The latest thinking from Greenspring Advisors.

More Conflicts At Big Brokerage Firms

J. Patrick Collins Jr., CFP®, EA

Did you ever wonder how a financial advisor makes their investment recommendations?  There are thousands of mutual funds on the market today.  How does he/she pick one over the other?  If your advisor works for a big brokerage firm like Morgan Stanley or Merrill Lynch, some of the decision making is taken out of his/her hands.  There is a little known practice that happens in which funds pay for "shelf space".  In order for a fund to be offered on a large brokerage firm's platform, they must pay hefty fees.  Some fund companies are happy to do this in order to gain distribution, while others refuse.  Here is Jason Zweig of the WSJ discussing some of the nuances:

The financial industry calls these fees “payment for shelf space,” and they can add up. At Edward Jones, revenue-sharing fees from fund companies topped $153 million in 2014, or just under 20% of the the St. Louis-based brokerage and advisory firm’s total net income that year.

At Merrill Lynch, fund companies pay up to 0.25% of sales and 0.10% of assets annually for “marketing services and support,” according to a 2015 disclosure. Morgan Stanley collects $750,000 per year from each of 28 fund companies it has designated “global partners” and $350,000 annually from each of another 11 “emerging partners,” according to the firm’s latest available disclosure.

The disclosure statements warn that revenue sharing can be an ethical minefield. Edward Jones says the payments create “an additional financial incentive and financial benefit” to the firm and its advisers. Merrill Lynch points out that funds that don’t enter into such arrangements “are generally not offered to clients.” Morgan Stanley says the firm may “promote and recommend” funds that pay higher revenue sharing.

Do you think there is a conflict here?  You bet.  Let me give you a real life example.  Before I founded Greenspring, I was employed by one of these large institutions.  After doing some of my own research I found a fantastic real estate fund that I thought would make sense to own in client portfolios.  But since this fund company was not willing to pay a portion of their revenue to my firm I was not able to offer it to clients.  As an advisor, when you can't recommend products that are in your client's best interest, there is a conflict.  One other thing you have to realize…the only way for the economics on this type of arrangement to work is by using high fee funds.  If you are offering your products on Merrill Lynch's platform, you can't pay Merrill Lynch 0.35% in the first year if your expense ratio is 0.2%.  Why do you think you can't buy a Vanguard mutual fund at these firms (which by the way is probably one of the best fund companies on the planet)?  Because Vanguard only charges 0.1%-0.2% for many of their fund expenses.  They don't charge enough to share fees.

Many investors think that a fee-based relationship is the same whether it is at Merrill Lynch, Morgan Stanley or an independent firm.  It's not.  While you may be paying similar fees to your advisor in each of these scenarios, what you don't see is that independent firms don't charge for shelf space, and therefore are free to recommend any product they think is best for their client.  The big firms only recommend funds that have paid them for shelf space.  This can have a major impact on fund selection and portfolio performance.