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.
Yesterday, 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 ¼ of 1 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 One costs only ¼ of 1 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 Two 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 Two is worse than Fund One 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 Two 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 Two 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, or better yet, probably.
The annual fee (called a "12b-1 fee") paid to financial advisers who sell Fund Two shares is 1 percent per year. That fee comes from the operating expenses. In addition, Fund Two's share class (C shares) usually pay the financial adviser 1 percent at the time of sale.
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 completely unclear to the Harleys. Was this adviser a "fiduciary," or a commissioned salesperson who owed them no obligation to disclose this information to them?
There is a possibility that a fiduciary standard will be adopted for commissioned salespersons in the future. The staff of the Securities and Exchange Commission produced a study in 2011 making that recommendation. The Investor Advisory Committee advising the SEC recommended that brokers providing "personalized investment advice" to retail customers be held to the fiduciary standard. 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. I'll review a list with you next week.
Julie Jason, JD, LLM, a personal money manager (Jackson, Grant of Stamford, Conn.) and award-winning author, welcomes your questions/comments (firstname.lastname@example.org).