a good investment advisor. At mPower, we have
30 dedicated and well-trained analysts who spend their time poring over a wealth of
statistical and strategic information about the funds we follow. On average, our analysts
spend about 50 hours per year researching each fund for which they are responsible. Also,
we are able to talk directly to fund management — those making the investment
decisions of the fund. How do we do it? Volume! Because we do this for a large number of
clients, we can provide a high degree of attention to each fund. Other investment advisors
may be able to provide similar resources.
Although my opinion is that investment advisors add value,
you may feel qualified to go it alone. If you do so, then it's silly to choose load funds.
But the key question is: If you want advice, how do you get it?
Picking an Advisor
There are two types of advisors — those who are commission (or load) based and those
who are "fee only." Fee-based advisors can earn a flat-dollar fee or a
percentage of the money you invest. Commission-based advisors are paid based on the
product you buy. They are not paid directly by you, but through the company whose fund is
sold. This can potentially set up an incentive for the advisor to sell specific funds,
based on the commission amounts companies pay advisors.
Commission-based advisors are more prevalent. They are the
ones you can usually access at most banks and brokerage houses, where investment services
are provided on a commission basis. It is a good idea to ask about the commissions an
advisor will receive before buying their "advice." And of course, if they are
tied to a firm that sells mutual funds, one must recognize that they have an added
economic incentive to induce you to buy and sell those funds. Of course, even if they have
a conflicting incentive, they still may provide solid information about investment
choices.
But just like with a car dealer, it's important to know all
of the motives of your advisors. Fee-only advisors charge you a fee for their services
(either a flat fee or a percentage of the money you've invested). You should make sure
that they are not receiving any other hidden commissions. Those commissions would detract
from your fund performance and create conflicting incentives.
So if an advisor is commission based, he or she may make
money on the amount you've invested. Have investors with commission-based incentives
really done better than investors without help? Perhaps — but not due to the funds
per se — but because of the advice received during a highly volatile market. But this
doesn't hold true for all investors. Only you know your own level of expertise and the
time you have available for researching investments.
Now if I can only find a fee-only Monte Carlo dealer.
 Lummer's Logic Archives
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