Using Investment Brokerage Firms Can Lead to Problems You Must Recognize

Some investors prefer to use investment brokerage firms because they believe there is a benefit to doing so. There are many good brokers out there; however, there are a variety of problems that have arisen within Canada’s brokerage industry.

There are longstanding practices that have benefited investment brokerage firms, the brokerage industry and securities salespeople, but they have represented a steady drain on the finances of many investors.

Let’s take a look at some of the problems that stem from the use of brokerage firms.

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Trailer fees and other “embedded” fees can be a problem with investment brokerage firms

Mutual fund buyers pay a yearly fee, or Management Expense Ratio (MER), of perhaps 2.5% of the value of most mutual funds they invest in. One and a half percentage points generally stays with the fund company, to pay for management of the funds, recordkeeping, administration and so on; one percentage point goes to the securities firm where the investor bought the fund, to be shared between the firm and the salesperson. The idea is that this fee goes to pay for continuing advice to the investor. The fund company continues to charge the 1% to the investor, and pay it to the brokerage firm, every year for as long as the investor owns the fund.

This “trailer fee,” as it’s called, is “embedded” in the fund investment. It’s part of the deal when you buy. Various securities commissions have put forward the idea that investors should have to agree separately to pay the yearly fee. After all, paying that extra 1% every year takes a surprisingly big bite out of the growth in your investment. Most investors would only agree to pay this extra 1% if they felt they were getting something for their money.

The brokerage industry likes things as they are. The industry argues that under this system, investors with large fund holdings subsidize the brokerage industry’s cost of providing continuing advice to small fund holders. If the trailer fee becomes optional, numerous fund investors might choose not to pay it. Small investors would then lose their access to continuing advice, according to the industry.

In fact, small investors rarely get meaningful financial advice. They have to fend for themselves. Brokers focus on servicing more prosperous fund investors who may have additional funds to invest.

For that matter, discount brokers also collect the trailer fee, even though they provide little or no advice or service to fund holders.

Some investment brokerage firms stress lower-risk, lower-return, but high-fee structured products for client accounts

These products are created when brokerage underwriting departments take genuinely desirable securities and slice and dice them into what you might call Frankenstein investments. These investments come with special characteristics that make them superficially attractive to investors, yet far more profitable for brokers. A good example is principal protected notes in which returns are tied to a stock market index.

You may not lose much money buying these investments. You may even make a few dollars. But it is certain that these investments will generate big underwriting fees like any new issue, followed by a string of management fees. When the structured investment gets redeemed in five or seven years, or sooner, the broker gets an opportunity to sell the investor something new.

After commissions and other fees come out of these investments, there’s little chance that investors will wind up with a profit to match their risk.

Bonus Tip: Switching to a discount investment brokerage firm has its own risks

Switching to a discount brokerage firm from a full-service broker makes sense for many investors. It’s sure to cut your per-trade commission costs. But low per-trade brokerage commissions are rarely if ever the sole reason for better investment results.

While there may be good reasons to switch to a discount brokerage firm, low commission fees will not help you choose good investments and can often lead to crucial mistakes like selling too soon.

As an aside, finding a good full-service stock broker is hard but not impossible. Some successful investors view their brokers as a valuable source of investment research, information and advice. But they keep in mind that brokers operate under the potential for enormous conflicts of interest. That’s why they carefully assess a broker’s advice before acting on it.

In the long run, the best way to cut commissions is by sticking to high-quality investments and making fewer transactions. If you do that, and diversify across most if not all of the five main economic sectors, and downplay or avoid stocks in the broker/media limelight, you are following our Successful Investor approach—and we feel that’s by far the best way to invest.

If your broker can help you invest successfully in high-quality stocks, and do it consistently, the extra commission cost per trade is probably worth it.

So before you switch to a discount brokerage firm, put yourself through a brutal self-assessment. Are you able to single out a selection of investments that are right for you, keeping investment quality and diversification in mind? If not, you may be better off with a full-service stock broker, provided you can find one who values your business and puts your needs first.

Have you ever worked with an investment brokerage firm and then left because of unfavourable practices? What led you to leave?

Do you invest through a full service investment broker? What do you find is the most valuable aspect of their service?


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