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Investment Abuses By Product… Investors walk in a landmine of potential abuses at full service brokerage firms. Some of the most common investments sold to investors are those where the client's interests and broker's interests are diametrically opposite. Consider the following products… A) Bonds
Few other investments are as wrought with as many abuses as bonds. Investor ignorance on a deceptively complicated product and greed on the part of the stockbroker are the two primary causes for these abuses. Investment professionals typically do an awful job of disclosing the risks associated with bonds. Brokers sell bonds as a conservative investment, when in fact many times they are not. Government bond funds often load up on mortgage-backed bonds such as Ginnie Maes to increase their yields. While these bonds are backed by the government, they can still be very volatile due to changing interest rates. These sorts of risks are generally not disclosed to investors. The biggest problem investors need to be aware of when buying bonds is that brokers receive the highest compensation for selling the riskiest bonds with the longest maturity. Clients generally have no idea of this relationship. This serves as an incentive to push high risk, lower quality bonds with long maturities. Brokers will push a lower quality bond from their firm's inventory because they can make more in commissions. Instead of recommending a bond to a customer because it is suitable or the best fit for that investor's portfolio, brokers are encouraged by their compensation system to recommend one bond over another because of the higher payout that the firm's inventoried bonds provide. Unfortunately, brokers usually receive more in compensation for selling lower quality bonds with long maturities, which often takes precedence over suitability considerations. Brokers also fail to tell investors that any bond, regardless of whether it is a government bond or an AAA rated bond, can lose money if it is not held to maturity. For example, a government bond purchased when interest rates are at five percent will plummet in value if interest rates subsequently rise to seven percent. If an investor sells her bond at that point, she will have a loss on the safest investment available. Another problem is that unlike stocks and mutual funds, bond prices are not readily discernable to most investors. In the usual principal transaction, a broker buys a bond at one price and sells it to the investor at a higher price and the broker and brokerage firm pocket the difference. When a broker buys a bond from an investor, they do the opposite, charging a "markdown." Unfortunately, bonds do not trade on an exchange, meaning investors have little way of gauging the actual market price. The NASD only requires that bond markups be "fair." B) Mutual Funds
When investing in mutual funds, your financial interests are directly counter to those of your stockbroker or financial advisor. It therefore should come as no surprise that your advisor has recommended you buy high cost funds and then sell these same funds within a few years of the initial purchase.The biggest problems with broker sold mutual funds deals with the high degree of switching between different funds and the fees associated with the funds. Mutual funds are one of the most popular investments that full service brokers and financial planners sell to their clients in large part because the commissions are so high. For "A" shares, still the most frequently sold share type, the brokerage firm receives approximately 4 percent up-front on the purchase price for a load mutual fund and a "trailer" commission each year based on the amount of money in the fund. The "trailer" is usually a very small percentage of the assets in the fund averaging anywhere from approximately 5 basis points (1/20 of 1 percent) to 25 basis points (1/4 of 1 percent). Even though most mutual funds should be held for a minimum of five to seven years, the average holding period for growth and value funds is under three years. Your broker is a big part of the problem. If a broker can convince a client to sell one mutual fund and purchase another one from a different family of funds, the broker can receive another 4 percent commission instead of the lesser yearly "trailer" commission. Brokers find it an easy sell to convince investors to liquidate a mutual fund that is not the current year's hot fund. The high degree of switching is caused, in part, by brokers failing to distinguish between investment returns and investor returns. What many investors fail to realize is that there is a major difference between investment returns (what the mutual fund's total return is from January 1st, to December 31st) versus investor return (what the investor who invests in that mutual fund actually receives as a total return). For example, from 1984 to 1995 the average stock mutual fund posted a yearly investment return of 12.3 percent. An impressive result especially when compared to the long-term returns for stocks. However, the average investor return over that same time frame was only 6.3 percent while the average investor in a bond mutual fund earned 8 percent. In other words, the average mutual fund bond investor did better than the average mutual fund stock investor during one of the greatest eleven year time periods in the history of the market! Consider the table below for an even longer timeframe. The results are staggering for brokers and their mutual fund holding clients. The table breaks down how mutual funds did and the investment returns investors received in those funds. The Stock Market, The Average Equity Fund, And The Average Fund Investor. Total Return On Initial Investment Of $10,000 (1985-2004)
Need more evidence? Looking at the S&P 500 for a nearly identical timeframe shows an even worse outcome for investors. A study by Boston based Dalbert Inc. entitled "Quantitative Analysis of Investor Behavior" tells us an investor who bought and held the components of the Standard & Poor's 500 stock index for the 20-year period between 1986 and 2005 would have realized an annual average return of 11.9%. However, by analyzing data from the Washington-based Investment Company Institute of actual fund flows during that period, the study found that the average equity investor actually earned just 3.9% annually, representing a "lost opportunity" of 77%. These results are incredible. There are a number of reasons for this discrepancy between what the average mutual fund returns and what the average investor who invests in those mutual funds receive. One of the major causes, however, is that brokers and financial planners generally sell investors whatever the newest, hottest mutual fund that is currently being touted. Typically, by the time the investor gets into the fund, most of the gains have already been made. The broker then has an easy sell a year or two later when he touts the new, hot, popular mutual fund. The broker's incentive is a large commission from the purchase of the new mutual fund coming on the heels of the previous load commission from a year or two back. Because we work on a fee basis at Prudent Asset Management and don't receive any commissions or fees, there is no financial incentive to engage in this sort of conduct four our clients. C) Variable Annuities
Variable annuities are the toxic waste of the securities industry. Incredibly, over $1 trillion sits in variable annuities through 2005. There isn't one scenario that can be articulated where variable annuities are the proper choice for an investor. Annuities are the highest commission product that stockbrokers can sell. The result therefore is that annuities are typically sold, not bought. Insurance agents, stockbrokers and commission-paid financial planners can receive a payout of up to 7 percent on annuities, which they share with their firm. Very few investment products pay this well. Load based mutual funds pay only, on average, 4 percent to the registered rep. Selling stock or bonds pay the representative only 1 percent. Prudent Asset Management charges less than 1% annually to manage client assets. Therefore, the incentive in many instances is to force a product that might not be suitable for the investor because the one who is making the recommendation gets paid more. Importantly, there are no breakpoints (reduced sales discounts for large purchases) with annuities. The investors' funds are typically tied up for years with high surrender charges. The annuities have extraordinarily high fees. There are big upfront sales charges and back-end surrender charges, which linger around 7% if you withdraw the money too soon. Another huge problem is that annuity expenses are often extremely high. Investors pay the traditional annual management fee just like they would with a traditional mutual fund. However, with annuities there is an extra layer of fees. In addition to the investment fee on the portfolio, there is a "mortality and expense risk" charge, typically 1 percent or more a year. There are also administrative and annual records maintenance fees. The average annuity has an expense ratio of 2.35% annually, according to Morningstar. That is more than ten times what it costs to manage the Vanguard Index 500 fund. Finally, any withdrawals from the annuity are taxed at ordinary income rates (which could be as high as 35%) instead of the much lower long term capital gains tax of 15%). The best evidence of how attractive annuities are to financial representatives is that in 2003, approximately $26 billion of annuities sold went into IRAs. One of the major advantages of annuities that financial planners, brokers and insurance agents push is that annuities are mutual funds that allow for tax deferred growth. That is undoubtedly true. However, putting an annuity in an IRA is virtually useless. There is no legitimate reason to put a tax-deferred investment like an annuity into a tax-deferred account like an IRA because an investor is already getting the benefit of tax deferred growth via the annuity. The unsuitable and egregious nature of stockbroker's buying variable annuities for the retired and in the retired clients' IRAs has been well documented by the NASD and NASAA, the national group of state securities commissioners. Variable annuities have made NASAA's top ten list of investment "scams" each of the last six years. NASAA recently disclosed its 2006 forecast of the 13 most common ways "investors are likely to be trapped in 2006." Of course, variable annuities were on their list. According to NASAA: Variable annuities are tax-deferred investments that typically place mutual funds inside of an insurance wrapper for tax deferred potential investment growth. While these products are legitimate investments, regulators are concerned about their popularity in the sales community. Commissions to those who sell variable annuities are very high, which provides incentive for sellers to engage in inappropriate sales. Variable annuities are only suitable for a very small percentage of the investing public and generally are not appropriate for most seniors. The steep penalties for early withdrawals also make variable annuities unsuitable for short-term investors. Be especially wary of any broker who wants to sell you a variable annuity to hold inside a 401(k) or IRA. You are already getting tax-deferred growth in an IRA or a 401(k), and the variable annuity simply adds a layer of cost with no additional tax benefit.The press has also cast light on the inappropriate and unsuitable nature of variable annuities, especially ones bought in an IRA. As noted by the Chicago Sun Times' Terry Savage in an article entitled "Tax-Deferred Annuities Often A Big Mistake" on August 22, 2005: It's becoming a national financial epidemic: tax-deferred annuities sold to people who don't understand them, don't need them, and might even be harmed by their high fees and surrender charges. The people who fall for this trap tend to be seniors, widows and others who have a sum of cash to invest and are seeking security. Instead, they get locked into expensive and ongoing management fees. And what do the salespeople get? Huge commissions. As much as 10 percent of the initial investment, and ongoing commissions for years after that! It's a huge violation of trust because a great number of these tax-deferred annuities are sold inside banks, where the trusting clients don't realize they aren't dealing with a banker. They're dealing with a securities broker licensed by the bank, and paid on commission. D) Individual Stocks
The most common disputes in NASD arbitration actions continue to involve individual stocks. Individual stock recommendations continue to be one of the broker's favorite vehicles for defrauding investors. At the end of 2004, American households possessed over $6.0 trillion in individual stocks, which was second behind only the $7.4 trillion in pension funds. An individual stock purchased at a full service firm costs approximately 1 percent of the purchase price. While this may not seem to be a large amount, the commissions can pile up quickly if a broker trades frequently in the investor's account.
The biggest problem investors face with individual stocks (besides unsuitable invests in view of the client's financial resources) is active trading or short term holding periods of those securities. The more active your stock portfolio is, the more compensation your broker earns. Therefore, your broker has the incentive to sell out of stock positions that should be held long term. For a discussion on the near impossibility of successful short term stock trading, please see on this website Core Investment Beliefs Guiding Prudent Asset Management (Consistently Outperforming The Financial Markets Is Almost Impossible). E) Margin
Margin is an extremely popular tool brokers utilize to take advantage of investors. A margin account allows customers of the brokerage firm to buy securities with money borrowed from the firm. The customer pays an agreed upon interest rate to the brokerage firm for the right to borrow the money. The Federal Reserve requires that investors making their initial purchase of a stock must pay cash for no less than fifty percent of the price. This is known as a margin requirement. A margin call is a demand that an investor deposits enough money or securities to bring a margin account up to the minimum requirement. If the investor fails to respond, securities in the amount will usually be sold. One reason why margin accounts are so popular with brokers is because they give the client extra buying power. This extra buying power can be used to purchase more securities and therefore generate more commissions for the broker. One of the problems with margin accounts, though, is that many brokers are using margin for investors who are inexperienced or do not understand the risks involved with these accounts. Brokers fail to inform investors that the risks with margin accounts are extremely high. Often, the first time an investor learns about the risks inherent in a margin loan is after the investor receives a margin call and extensive loses are sustained. Brokerage firms and brokers typically do not do an adequate job of disclosing the risks to investors before they take out a margin loan. Unfortunately, margin abuses increased dramatically in 2000, at the height of the tech and telecom bubbles. In 1997, there were only 25 margin complaints filed with the NASD compared to 284 in 2000. Through March of 2001, the number of margin complaints was 98. F) Options
Not a great deal needs to be said about options. Though there are some option strategies that are conservative in nature, most options are inherently speculative and should only be used with a highly sophisticated, experienced investor. Most brokerage firms have relatively strict criterion for who can buy, sell and trade options. Brokers love them because as a percentage of the principal, no other product pays a higher commission. Options are usually not a suitable investment for most individual investors. |