-- Published: Tuesday, 11 March 2014 | Print | Disqus
By Dennis Miller
You donít have to be an expert at ferreting out a bad financial advisor; if you were, you probably wouldnít need one in the first place. Thankfully, you donít need to become an expert in finance to spot the red flags. Weíll go over a few key warning signs here.
Credentials and Experience
Financial advisors often have all sorts of certifications and association memberships. While many of them sound impressive, theyíre actually not terribly difficult to acquire. For example, the Series 7 Test, which allows one to sell securities, is just a 250-question, multiple choice exam; one only has to answer 72% of the questions correctly to pass. Another key test, the Series 66, is only 100 multiple choice questions. These arenít difficult hurdles to jump over.
For this reason, many advisors are not highly proficient in their trade, despite what the certifications imply. I know of someone who went to take the Series 7 Exam and told about meeting a young shoe salesman there. The shoe salesman realized that he had quite a skill in sales, so he decided he could make more money selling mutual funds than shoes. He passed the test on his first try with no prior financial experience.
We donít want to demean all financial advisors, but this isnít an unusual case. Most of these kinds of advisors end up at firms that follow the suitability standardóa less than optimal code of professional conduct. Professional firms that adhere to a higher, fiduciary standard would likely weed them out fairly quickly. They have a reputation to protect and can ill afford an employee of questionable ethics.
Certainly, some credentials are tougher than the Series 7, such as the Certified Financial Planner, but that still doesnít guarantee a truly knowledgeable person. Nonetheless, the more credentials and certifications an advisor has, the better. He at least shows a willingness to learn and invest time in becoming a better advisor.
What about the advisors with actual degrees in business or finance? This isnít a guarantee of quality either. Many a commencement speaker has referred to a degree as an opportunity to go into the world and learn. A degree in finance or business may get a person in the door of a professional firm, but one still has to learn everything in this industry from the ground up. A degree is good, but it doesnít necessarily give a huge edge.
Thereís absolutely no reason to settle for a freshly minted advisor; the more years in the industry the better. There are plenty of advisors begging for your business. Many of the top professional firms do not hire anyone who does not have a good track record of experience.
Many of the captive houses are losing a lot of their top people. They are looking for firms that are truly independent, where they can apply their skills and experience for the remainder of their careers. Demand more credentials and experience and be wary of brand new advisors.
Fees and Expenses
When it comes to fee structure, character matters over credentials. Whether youíre someoneís first client or their thousandth, he can just as easily pull the wool over your eyes with fees. You should always seek low-fee fund options. Ask for low-fee funds as well as exchange-traded funds (ETFs) and index fund options.
Professional financial advisors can go to either extreme. Some actually have a contract that stipulates anytime your money is invested in a fund where they receive a commission, that commission is credited back to your account. Other firms will take those commissions and use it to enhance the personal compensation of the advisor.
Asking your advisor to show you ETFs and low-fee fund options is a subtle test. If he or she pretends that high-fee mutual funds are the only options, then thatís definitely a red flag. In some situations, a higher-fee fund might make sense, but the advisor better have a damn good reason for it. It is our responsibility to ask for and listen to the reason and then decide for ourselves if it makes sense.
So, whatís a reasonable expense fee for a mutual fund? According to the Investment Company Institute (ICI), the actual average rate paid by mutual fund investors was 0.77% in 2012. That goes to show that investors are staying clear of the higher-fee funds. They are seeking out cheaper mutual funds, and even cheaper ETFs and index funds.
Equity funds will have slightly higher fees than money market funds and bond funds, so be aware of this difference. You might pay more than average for aggressive growth strategies or international equity funds. On average, these will charge 0.92% and 0.95% respectively. If youíre pursuing these strategies, give your financial advisor a little leeway Ė but not much.
Load fees are also important to understand. Iíll share a short description of various load shares, but the main takeaway is that you want a no-load fund. Think of load shares as a sales tax on your fund purchase Ė not a good thing.
The only situation where a load fund might be good is when you plan to hold shares for a very long time Ė close to a decade. Load funds will have a high upfront fee, but the annual fees are typically a bit lower, so if youíre in the fund for the very long run, they might work out. However, unless youíre committed to a very long-term investment, we suggest no-load funds.
- Front-End Load Shares Ė typically called Class A Shares.
With these funds, you pay a percentage of your assets when purchasing the fund. The maximum one can be charged by law is 5.4%, which is an enormous amount. Think about it. Youíre down 5.4% on day one. However, many investors get a discount through employer-sponsored retirement plans, so the average front-end load share paid for an equity fund by the average investor is 1%. Going through a financial advisor, it will likely be slightly more. Match that with a 0.77% average annual expense fee, and youíre still considerably behind right off the bat.
- Back-End Load Shares Ė typically called Class B Shares.
As you might have guessed, you pay a percentage of assets when redeeming the fund rather than at purchase. However, the fee will often decrease the longer one holds the shares. Essentially, the mutual fund company wants to get your money one way or the other, through years of annual fees or through the back-end fee. Either way, youíll end up paying.
- Level-Load Shares Ė typically called Class C Shares.
These shares are a combination of back-end load shares and no-load shares. The back-end fee will be lower than regular back-end load shares, but the annual fee will be higher.
- No-load shares
As the name suggests, there is no back-end or front-end load fee here. However, the annual fees are slightly higher. Unless you plan to hold a fund for nearly a decade, you will save money by going with a no-load fund. As more people are figuring this out, they are flocking to these funds.
Some advisors will want to put you into the front-end or back-end funds. Thatís how they get a cut of the deal. However, you should insist on a good reason why, and ask for a much cheaper fund or ETF alternative. If push comes to shove, you can always ignore your advisor and call the mutual fund company directly to purchase the no-load funds. That might seem like a mean thing to do to your advisor, but then again, charging someone unnecessary fees sometimes as high as 5.4% isnít nice either.
Remember that understanding these fees and other product alternatives isnít just about cash in your pocket. Itís about understanding the character of your advisor. If heís not getting you the best deal available, then thatís certainly a red flag.
Check for a History of Fraud
This one seems like a no-brainer, but weíll make it easier with links to several sites that track advisor and broker improprieties. Here are a few places to check:
- The Financial Industry Regulatory Authority (FINRA)
This organization is the same one that administers the Series 7 Exam. Its search tool lets you find out how long an advisor has been registered and if he has any history of incidents. It will even tell you whether or not someone has been fired. Once youíve selected an advisorís name, make sure to click on the detailed report link which specifies everything from a complete employment history to descriptions of specific damages and incidents.
You can also look up information about individual firms such as their assets under management and the size of their average client.
- SEC Investment Advisor Public Disclosure
This is another site with much of the same information as the FINRA site.
- North American Securities Administrators Association (NASAA)
This site has a couple of interesting ways to find out more about offenses in your state. First, you may browse its contact list of state regulators, or you may also view its list of state enforcement websites.
Since some advisors are paid on commission, they have an incentive to constantly make trades, a practice also known as ďchurning.Ē When a broker is constantly pestering you with reasons to buy and sell, this can be a little obvious. However, there are other areas where they can trick you into buying or selling more than necessary. For example, they can insist on regularly fine-tuning or rebalancing your portfolio to make sure all the allocations are even. If a portion of your portfolio has really become overweight or underweight from gains or losses, this might be appropriate; but rebalancing your portfolio on a monthly basis for very small changes just isnít necessary. This practice can trick a lot of people since it seems sincere and appears to make sense.
Your portfolio should need rebalancing only once or twice a year, or when thereís been a large move up or down in the market. Otherwise, an attempt to rebalance is suspect.
No Research Department
One of the benefits of big-name companies is that they come with extensive, professional research departments. As a result, their recommendations come from proper due diligence. If you have more questions about a certain company, the advisor can find out more about the investment through the equity research department.
However, this might not always be the case with small, independent financial advisors. Although many donít have full research departments, they can still pay for research from other sources. If a company doesnít have a source for research, you should be concerned about the quality of its recommendations.
Sure, some investments might still be appropriate without a full research department. For example, if the advisor recommends extremely diversified funds, then this really isnít a problem. But if your advisor is recommending purchases of Microsoft, Coca-Cola, and IBM but really has no research to back these recommendations, thatís a problem.
We want to reinforce that we should delegate Ė not abdicate Ė our nest egg to a professional financial advisor. Trust is paramount. There are many good professionals available who have earned their clientsí trust year in and year out. That is the advisor we all are looking for. While watching out for these five items doesnít guarantee a good financial advisor, it certainly will weed out the worst apples.
It can be difficult to find a financial advisor who will always come to you with the cheapest and best options. Some financial advisors have all the wrong incentives in place. However, knowing their compensation structure and the other available options helps to keep you in the driverís seat.
Keep in mind that some advisors are fee-based or donít receive commissions or kickbacks from mutual funds, so they necessarily avoid some of the conflicts of interest mentioned above. You can search for fee-based advisors in your local area on The National Association of Personal Financial Advisors (NAPFA) website. This is a good place to start, but make sure you still get a clear explanation of a prospective companyís fee structure.
To sum it up, donít fall for high fees and big-load funds, and watch for excessive trading. Seek out credentials, experience, and a clean record. Ultimately, an advisor canít force you into anything. If one offers expensive products, push back and ask for cheaper options, or find another advisor. If you find a good one, hold on to him or her. They are worth their weight in gold.
The Money Forever team is here to help you sift through the rubble and find the exceptional advisors. If you'd like to receive more information on how to find an advisor to prescribe the right financial solutions for you, please check out our special report, "The Financial Advisor Guide." If you are not already a subscriber, you can still get your own copy HERE.
| Digg This Article
-- Published: Tuesday, 11 March 2014 | E-Mail | Print | Source: GoldSeek.com