Beware: Brokers Offer New Program

We believe that it is important for investors to understand how and how much they are paying for investment advisory services. In many cases, the fees investors pay are deliberately obscured, and hidden from view. It is in this regard that we want to explain two important and highly significant trends which will impact investors� decisions for investment advisory services.

The first change is the push by large brokerage houses to sell investors on the use of individually managed accounts rather than the brokerage�s own mutual funds; and the second is how investors are being asked to pay for their brokerage fees. While these two things – separate accounts and changes in brokerage fees – are very much related, the relationship will not be apparent to most investors.

Individually managed accounts differ from mutual funds in that the managed account investor actually owns the individual securities chosen by the money manager rather than owning an interest in a large investment pool through a publicly traded mutual fund. Individually managed accounts have distinct advantages over mutual funds. Mostly, the advantages include

  1. being able to invest all of your money without holding some cash on the side to honor redemptions,
  2. being able to control your tax liability,
  3. qualifying for reductions in fees when you have over $500 thousand or $1 million invested,
  4. knowing which investments you own,
  5. tailoring your investments to accomplish your goals more precisely, and
  6. managing your income stream better.

An article in the August 6, 2001 edition of The Wall Street Journal (which we are enclosing with this newsletter) described how investors increasingly prefer individually managed accounts over mutual funds, pointing out that assets in individually managed accounts grew at 20% in 2000 while assets in mutual funds declined -2.3%. The article also points out that for years, Merrill Lynch focused its representatives on promoting its mutual funds – but not any more. Along with other large brokerage houses, Merrill is now making a big push for separately managed accounts.

And in addition, Merrill is following the trend at other large brokerage houses to change its fees from transaction based commissions to fees based on asset values. To understand how these two trends are related, it is necessary to note the decline in brokerage fees in recent years. Instead of paying $100-$200 to trade a stock, thanks to technology and competition, investors can now easily trade stocks at fees ranging from $10-$25. This dramatic reduction in fees caused an important source of revenue for brokerage houses to dry up, and they needed to replace it. Hence the shift from commissions to asset based fees.

But just changing from sales commissions to asset fees wouldn�t do it for Merrill. Charging asset fees on accounts which were already heavily invested in their mutual funds would have represented such a severe conflict in interest that the SEC would not have been able to overlook it. Without changing the way it was doing business Merrill would be collecting three fees;

  1. a fee for underwriting the stock of the corporation it has as an investment banking client,
  2. a fee for managing the mutual fund the stock might be held in (the normal way mutual funds get their fees), and
  3. a fee based on the market value of its mutual funds held in its investors accounts.

In effect, Merrill would be getting paid once by the corporate client and twice by the retail client.

So, to remove some of this conflict, Merrill had to redirect its clients from mutual funds to individually managed accounts. While Merrill and others will have declining revenue in their mutual funds, they will make up for it by charging their newly converted individually managed accounts. The article points out that, after discounts, the average managed account fee is still 1.8% of assets.

But clients of brokerage houses must still come to grips with the inherent conflict of interest present in the brokerage business – raising cash for their corporate clients by underwriting their stocks and simultaneously investing their retail clients in the same stocks. The only way an investor can be sure that an advisor is serving their best interests is if the advisor�s sole source of revenue is from its clients. For a hint as to who provides this service, call 410-461-3900.