If you have been reading my column regularly, you know that for the past 15 years, I have been making time (two hours a week) to "meet" with readers who have questions about things financial. These talks help me understand what's on readers' minds, which helps me write a better column.
Last week, I met with a retired couple whom I'll call the Harleys. The Harleys said they felt "naive" when it came to judging how their financial adviser was treating them. They brought along a report that showed the performance of a dozen mutual funds that they owned.
The report provided the name of each fund and its one-, three-, five- and 10-year returns. That information was pretty clear. Understandably, some funds had higher returns than others.
One potential area for misunderstanding, however, was that the data were not reflective of their experience, since the report did not show the Harleys how long they owned the funds.
For example, if one fund had a 10-year return of 10 percent, that figure would not be a reflection of the Harleys' performance unless they bought the fund exactly 10 years ago and didn't add or subtract from the holding. It would be unusual to assume that the Harleys bought each fund exactly 10 years ago -- or for that matter, five years ago or three years ago or one year ago.
The Harleys wanted to understand their costs of doing business with the adviser.
The report was helpful in that it provided three columns of cost figures. Let's take one at a time:
1. "Operating expenses" reflect an annual percentage of the costs borne by the fund to do business, such as the cost of the portfolio manager. The funds the Harleys owned had annual costs ranging from a low of 0.25 percent to 3 percent.
2. "Maximum Front Load" is the commission that comes off the top when someone invests in a fund. The Harleys' front loads ranged from zero to a maximum of 5.75 percent.
3. "Maximum Back Load" is the commission the fund charges if you want to redeem (sell) your shares before a certain period of time, which can range from one year to seven years or so, based on the fund's specific parameters. In the Harleys' case, the back loads ranged from zero to 1 percent.
The Harleys mentioned that they never paid attention to these three columns before, and they didn't recall their adviser reviewing these numbers with them.
What to make of this information? Let's compare the least-costly fund to the most costly.
Fund A costs only 0.25 percent per year in operating expenses, with no front load and no back load. Its one-, three- and five-year performances were 5.2 percent, 9.2 percent and 8.5 percent.
Fund B costs 3 percent per year, with no front load and a back load of 1 percent. Its one-, three- and five-year performances were -3.1 percent, 2.7 percent and 5 percent.
You can't conclude that Fund B is worse than Fund A in terms of performance, since one is a bond fund and the other is a hybrid (stock-bond combination). But you can wonder why the adviser chose Fund B over a less-costly version of the exact same fund.
That brings up share classes, a subject I wrote about a few years ago for the Practicing Law Institute, called "Uses and Abuses of Mutual Fund Share Classes." Fund B is a "C" share class. The same fund is offered in five other classes. The one and only difference between share classes is the investor's cost.
Were the Harleys offered a choice of share classes by their adviser? No.
If they had been, they could have chosen a class that cost about a third as much in annual operating expenses, with no upfront or back end loads.
Did the financial adviser not know about the different share classes? Highly unlikely.
Did the financial adviser benefit from the more costly share class? Possibly.
The annual fee (called a "12b-1 fee") paid to financial advisers who sell Fund B shares is 1 percent per year. That fee comes from the operating expenses.
The 12b-1 fee paid to the lowest-cost share class is zero.
This brings up the role the financial adviser was playing at the time of the sale, which was unclear to the Harleys. Was this adviser a "fiduciary," or a commissioned salesperson who owed them no obligation to disclose potential conflicts of interest?
Whether all financial advisers should be held to the higher standard of fiduciary is currently under consideration. The staff of the Securities and Exchange Commission produced a study in 2011 making the recommendation that "personalized investment advice" even if offered by a commissioned salesperson should be held to the fiduciary standard. The Investor Advisory Committee advising the SEC concurred.
Whether this would make a difference in the lives of investors such as the Harleys remains to be seen. In the meantime, it's a good practice to ask questions about costs and compensation.
Next week, let's review what questions to ask.
If you want to understand the historical evolution of the financial adviser, you may want to attend the American Association of Individual Investors (AAII) dinner presentation in Darien on Wednesday, Oct. 23.
Howard G. Berg will share the unique perspective of a Wall Street senior executive who lived through the industry's evolution from the time the market traded 2 million shares a day to today's 10 billion. For information, call Ronnie Braun, the president of AAII's CT chapter, at (203) 488-1721.
I know Howard well. He helped me formulate my firm's vision and values.
Julie Jason, JD, LLM, award-winning author of "The AARP Retirement Survival Guide: How to Make Smart Financial Decisions in Good Times and Bad," and "Managing Retirement Wealth: An Expert Guide to Personal Portfolio Management in Good Times and Bad," is principal of Jackson, Grant Investment Advisers, Inc. of Stamford. Please e-mail her with questions at firstname.lastname@example.org or write to her c/o The Advocate, 9A Riverbend Drive South, Box 4910, Stamford, CT 06907. Copyright 2013 Julie Jason.