Defending Kickbacks

The Wall Street Journal reports that the SEC will soon decide (well, sometime this year) whether brokers should be subject to a fiduciary standard in their dealings with clients, as registered financial advisers are today. At present, brokers only need to show that investments they recognize are “suitable” for their clients—roughly speaking, that they are in an appropriate asset class.

Not surprisingly, the brokerage industry is up in arms. They want to be able to push clients into the products for which they receive the highest commissions—a practice that (they say) could be more difficult under a fiduciary standard. According to one lobbyist,

“a universal fiduciary standard could end up hurting many investors. Lower- and middle-income investors often turn to brokers who are compensated through product commissions, he says, because such clients are less attractive to financial advisers who are compensated based on a percentage of assets under management. Higher costs could prompt some brokers to drop commission-based accounts in favor of more-lucrative accounts that charge a percentage of assets under management, leaving many lower- and middle-income investors without anyone to turn to for investment advice.”

(That’s a paraphrase by the Journal writer, not a direct quotation.)

First of all, note the underlying chutzpah here. The SEC is thinking of requiring brokers to act in the interests of their clients. The defense is, “We’ll have to change the way we do business.” How is that not an admission that they aren’t currently acting in the interests of their clients?

Second, let’s dig into the supposed benefits of commissions. Another word for “commissions” is “kickbacks.” Basically what’s going on is that some mutual fund company is charging a, say, 5 percent load, and then it’s paying some of that back to the broker who steered you into the fund. In other words, the only reason the fund company is paying a kickback to the broker is that it is making an even higher profit from the customer.

With the sales load, it’s obvious. But it’s also the case for a “no-load fund” with a high expense ratio. Brokerage commissions are not supposed to be included in fund expense ratios. But expense ratios do include 12b-1 fees, which are used to pay kickbacks to brokers.* Again, the kickback is just a way for the fund company to share with the broker the excess profits it earns from the customer who buys that fund—as opposed to, say, the index fund with an expense ratio of 10 basis points or less.

Now, sales commissions can make sense in some markets. For example, say there are two products in the market. A is worth $100 and costs $100 to make; B is worth $110 and costs $100 to make. But only professionals know which is worth more. In that case, if B is priced at $108 and $4 of the profits go to the broker as a commission, then your broker is more likely to steer you into B, and everyone is better off. (Of course, on these facts, the broker would still steer you into B even with the fiduciary duty, so a fiduciary duty rule would do no harm.) Or there can be a market in which ordinary customers have to go through brokers—that is, every product has a sales charge, one way or another.

But that’s not the case with mutual funds in liquid asset classes, which you can buy directly from Vanguard, Fidelity, and many others. There’s no reason to believe that, on an expected basis, a higher-priced product (in expense ratio terms) will have higher returns than a lower-priced product. Higher-fee funds are a combination of higher expenses on pointless things (“research,” trading costs) and higher profits for the fund company, which they are willing to share with brokers as a cost of doing business.

In other words, the sole reason the broker gets a commission is that he is selling you a worse product than the low-fee index fund. The excess profits and the kickback go together; you can’t have one without the other. If brokers choose to drop lower-income clients, then said clients are better off for not getting bad advice. If they need advice, then they should consult a fee-only adviser; the amount they spend in fees will be more than made up in avoiding poor investments recommended by brokers with hidden agendas.

* The Investment Company Institute, apparently in all seriousness, says, “Rule 12b-1 plans have provided an important addition to the choices investors have in how to pay for their fund shares.” Like, you could pay less, but now you canchoose to pay more!