Dirty Little Secrets – Games Brokers and Financial Advisors Play

Dirty little secretsThere is a popular saying that “knowledge is power.” Nowhere is that truer than in the world of investing. Knowledge allows an investor to be proactive and prevent unnecessary financial loss.

In my experience as a securities compliance director and a securities and wealth preservation attorney. I have seen a lot of “trickeration” strategies used by the financial services industry. In most cases, the “trickeration” strategies are employed to provide more compensation to the financial advisor at the investor’s expense.

Four of the most common deceptive practices used in the industry are:

1. Inverse pricing by variable annuities – This refers to the practice by the variable annuity industry to base their annual fees on the total value of the variable annuity rather than the cost of their legal obligation to the annuity owner, commonly referred to inverse pricing since the fee is not based on the actual potential cost to the variable annuity issuer. Most variable annuities obligate the variable annuity issuer to pay the annuity owner’s heirs the greater of the value of the variable annuity or the owner’s actual contributions.

Given the historical trends of the stock market, it is unlikely that the value of the variable annuity will be less than the owner’s contributions. Consequently, inverse pricing essentially guarantees the variable annuity issuer a substantial windfall at the owner’s expense. Most variable issuers charge an annual fee of 2 percent or more, despite the fact that one well-known study estimated that the actual value of the protection for which the fee is charged is approximately 0.10 percent.

The annual fee charges is even more egregious when one considers that each 1 percent of additional investment fees reduces an investor’s return by approximately 17 percent over a twenty year period. When you add the additional fees for a variable annuity’s sub-accounts, the total fees on variable annuities often exceed 3 percent or more, effectively reducing an investor’s end return by over 50 percent or more. For more issues with variable annuities, read Stuart Berkowitz’s article, “5 Reasons you Should Be Wary of Variable Annuities.

2. “Pseudo” diversification – This refers to the practice of providing investors with investment recommendations among various types of investments, e.g., large cap growth funds, small cap value funds, international funds to make an investor believe that the recommendations will provide them with a diversified investment portfolio. But looks can be misleading.

True diversification provides investors with both upside potential and downside protection against substantial losses.  However, given the high correlation of returns among most equity based investments, the recommendations do not provide the protection provided by diversification at all. In most case, “pseudo” diversification simply provides an investor with an unnecessarily expensive index fund and reduced returns.

3. Relative returns – Also known as the “we’re number 1” scam. Investment ads and advisors like to tout that their product has had the best performance compared to their competitors. This comparative, or “relative,” performance allows an investment company or financial advisor to make such a claim, even though the actual return was lackluster or even negative. This is a common practice after a down year for the stock market, such as the bear markets of 2000-2002 and 2008, when many mutual funds suffered losses of 30 percent or more. The fact that one’s mutual fund suffered a 30 percent loss while another fund suffered a 32 percent is hardly cause for celebration.

4. Actively managed mutual funds – I discussed the equitable fee issue with actively managed mutual funds in a previous article, “Determining the True Value of Actively Managed Mutual Funds.” In short, in most cases the cost of active management significantly exceeds the benefit, if any, of active management, often by 300-400 percent.

To learn more about James Watkins, visit his site at www.investsense.com.

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