Monday, June 28, 2010

INVESTOR RISK: SKIM NOT SCAM!



SKIM: Skimmed milk refers to milk which has had the rich cream taken off the top, leaving a less rich milk product. For our purposes skimming refers to removing a hidden fee from a mutual fund portfolio prior to valuing the portfolio for an investor. It also leaves a less rich portfolio for investors.

The media and casual investors intently follow the stories of investment scams and how they devastate the lives of investors and their families. It is understandable of course: a good human interest angle will definitely get the attention of readers!
In fact, the damage done by investment scams and frauds is very minor compared to the damage done within the standard “rules of engagement” between investors and investment firms. F.A.I.R. Canada has reported that as little as 2% of the dollars lost in major frauds over the past decade in Canada involved a regulated investment firm. In short the odds of being “scammed” in a recognized mutual fund are near zero. The odds on having your investments “skimmed” however are close to 100%!

THE SKIM: As an investor you put money into a fund to gain diversification and professional management. Those are worthy goals and the fund industry is fully capable of delivering on both fronts. The issue that leads to the skim is putting a value on the services you want. In effect the industry has clouded the process on two key fronts by:

- Adding mandatory “advice charges” to many mutual funds, most often through hidden and excessive sales fees being mislabelled as an advice fee.

- Portraying licensed fund sales persons as “Financial Planners”, “Advisors” or some form of Vice President/Director. These titles imply an advice or planning offering often not available.

The net effect, for most investors, is a steady skimming of your investment portfolio in return for little or no advice or planning services. In fact, there is no requirement for a fund salesperson (your planner or advisor based upon their job title) to even talk with an investor in order to justify the skimmed fees for “advice”.
You can, in effect, be charged fees for an unlimited number of years without even knowing who your current advisor/salesperson is! Your salesperson could sell their clients to other salespeople and the advice fee continues to be skimmed annually and forwarded to the new “advisor” you have often never even met.

WHAT IS MISSING: At its most basic level, what is missing is the quality professional advice and planning most clients need but cannot identify or articulate without having experienced it. Basics such as a detailed financial plan, an annual review of the Investment Policy Statement, disclosure of material information on changes made in fund management, an assessment of client need versus risk etc.
All of these would require a salesperson to spend time before a client meeting doing preparation, time in a meeting reviewing client requirements and current finances, and post meeting time to implement any required changes. If a salesperson spent 3 hours per client per year doing a proper review then the fee likely could be earned.
Does it happen? No it does not. How do I know? I worked for a major bank with a large financial planning team. The bank would never allow sufficient time to do even a basic annual review. We always had literally thousands of uncompleted reviews and no prospect of ever getting caught up.
Why? Take even 250 clients times three hours and you have 750 hours of review work. That is roughly 100 days of work per year. So, the salesperson gets the fee if they do not do the work and they get the same fee if they do complete the work. How many salespeople do you think will opt to do the work? What if you have 300 or 400 clients? The system clearly cannot work as it is structured.

WHY JOIN ORGANIZED CRIME WHEN YOU CAN GET RICH USING LEGAL SKIMMING TECHNIQUES?

As an ex-banker I was always amazed that bank robbers would risk up to ten years in jail to rob a bank for $300 (average take from a bank robbery these days is quite low) when instead passing bad cheques/cheque fraud could earn you thousands with virtually no risk of jail time. Only a dummy robs a bank using a mask and a gun these days.

Similarly, I cannot understand why fraudsters would go through the hard work and stress of scamming investors (false documents, false statements, a risky paper trail, high risk of being exposed and charged with a crime), when you can legally “skim” investment accounts with fees that add no apparent value and are not required to be disclosed to investors.

What Does Add Up:
Investors pay a number of innocuous sounding fees either directly or indirectly from their investment accounts. Most investors work on a basis of trust and have no clue what dollar amount they are paying nor what they should be receiving for those fees. This is the environment that makes the skim possible and lucrative.
The average planner/salesperson may have a portfolio under administration of $20 million dollars. At a mere 0.5% skim the portfolio is diminished by $100,000.00 per year. Many trailer fees are as high as 1% which translates to $200,000.00 being taken every year from client accounts. There is no accountability that would require any work to be done by the salesperson. The money is skimmed by the fund firms and forwarded directly to the salesperson's firm.
Many salespeople lock clients into the fund via a deferred sales penalty program for up to seven years. In the simple example given, with a 0.5% trailer fee, the total money skimmed by the average salesperson over that sales cycle will be $700,000.00. Now picture a firm with 1,000 salespeople on staff. I think it becomes clear why fund sales are such a lucrative business and why your salesperson can drive a nicer car than you can.

For those who say, well the salespeople have to eat too I will remind you of two things:

1- Front end loaded fees: Salespeople often receive 5% of the invested funds up front from the fund firm. On a $20,000,000 portfolio that is $1 million dollars. The commission is split amongst the 600 or so client accounts of the salesperson and is again a hidden charge. (Investor Economics data suggests the average portfolio for a salesperson in the advice business is just over $20 million)

2- With the skimmed fees we are talking about a forced, concealed payment for a service that is often neither articulated nor delivered to the client.

BEATING THE SKIM: We do not have to be skimmed as fund investors. You have several options to help fix the problem.

1- Set clear expectations with your salesperson for what you expect for the fees you pay.

a. Communication should include monthly updates, and semi-annual conversations as well as at least one face to face meeting every year.

b. Investment information should include an estimate and explanation of all fees paid from your account , performance results versus a set benchmark, and current versus targeted asset allocations.

c. Planning information should include a review of your financial situation, income, expenses, and liquidity needs going forward.



2- Ensure that your salesperson has the capacity to handle your account effectively. A salesperson with 100 clients is more likely to have the capacity for a review than a salesperson with 600 accounts. Ask about support staff but remember support staff is to aid with internal paperwork not to handle client reviews.

3- Purchase low cost mutual funds and you will not have as many worries about skimming. You can purchase funds without embedded advice fees from a number of fund firms and can purchase ETF funds without embedded advice fees as well. Ditching your advisor/salesperson does not ensure you avoid the skim as discount brokers often take the skimmed fees that normally went to the salesperson. That is of course the height of skimming as discount firms are not even licensed to provide any advice to investors.

It is not easy to be a wise investor when the market is such a deceptive place. It truly is a “buyer beware” experience and not a safe place for those who tend to trust without verifying.




sois mike

1 comment:

Iris said...

This is fantastic!