When financial advisors first get into the business, we basically agree to run our practice by certain common-sense rules and abide by a demanding code of conduct. But some advisors stray from the rules, and the worst ones make the headlines. That gives the entire industry a bad name, which is unfair, because the vast majority of advisors are hard-working, highly ethical individuals who take their responsibilities as seriously as any other professional. It’s not often easy to spot the bad apples, so in this article, I’ll provide some examples of practices that are frowned upon, unethical, or just plain bad business. If you spot any of these, all your alarm bells should go off.
Churning and the DSC option
There are two main methods of churning – that is, buying and selling securities simply to make a commission. Churning mostly occurs in a stock account where a broker is making countless trades simply to generate commissions. It can also occur with mutual funds, where an advisor recommends purchasing a fund with a deferred sales charge (DSC) when a previous DSC fund has either matured (all units are fee-free) or almost matured.
If a DSC fund has almost matured and has $1,000 left in fees, a favorite play of an unscrupulous advisor is to either let the client eat the $1,000 or rebate it back to them, while he earns $4,000 (for example) on the DSC from the new fund(s), leaving him or her with a tidy profit for simply shuffling the deck.
When advisors make fund switches, it is called “servicing,” and your advisor already gets paid for that. Servicing is part of the job. Locking clients in for a second time at a hefty additional fee is not.
Almost every mutual fund pays financial advisors a “trailer fee” for ongoing management. In the old days everything was done with a big commission upfront, but some disreputable advisors made the big sale and neglected to stay in contact with the client, which is not how financial planning is supposed to work. The trailer fee was created to punish an advisor who doesn’t provide service or gives poor advice to a client who can vote with their wallets (go elsewhere), and this will affect the advisor in the pocketbook.
Most financial advisors attempt to see clients once or twice a year to review their portfolios and make any changes necessary due to changes in the client’s life or fundamental changes in the marketplace.
Stocks should be traded only if the broker or advisor can provide justification as to why the client would be better off making the trade and can back up his or her arguments with facts and figures.
A DSC mutual fund that is almost fee-free or is already fee-free should never be moved back to a DSC fund, because the advisor would then be getting paid twice on the same money. That’s not fair to Mr. Client. If you have had this done to you, or have been asked to do this, first call your advisor’s boss and then make a complaint with a regulatory board or securities commission. These are the Mutual Fund Dealers Association (MFDA) for mutual funds, the Investment Industry Regulatory Association of Canada (IIROC) for stocks, or your provincial securities regulator.
My personal belief is that the DSC option should be used very sparingly. Advisors new to the business might use it in the early years to help get their practice off the ground, but only if the fund first meets the client’s needs. But I have heard of veteran advisors who earn over $300,000 per year and still use the DSC pricing option that can lock a client into a fund company for six or seven years. The DSC option takes away clients’ flexibility, so how can that help the client? My advice is this: If your advisor recommends rolling a maturing DSC fund over into another DSC fund, find another advisor.
Always buy no-load funds (that is, zero front-end commission), so you can always redeem or switch with no fees or worries. Your advisor will earn money for managing your account, but won’t receive a big commission on the fund purchase plus fees for managing your account.
There is a low-load fund purchase option that locks you into the fund company for two to four years. Your advisor earns less commission for a low-load fund (usually 2% compared with 5% for DSC fund), but it’s still best to avoid.
Be very leery of using leverage (borrowing to invest).This can be used in limited circumstances, but this strategy has hurt many investors who don’t get the complete picture of the risks involved. If your advisor recommends a leveraging strategy to you, listen to see if he or she mentions the severe impact that down markets or corrections will have on a leveraged investment. But if all your advisor shows you is a graph of a steady 7% gain every year for a decade, run away quickly, because markets don’t ever do this, let alone for 10 years.
Leverage is a long-term strategy for those who know precisely what they’re getting into. Consider leverage as a strategy only if you first maximize your RRSPs and TFSA every year, don’t owe too much on your mortgage, and have a job where downsizing the workforce isn’t easy to do (nurses, teachers, firefighters, doctors, police officers, to name a few of the “safer” occupations). You can write off the interest servicing costs of your debt for tax purposes, which is a benefit, I suppose, in the same way you can use capital losses to offset capital gains – but that’s not enough of a compelling reason to use an aggressive strategy like leverage.
Remember that although leverage can build assets quickly, it can destroy assets just as fast. If the value of a leveraged asset drops, you could be in the unfortunate situation of paying off a loan on an asset you no longer want, and that may in fact be worth less than your loan. In addition, you can spend a lot of time in the hole, paying interest on your debt as you wait for the value of your asset to recover. And it’s a lot tougher to climb out of a hole than it is to dig it. A $40 stock that drops to $20 has lost 50% of its value. But just to get back to its original $40 value, that $20 stock will have to gain 100%!
Living by the rules
Most advisors live by the rules – not only because it’s the right thing to do, but also because it’s good for business. We get into the business to help our clients reach their financial goals. We aim to fulfill our obligations with integrity and good faith; to know and understand the financial circumstances of our clients and to serve them by meeting their needs; to make suggestions for change in a personal financial program only in the client’s best interests; and so on. I know of no other way to gain and keep clients through the years.
So if you ever think a strategy is unsound or too risky, don’t be afraid to check it out with a reputable and knowledgeable source for a second opinion. After all, it’s your money, and your financial future.
Bruce Loeppky is a financial advisor based in Surrey, B.C., and a regular contributor to the Fund Library. He can be reached at firstname.lastname@example.org.
Notes and Disclaimers
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The foregoing is for general information purposes only and is the opinion of the writer. No guarantee of performance is made or implied. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice. However, please call the author to discuss your particular circumstances.