This is a guest post from Patrick Collins, CFP®, EA. Patrick is a Principal of Greenspring Wealth Management, Inc. and heads the firm's Private Client Group.
I recently received a call from a client of ours who has accounts at multiple brokerage firms. She was being pitched a new issue municipal bond closed-end fund from one of her brokers and she wanted my advice on whether she should buy it. I was well aware of these types of products as they were very prevalent back in my days as a broker at Merrill Lynch. In my office, there was a typical process to selling these products: a new issue would become available and advertised through sales meetings and brochures to all the brokers in the office. Here is the sheer genius of the manager at Merrill. She would post the sales rankings of all the brokers in the office. Sometimes there would be a reward for the largest producer (gift certificate, etc.), but most of the time just posting a report was enough to get a bunch of highly competitive people motivated to sell a product. Selling this product wasn’t about giving good advice to clients; it was about getting your name on the top of that list. I wish I could say that this was only applicable to a few brokers in my office, but the vast majority participated in these sales contests.
It has been 5 years since I left that environment, and as my client explained the product to me I came to two realizations, but first let me explain what she was being "pitched."
A highly respectable investment company was rolling out a new issue. This was going to be a closed-end, leveraged national municipal bond fund. Here are the particulars:
- Offering price - $15 per share
- Sales commission - $0.705 taken from NAV of fund, so no transparency from the client's perspective (unless they read the offering documents)
- Expected yield - 6%
- Net expense ratio - 0.86%
At face value, it looks like a reasonable investment. The sales load is 4.7% which is high and the expense ratio is higher than what I’d like to see for a bond fund, but both are within reason. Here are the realizations:
1. Brokers who sell products can never truly be fiduciaries.
This is one of four almost indistinguishable products that this particular investment company has brought to market in the last 10 years. On top of that there are approximately 10 other closed-end municipal bond funds that are almost identical to this product. Why is this important? These existing closed-end funds can be purchased on the secondary market. Even the most expensive brokerage commissions are going to be less than 4.7% of the purchase price of a trade. If there is an identical fund that costs less to purchase for the client, how can you ethically recommend a product that costs more? And don’t give me the “the fee is disclosed to clients” line. A true fiduciary doesn’t hide behind disclosure, but puts the client’s interest first whether or not the client even knows he/she is doing the right thing.
Also, a quick look at the performance of these funds shows just how terrible they have performed relative to their peers and index. This particular company’s existing closed-end fund’s average annual return was 65% less than the relevant municipal bond index over the past ten years. Again I ask, how can anyone who does due diligence for their clients recommend a product like this?
2. Requiring all financial advisors to be fiduciaries would completely eliminate these types of products (or at least the current selling terms associated with them)
My second realization was that if the SEC and FINRA ever decide to require everyone giving financial advice to be held to a fiduciary standard, much of the products that are on the market today (including mutual funds, pre-packaged 401k plans, and closed-end funds) are going to have a hard time remaining in existence. While that is a good thing, we have to be realistic. Companies earning billions of dollars in fees aren’t going down without a fight.
For those brokers who are reading this, I understand that you are sensitive to these issues. Maybe you strive to operate as a fiduciary at all times (even if your firm won't acknowledge as such) so this doesn’t apply. I was in your shoes five years ago and didn’t like people telling me that even just a little part of my business could be considered unethical or not in the best interest of my clients. I spent time thinking about these issues before I left Merrill Lynch and was convicted that operating as a fiduciary was always the right thing to do even if it meant I had to strike out on my own.