The Hidden Truth about How Many Large Investment Firms Pick the Investments They Offer – Part 2: Revenue Sharing
This month’s blog is a continuation from last months in regards to how many of the largest investment firms try to maximize profit at the expense of the average investor. The topic today is one that I would say 99% of the population doesn’t know about and about 70% of the financial advisor population doesn’t fully understand. That topic is ‘revenue sharing’.
I’ll start explaining this with a story. Let’s say I’m the head of a large investment firm with over 10,000 financial advisors and billions under management. Let’s say you run a new mutual fund company who wants to sell their product through my company because you want access to my 10,000+ advisors and my firms assets under management. So we arrange a meeting and you pitch your mutual funds and your company to me. I like what I hear, so have legal write up a contract and when you read it, you see that for every sale done at the investment firm that you have to pay the firm a percentage of the sale. Confused, you ask, “Don’t you get a cut of every sale that an advisor does anyway? Why do I have to pay you as well?” I respond by saying, “If you want access to my firms sales power, then you will agree to this and pay it. I’m not a small company. If you want in, you have to ‘pay to play’.” You go back and discuss it with your fellow executives and do some research. You learn that pretty much all the large investment firms do it this way and some charge more than others. After much discussion, you decide to raise your internal mutual fund expense ratios a small bit to cover the additional fee. You come back to me and sign the contract.
Now I go to my 10,000+ advisors and tell them we have a new addition to our ‘preferred group’ of mutual funds! You can sell this new investment and local trainers will be contacting your offices soon. The advisors have no idea what the ‘preferred group’ really is and they take the name at face value thinking that they are the best of the best funds out there as researched by the company.
This story illustrates ‘revenue sharing’. It is simply a way for the large investment corporation to make more money that the financial advisor does not get (or see) and it typically causes mutual fund companies to raise internal expense ratios, which reduce an investors rate of return. This hurts investors in another way too. Let’s say there is a good mutual fund company devoted to keeping their internal fees low. They have great products and great investment returns and they morally refuse to sign revenue sharing arrangements because they don’t want to raise fees to their investors. Using the story above, this firm comes to me and my investment firm, so I tell them, “You are one of the top five largest mutual fund companies in the world and you have great products. I do want you in our system, but you have to sign this revenue sharing agreement if you want access to my 10,000+ advisors.” They refuse. However, I don’t want to look bad and my advisors have been asking for access to this company. I agree to let them in the system. However, they will be outside of the ‘preferred group’, so if an advisor wants to sell it, they will have to pay a large transaction charge. What does that mean?
Here is another story to illustrate how important that last point is. A financial advisor is doing research on available mutual funds for his upcoming client meeting. He has had lots of training on his company investments and some training on the ‘preferred group’ of funds. However, his research has uncovered a good investment in a company outside this list. They are one of the largest mutual fund companies in the world and have great performance. He checks to see what the transaction fee would be if he put a client into it. He knows that a ‘preferred group’ transaction will cost him personally $15 against his commission. He looks it up and shockingly discovers that the transaction fee is $75 for this other company. That is 5x more!! Since he is running a business and wants to stay in business, he decides to stick within the ‘preferred group’. The client has no idea this went on and the advisor does his presentation and sells the investments that his company has funneled him into selling. And those are the products that make the company the most money. See the problem here? Huge conflicts of interest that hurt investors by limiting access to certain investment products with typically higher fees.
Personally, it took me years to figure this out. I didn’t believe it at first, but the more I researched and the more questions I asked, the more I realized this was the truth. This was yet another reason why I decided to go independent and get away from the large investment firms and the sneaky ways they get advisors to sell certain things. I know that most advisors don’t understand this because almost every advisor I talked with in regards to this had no idea (unless they came from a big firm and are now independent).
I hope you found this helpful and please let me know if there are topics you would like me to write about. My next month’s topic will be around “Income Inequality in America”. It is a bit of a political topic, but I put a different spin on it that I hope you will find interesting.Google+