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The Ethical Investor: Wall Street Ripoff #3 - Hiding Fees and Expenses

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Before speaking about hidden fees and expenses, I'd like to take a moment to discuss the magnitude of the fees that Wall Street admits to and discloses for managing your money. There is no reason to delve into the world of hidden fees when stockbrokers, financial advisors and mutual funds admit in their own documents to charging clients as much as 1% to 2% per year for investing their money.

If a financial advisor were able to garner 12% returns on your portfolio you might conclude that it was reasonable to pay him 1 to 2% a year in fees. But if general inflation was 9% for that year, like it was for many years back in the 70s and 80s, that would mean the real return on your portfolio after accounting for inflation was not 12%, but more like 3%. And let's assume of this 3% you had agreed to pay your financial advisor or mutual fund 1 to 2% in stated fees. This means that you are giving away 33% to 66% of your profits to your financial advisor. Certainly extremely generous, if not completely crazy.

In today's world of very low inflation the same calculus applies. Now, financial advisors are reporting 6% gains for your portfolio, but inflation is close to 3% so you're real gain in purchasing power or wealth is only 3%. Again his 1% to 2% fees represent 1/3 to 2/3 of your total annual profits.

In addition to these egregious stated fees, Wall Street has many methods to hide additional fees and charges from you. Many Wall Street brokerages and online brokerages offer what they say are no fee accounts. But when you look at them in more detail, inside the account they offer investment alternatives like high fee mutual funds. Who do you think is paying those mutual fund charges? I can assure you banks do not own some of the largest buildings in town and brokers do not earn their million dollar plus salaries by offering their clients free services.

Even savvy investors who try to track the expense ratios of various mutual funds in an attempt to control costs might be surprised to learn that there are other real costs, not reported in the expense ratio, that they are absorbing. These trading and transaction costs are very real, but are not captured in the expense ratio. And how big might these trading and transaction costs be? They can make a fund 2 to 3 times more costly than advertised in its expense ratio. One study in 2009 found that average trading costs for thousands of US mutual funds was 1.44% of total assets which was in addition to their stated expense ratios.

Brokerage commissions make up a significant percentage of these hidden transaction costs. The SEC requires that the total amount of brokerage commissions paid by a mutual fund be disclosed and expressed in aggregate dollars but often it is not translated into a percentage cost and is not included in the expense ratio.

A much less understood cost of doing business with a traditional broker is the bid/ask spread. When you go to sell IBM stock on a market-based exchange you are not given one price, but rather two prices, one at which the broker is willing to purchase your IBM shares, or the bid, and the other at which he's willing to sell you additional IBM shares, known as the ask. While competition amongst brokers and dealers keeps these bid/ask spreads fairly narrow and thus your costs down, things are quite different for small investors using traditional brokers to implement their trades.

The key to keeping broker/dealers honest when they quote you a bid/ask spread is that the broker/dealer cannot know in advance whether you are a buyer or a seller of shares. If he knew that you are a seller of IBM, he would push the bid/ask spread that he quoted you against you such that you would recognize significantly less in aggregate for the sale of your IBM shares. This is a cost of dealing with a brokerage that few people truly understand.

And this is exactly what happens in a traditional broker/small investor relationship. When you tell your broker that you want to sell a block of IBM shares, he doesn't call his broker/dealer and ask for an unbiased bid/ask spread. Instead, most likely, he tells his broker/dealer that he has a small investor that wants to sell IBM. His broker/dealer, working for the same company, knows to push the bid/ask spread against you and rob you of additional dollars from your IBM share sale.

While bid/ask spreads can be as narrow as .1% in a perfectly functioning market, when the broker/dealer knows what side of the trade you intend to be on, whether you are a buyer or a seller, he can artificially inflate the bid/ask spread three or four-fold.

And that presumes that you have an ongoing relationship with that broker. God forbid you decide to cut these brokers out of your investments. Once brokers and their broker/dealers realize that you are ending a relationship with their brokerage there is no limit to how greedy they can become and how much they can punish you by quoting enormous bid/ask spreads and quoting very low prices for liquidating your portfolio at their firm. I have seen clients of my investment advisory service lose as much as 5% to 7% of their total portfolio value when they ask to leave a brokerage relationship.

We haven't even mentioned the possibility of soft money transaction costs in which brokers put you into funds that are run by friends who end up compensating the brokerage with either free research or increased trading volume. The broker is getting something for free, but you aren't. You are paying the full fees of the broker's friend's fund out of your portfolio's potential profits.

Finally, there is a cost to aggregating everyone's trading of stocks in a big mutual fund. The big mutual fund, when it wants to get out of its IBM stock has such an enormous position to unload that it can literally move the market price against the firm. By being big, the mutual fund creates its own illiquidity which means to sell a big position they net less dollars. It costs more for the firm to get in and out of its big positions than it would you. These costs can be even bigger than the total brokerage commissions the funds pay so is an additional cost to you the investor.

If all this seems unbelievable to you, it really is much worse that I have presented. For you see, modern finance theory has pretty much proven empirically that these brokers and their firms and their research staffs bring little value to you or your investments. As a matter of fact, mutual funds over the long-term have underperformed the stock market by almost exactly the amount they charge in fees and expenses. There is no real value to any of their stock picking, research ideas or trading.

So if you're saving for retirement and have an investment horizon of some 30 years and have agreed to pay your broker 1 ½% to 2 1/2% in stated and hidden fees and expenses, your wealth may not increase, but his definitely will. As a matter of fact, if he takes 1 1/2% per year from your portfolio and it ends up growing simply at the inflation rate, he will end up with more than half your wealth in 30 years. Now you know why bankers can pay themselves millions of dollars in bonuses.

If you think the answer is to just buy and hold a passive low-cost well diversified index fund, you will have to wait for our next installment of The Ethical Investor in which we argue that Wall Street is turning us into passive sheep ready for shearing and they have the clippers ready.

20 Ways Wall Street is Ripping Off Small Investors:

1. Providing nominal returns, not real returns.

2. Encouraging too much diversification, if that's possible.

3. Hiding fees and expenses.

4. Turning you into a passive investor.

5. Convincing you that money markets are the same as cash.

6. Telling you that bonds are safer than equities.

7. Explaining that in the long run equities outperform bonds.

8. Simply by lying about their products.

9. Convincing you that their bank is a large, stable, safe operation to deal with.

10. Recommending products that have enormous sales commissions attached to them.

11. Cheating you on bid/ask spreads.

12. Selling you what they don't want.

13. Measuring your success in dollars.

14. Lending your securities to others.

15. Ripping your eyes out if you ever try to close your account.

16. Grabbing any slight positive real return for themselves.

17. Sticking toxic waste to small investors.

18. Pretending they can pick stocks.

19. Acting like they are your best friend and they have your best interests at heart.

20. Knowing next to nothing about the value of holding real assets like gold and real estate.

John R. Talbott is a bestselling author and financial consultant to families whose books predicted the housing crash, the banking crisis and the global economic collapse. You can read more about his books, the accuracy of his predictions and his financial consulting activities at www.stopthelying.com.

Content concerning financial matters, trading or investments is for informational purposes only and should not be relied upon in making financial, trading or investment decisions.