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When ETFs Won’t Save You Money

Evan Cooper Oct 01, 2015


There’s growing awareness among investors that exchange-traded funds are a lower-cost way to invest in equities. Many dividend investors are particularly fond of the low costs and diversification attributes of ETFs, especially since there are now a variety of ETFs designed just for them.

Advisors have figured out the advantages of ETFs too — but some in ways that don’t necessarily benefit investors. The reason involves a quick dip into some mind-numbing regulatory issues.

When the ETFs as we know them came onto the scene in the mid-1990s, they were first embraced by market professionals, wonky and adventuresome individual investors, and a class of professional advice-givers known as Registered Investment Advisers, or RIAs. The quirky spelling of “adviser” comes from the Investment Adviser Act of 1940, the regulation that governs RIAs, the mutual fund industry and many of those who manage money on behalf of others.


Fiduciary Standard


The 1940 Act, as it is known, requires that those offering advice act as fiduciaries to clients, meaning that they put the interests of their clients before their own interests. For an analogy, consider that a dentist is required to put the patient’s interests before his or her own. A dentist who recommends pulling a perfectly healthy tooth simply to make money has breached his or her fiduciary duty and could face professional and legal sanctions.

In finance, since RIAs are required to put client interests first, they are required to recommend the best investments for a client, not those that that earn the RIA the most money. Unfortunately, the vast majority of financial advice givers are not RIAs — which is not to say that all RIAs are saints; Bernie Madoff was an RIA and look what he did.

Most advisors (here I’m using the generic “o” instead of the “e”) work for broker-dealers, which are the companies whose literature and ads have tiny type at the bottom that say something like “member of FINRA and SIPC.” Those acronyms, respectively, stand for the self-regulatory body of the securities industry and the quasi-governmental organization that helps cover losses in brokerage accounts if the firm goes bankrupt. If you get literature from your financial advisor or his/her firm that has those disclaimers, it’s almost a certainty that your advisor is not a fiduciary.


Suitability Standard


Instead, if your advisor works for or through a brokerage firm, he or she comes under the umbrella of a different set of securities laws that require that investment recommendations be “suitable.” An advisor under such a regime couldn’t put an 88-year-old widow into speculative stocks, for example, because such risk would be “unsuitable” for someone that age. But they could recommend a suitable conservative fund that paid the advisor a handsome commission — and not recommend a virtually identical no-load fund that paid no commission at all, saved the clients lots of money, and would result in greater long-term performance.

So back to ETFs. Since investors over the years have seen the folly of paying conventional brokers hundreds of dollars in commissions when they can get the same transaction for practically nothing through a discount broker, most brokerage firms have switched to a fee-based compensation structure. By having clients pay a fixed percentage of the total value of the portfolio each year, the brokers and their firms are assured of steady income and the client can trade whenever necessary for no extra charge while theoretically taking advantage of the advisor’s insights and wisdom regardless of whether there is a transaction.


Wider Adoption


For their fee-based accounts, many advisors have now come to support and use ETFs instead of higher-cost mutual funds. But the reason does not necessarily stem from altruism or a sense of fiduciary obligation.

The reason is that when commissions formed the bulk of broker compensation, brokers earned the equivalent of roughly 2% of the value of the assets in their clients’ accounts. To keep that level of compensation under a fee-based regime, they can’t have their clients trade too much (since it does cost something for the brokerage firm to conduct and record the transaction), and they have to fill the portfolio with investments that have lower costs. ETFs, which cost less than mutual funds because the structure of a mutual fund simply costs more to operate, fit the bill. But the cost-savings of the ETFs in fee-based brokerage accounts flow mostly to the broker and the brokerage firm, not the client, who is still paying about 2% of assets under management.


Where Are the Savings Going?


ETFs, of course, still can make great sense in an investment portfolio, and a broker’s advice in constructing that portfolio may be worth more than the fees that are charged. Still, keep your eyes open, because you may not be saving as much as you think you are.


Image courtesy of graur razvan ionut at FreeDigitalPhotos.net

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