Broker Logic 101

09/23/2007 08:45 pm ET | Updated May 25, 2011

I am mystified by investors who use brokers. Maybe there are "good" brokers who focus on asset allocation, know how to measure risk and recommend low cost index funds to their clients. I have never come across one.

Their ability to justify padding their pockets at the expense of their clients never ceases to amaze me. Let me give you one glaring example.

Most actively managed funds sold by brokers have different classes of shares. Typically, they consist of A, B and C shares.

One academic study demonstrated that at no investment amount, and no holding period, did B shares make sense for the investor.

So why would a broker recommend B shares? Because they get fatter commissions for selling them.

For short term investments, C shares are the best option. However, why anyone would invest in a mutual fund for a short term is beyond me.

For everyone else, A shares are the least costly option.

Recently, I caught a broker with his hand in the till. He had placed a client primarily in C shares. This is a great deal for the broker because the longer these shares are held, the greater the broker's commission. In the trade, this is known as "annuitizing" an account. It gives the broker an "annuity" of an annual fee.

When the client brought this to the attention of the broker, his explanation was a great example of "broker logic 101."

He said he carefully "monitors" mutual fund investments and C shares give him the "flexibility" to move from a fund that is "likely" to underperform into a better performing fund.

Aha. Now I understand. Brilliant! He must be very skilled.

Unfortunately, there is no data indicating that anyone has the ability to predict who is "likely" to become a hot fund manager.

In one study, only about 14% of the top 100 fund managers in one year repeated their top 100 performance in the second year.

Another study of the performance of mutual funds for a ten year period ending in 2001, found the average returns of these funds was 12.4% a year. During the same time period, the S & P 500 Index returned 12.9%.

After reviewing this data, Jonathan Clements, the highly respected financial journalist at The Wall Street Journal concluded that "reams of statistics prove that most of the fund industry's stock pickers fail to beat the market."

Don't be fooled. If you are holding B or C shares, your broker has probably placed his or her financial interest above yours.

Of course, there is no valid reason for buying any actively managed mutual fund.

For that matter, investors would be far better off if they did not use any broker or financial advisor who claims to be able to "beat the markets."

But that is another story.

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein.