How the Financial Services Industry Makes Money

The financial services industry – which provides investment products and advice to investors – is very large and a lot of people in the industry earn very nice incomes. The finance industry employees are not usually paid out of investment gains. The revenues for the industry come from the fees, commissions and price spreads paid by investors in one form or another. As a new investor, your understanding of what costs are incurred with specific investments will help you make investment choices in your best interest – not the broker’s or advisor’s – and understand how the cost will affect the potential returns of specific investment choices.

The costs of investing can be broken down into three categories: commissions, spreads, and management fees or expenses. An investment choice or product may have one or all three types of cost associated with it. Every type of investment cost has an effect on the potential return you can earn from the investment.

Commissions

Investment commissions are usually an obvious charge. Online stock brokers readily advertise their low commissions – about $1-$10 per purchase. With an online brokerage account it is important to understand all of the fees and commission levels charged by the broker. The low advertised commission rate usually only applies to trades made online. If you need a broker’s help via phone to complete a trade, that commission will jump to $40 to $50, depending on the broker’s commission schedule. You must also remember that a stock commission is charged when you buy stock and again when you sell. The online brokerage companies encourage active stock trading. This encouragement is to generate more commission revenue for the broker and heavy trading is almost always not in the best interest of the typical investor. Therefore, a stock broker’s interests and a personal investor’s interests conflict. Never take advise from your broker.

Mutual funds sold by brokers or investment advisors also have a commission structure, usually referred to as the load. Mutual fund loads are charged on the front end of a purchase and typically range from 2 to 5 percent of the amount invested (if there is one). An investment advisor earns a portion of the load as his commission for selling the fund. The load is charged in the price paid for each mutual fund share. For example, if a fund’s current share value – called the net asset value or NAV – is $10 and the fund has a 5 percent load, shares will cost $10.50 to purchase. The load percentage for a mutual fund is disclosed in the fund’s prospectus and should be disclosed and explained by the investment advisor selling the mutual fund.

One type of fund shares – usually referred to as Class B or back-end loaded shares – do not charge an up front load, but instead have a decreasing surrender fee over a period of 5 to 8 years. In almost all circumstances, Class B shares are a worse deal for investors than the front loaded shares of the same fund. Many fund companies have stopped offering back-end loaded shares. Furthermore, given the large range of options that don’t charge a load on the front or the back end, you should almost certainly never have to pay a load.

Spreads

Almost every type of investment security or product has a price spread. The spread is the difference between where a market participant has indicated a willingness to buy and the price where someone has indicated a price to sell. These prices are referred to as the bid and ask prices. The spread may be as little as one or two cents on actively traded stocks and ETFs. On other products spreads can be much wider, reach levels of 10 to 25 percent or more of the security’s value. Investments which typically have significant spreads include stocks traded over-the-counter, including penny stocks and market listed stock options. The problem with spreads is that you must first earn back the spread before an investment becomes profitable. As an extreme example – but it could occur – you buy 10,000 shares of a penny stock with a bid of 10 cents, costing you $1,000 plus commissions. If that penny stock has a 5 cent bid-ask spread, the stock must go up by more than 50 percent before you earn a profit. The financial institutions which make the markets in these securities earn huge amounts of money from selling at the bid and buying at the ask prices. No-load mutual funds are one product type without any spread. Shares are bought and sold at the same price, set once each day.

Bonds are another investment type which use spread pricing. A brokerage company may advertise zero commissions for bond investing, but will not disclose the spread the company earns on bonds. Bonds from municipal and corporate issuers have a tremendous range of quality and yields. An individual investor has little resources to determine a fair value for one of these bonds — leaving the door open for a broker to put significant markup into the price of a sold bond or make a low bid offer for a bond an investor wants to sell.

Management and Expense Fees

The companies which promote and manage mutual funds and exchange traded funds earn their money from management fees charged against a fund’s assets. Expenses incurred to run a fund such customer service costs are also charged to a fund’s assets. All of the fees and expenses charged against a fund’s assets are published as the fund’s total expense ratio. Expense ratios range from about 0.10% – 1/10th of one percent – to 2% or more. The ratio is an annual cost, so the expense ratio is the amount by which the expenses of the fund reduce the performance of the portfolio over the course of the year.

The Investment Company Institute publishes a Fact Book each year which includes data on expense ratios. In 2010, the average expense ratio paid by shareholders was 0.84%. In my opinion, you don’t ever need to be close to that average fee level because you can get good index funds with Vanguard with expense ratios between 0.05% and 0.30%

Actively managed funds have investment managers who choose which investments to buy and sell based on the fund’s investment objectives. Index funds hold securities to match a specific stock or bond index. Index funds have much lower expense ratios than actively managed funds. An investor who chooses an actively managed fund must be aware of the higher expenses and have an expectation the fund manager can provide an additional level of performance when compared to a similar, passively managed index fund. Unfortunately, the facts point to almost all fund managers being unable to provide enough of an advantage to make up for the increase in fees.

Wrap accounts are services offered by investment firms and advisors. With a wrap account, you pay no commissions. Instead, the investment firm charges an annual fee based on a percentage of the amount of money you have invested. Wrap account fees are usually one percent and up – depending on the investment amount – and those fees stack on top of the fund expenses of the mutual funds usually used in a wrap account. Going the wrap account path with an advisor may avoid the up front load of load funds, but total costs over a several year period of time should compared.

Final Thoughts

Now that you understand the different ways the financial industry can grab a portion of your investment money, you should be able to compare the real cost of different investment alternatives. For every idea promoted by the financial services community, there is usually a lower cost way to get the same investment results. Low cost investment options include no-load, low expense mutual funds – especially index funds – and buy-and-hold stock investing. For the majority of investors it is better to invest in bonds through a low cost fund than to buy individual bonds.

If a broker pushes a product which is not publicly traded where you can look up the price and commissions and expenses are not disclosed, do not invest. That product is designed to make more money for the investment firm, not the investor.

I recommend just finding a few simple Vanguard index funds and investing in those for really low expenses with really low maintenance. For more details on what I think your best investing options are go here.