We come across many investors who have questions about financial management fees. It can get especially complicated with the different ways that different firms charge their clients. To help you learn more, we interviewed one of our AFAM Capital experts, Chris Creed.
Chris has been in the financial services industry for over 24 years and is a certified financial planner. He became interested in the stock market when he received a gift from his parents of four shares of an energy stock when he was eleven years old. He then followed it religiously in the newspaper, which spawned his fascination with the financial markets. “I realize what an emotional impact sound investing can have in one’s life. It is a privilege to be a part of that on a daily basis.”
This series of blog posts will offer a deeper understanding of three models: commission-only, fee-only, and hybrid (fee + commission). By the end of the series, you’ll have a clearer understanding of how different investment firms structure their fees. More importantly, you’ll have the information you need to determine what model aligns best with your own financial goals.
In the first article, Chris tells us more about commission-based charges as well as related concepts such as loaded funds, A-B-C shares, wrap accounts, and more.
Interviewer: I wanted to talk to you about the fee-only, versus fee-based, versus commission-based investment management. Let me start with this. What would you say are the different models out there? Are those the three, or are there really two models that look like three? What would you say?
Chris: I think the way you put it is pretty accurate. There are really two models that look like three. The two models are fee-only and commission-only, and then fee-based would be a hybrid of both of those.
Interviewer: So what is commission-based?
Chris: Commission-based, or commission-only, is the original model that you probably think of when you think of the traditional stockbroker. It’s a cost for a transaction. So if you buy or sell, for example, a stock, a bond, an ETF – any type of transaction you do – you’re levied a transaction cost, known as a commission. That way of charging for services has greatly diminished over the years, but it still exists. Those costs, those commissions, can be as much as several hundred dollars with a full service broker, to just a couple of dollars with a discount broker. Commissions vary based upon the service level of the broker, the amount of shares purchased or sold, and the ease with which those shares can be transacted on the market (liquidity). Even the type of transaction can factor into cost; a market order may cost less than a limit or a stop order.
Interviewer: So let’s say I’m buying a stock, or mutual fund, or even an ETF. Do I pay that fee when I buy it? Do I pay it when I sell it? When is the commission charged?
Chris: In most cases it’s both when you buy and sell it, especially an equity, an ETF or a bond. The mutual fund might be an exception to that, depending on the firm you’re working with.
Interviewer: Can you give an example in context of percentage? What should I expect is a typical percentage when I buy? What should I expect as a typical percentage when I sell?
Chris: It really depends on the firm you’re working with. But I’ll give you examples with a full service broker and with a discount broker. There are still some places where you might buy, for example, $10,000 worth of GE stock, and pay $180 commission for that. So in that example, around 1.8 percent. That might be at one of your big brokerage houses, where you’re working with a full service stockbroker or financial advisor. On the flip side of that, you might be a do-it-yourself investor, and buy it through one of the many discount brokers out there. For that same $10,000 transaction with a discount broker, you might pay in the ballpark of $5. So there is a pretty big difference between working with a full service broker on a transactional basis, or doing it yourself through a discount broker on a transactional basis. When I say transactional basis, that’s the same as commission-based.
Interviewer: Let’s say I go sell the same $10,000 of shares. Then I pay the same commission again?
Chris: You’re exactly right.
Interviewer: You said it might be a little bit different with mutual funds. How are mutual funds different?
Chris: This is a complicated answer, but I’ll give it a shot. There are a lot of firms that don’t charge any transaction cost to buy or sell a certain group of funds. Some discount brokers do charge a fee for buying or selling different funds. Some firms have preferred fund families that don’t have charges. So it really varies from firm to firm. But a typical cost might be $25 at a discount broker to buy or sell a mutual fund.
This is not to be confused with loads. Loads are sales charges levied by the mutual fund companies themselves, and those have nothing to do with where you transact your mutual fund purchase. So if you’re buying a loaded fund, it may have not only a sales load, but also a buy or sell commission. You can also buy a no-load fund that has a commission to buy or sell it. However, some places don’t charge any transaction cost for the mutual funds. So again, it can vary quite a bit from firm to firm. The question to ask is what is their mutual fund policy for transactions.
Interviewer: When you talk about loads, there’s this concept of front loaded and back loaded. What’s the difference between those two?
Chris: The easiest way to determine if it’s front loaded or back loaded is to look at the letters: A, B, C are generally what you’re going to run into. A is front-loaded. B is back end loaded. C is a deferred charge. So an A, a front end loaded, or A share mutual fund, is generally charging the client a cost for buying that fund. A typical front end load for less than $50,000 might be as high at 5.75 percent. Many fund families, such as ones you may have heard of like American Funds or Pioneer, will lower the charge as you buy more of that same fund family. That’s called a breakpoint discount and may be based on hitting a threshold like $50,000 or $100,000. Then at some point, maybe a million dollars, they may charge you no sales load.
The next kind, a B share mutual fund, is back end loaded. They won’t charge you up front, but they’ll have a schedule of charges that decline every year based on your holding period. It’s known as a contingent deferred sales charge schedule, or CDCS. If you hold it long enough, you may not pay a charge at all.
The C share mutual fund generally will have no front end load. It may have a small back end load. But generally it’s for somebody who is thinking about changing funds more often. It provides a way to not pay loads on an otherwise loaded fund with the idea that you’ll be switching around. Ironically enough, the C shares generally will cost you the most amount of money, especially if you end up holding them for a longer period of time.
Interviewer: So what’s the best one to get: A, B, or C?
Chris: It really depends on your circumstances. In very few circumstances will a B share make sense for someone. If you’re going to be concentrating on a single fund family, and hitting some of those discount breakpoints, an A share might be the least expensive option of the three. If somebody was going to be moving in and out of funds regularly, in a maybe one- to two-year time period, the C share might make more sense. So the question I’m really answering is what is the less expensive way. It’s not necessarily the best way, because with the A shares you’re limiting yourself to a single fund family if you’re trying to hit those breakpoints. Maybe at the expense of diversification by manager. With the C shares, many would argue that you shouldn’t be shifting funds that often anyway because it’s difficult to predict short term outcomes. So the A share can be the least expensive if you’re concentrating dollars there, but it’s not necessarily the best.
Interviewer: Why do you say that the B shares are usually not a good choice?
Chris: Because they have a higher operating expense, as well as a penalty to pull out. If you’re pulling out, even for good reason, you’re still going to be stuck with a 3-5% cost. But there’s the fact that B shares often convert to A shares after a period of time, depending on the fund. So you can figure at some point after that period, say for example seven years, they start to look like A shares in terms of cost. Then it’s kind of a wash, if you made it through that period where they would ding you for leaving the fund.
There are also no-load funds, R (retirement) shares, I (institutional) shares, Investor Class shares, Advisor Class shares… We could go on for days about this. The most important aspect of any mutual fund purchase should be to read the prospectus – mutual funds are required to provide a full accounting of the fund’s fee structure within this document.
Interviewer: Then what was the other method of buying mutual funds that you mentioned?
Chris: Some people buy mutual funds with what’s called a wrap account. A wrap account charges an advisory fee. Maybe it charges one percent, and then you have an account made up of different mutual funds. A lot of times they’ll have A shares in wrap accounts, or they might have no-load funds. But those A share charges are generally waived, because you’re paying your advisor a wrap fee, that advisory fee. This can be a pretty expensive arrangement. Because with one percent charged to the advisor, and the underlying operating expenses of the funds averaging around one percent also, the client is paying about two percent per year, or more, depending on the funds they use.
Interviewer: People who do these wrap fees, are those lone gun CFPs (certified financial planners), or are those big brokers? Who typically offers those?
Chris: They all do. It’s a very common way for advisors to charge their clients. You can get that at Merrill Lynch, or Wells Fargo, or you can get it with your local LPO guy. It’s all over. They all have them.
Interviewer: Let me transition a little bit. I want to talk about sweet spots for each of these models. So let’s talk about the sweet spot for commission-based. When is commission-based the best strategy to use?
Chris: Commission based would be the best strategy to use if you had some experience and the knowledge to manage your own portfolio. For example, if you were a person that is knowledgeable enough to manage your own portfolio, then certainly you could do that at a discount broker at a very inexpensive cost. If you’re a person that has the time, training, and the temperament to handle your own portfolio, then you probably don’t need to pay somebody for ongoing management. (end of this excerpt)
Don’t miss the next blog in this series, in which we’ll talk to Chris about the fee-only model of charging for investment management, as well as the “hybrid” fee + commission model. Then in article 3, we’ll cover the pros and cons to consider when deciding what’s best for you.
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