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The Dangers in Up-front Commissions
As an investment intermediary, we have long been critics of the payment of up-front commissions by product providers to brokers or intermediaries in the Irish marketplace. We believe it encourages the selling of financial and investment products rather than the provision of impartial advice, which is what the consumer is clearly entitled to. This article explains why we believe that up-front commissions act against the customers best interests and why such commissions continue to distort the market in financial and investment advice.
The UK banned up-front commissions six years ago. Despite the considerable body of evidence over the years that up-front commissions lie at the heart of every investment scandal, the Irish Regulator continues to allow up-front commissions in Ireland. As advisors, we do not receive up-front commissions or exit fees from any product provider and in the main we use the Davy Select platform for our investment clients and here are the reasons for that:
- For the client there is a transparent annual management fee of 1.0%. That fee is split 0.4% to the platform, Davy Select, and 0.6% to GillenMarkets, the advisor.
- There is no VAT on that fee, no up-front costs/commissions and no exit costs (or redemption penalties).
- There are no trading costs i.e. it costs our clients nothing when we make changes to their portfolio. This point is significant as it ensures there is no incentive to make changes in a client's portfolio, so that changes are only made if we deem them in the client's best interest.
- We can select stocks, exchange-traded funds and investment trusts listed and traded on global stock markets and the platform also provides us with access to most of the investment funds available from leading global fund managers.
In our view, it's the best overall solution for our investment clients and explains why we tend not to use the life company offerings. If our offering sounds attractive to you then contact us for a chat. We have a minimum investment amount of €0.5 million but we can also deal with you if you are likely to get there within a reasonable period of time. We understand that our offering doesn't accommodate everyone but we are a boutique operator providing a customised professional investment service.
Up-front commissions incentivise selling. Unlike car insurance or household insurance, however, approaching investment advice by providing an incentive to sell is simply not in the consumers best interest. This is why we disagree with the Irish Regulator's current stance. We hope the Regulator changes its position in time and without too much delay.
It is also our view that allowing up-front commissions is distorting the marketplace for investment advisors to the benefit of life companies, the banks, other product providers and brokers that accept up-front commissions. First off, up-front commissions paid to intermediaries for selling a product are ultimately paid for by the client. This cost can be levied up-front in some cases or in other cases it is recouped in the form of higher annual management charges within the fund and/or exit penalties imposed on clients if they wish to redeem their investment.
In our view, this is a significant impediment for clients wishing to change investment products or indeed change advisors. In addition, the landscape for the delivery of investment solutions has changed significantly, but platforms that provide no up-front commissions to the advisor are at a distinct disadvantage in terms of attracting investment flows from the broker/intermediary market.
Let's now have a look at two investment products that, in our view, are not in the consumers best interest and probably would not exist if up-front commissions did not exist. The first is guaranteed investment products and the second is absolute return funds. To understand why these products are not really in the consumer's best interest we need to go back to investment basics.
The economy is generally in one of four states; prosperity, recession, inflation or deflation. Three of those states represents risk. The original four asset classes allow an investor to benefit from prosperity while also covering the three major economic risks. Those four asset classes are equities (and equities include property), bank deposits (cash), inflation-linked government bonds and fixed income government bonds.
Prosperity has been the norm in the developed world and so long as democracy is the order of the day and the government is pro-business then economic growth should continue to be the norm going forward. Equities (which include property) benefit directly from an improving economy. Bank deposits are handy in the early stages of economic recession when central bank-driven short-term interest rates are normally rising to cool an overheating economy. So, an investor who wants to mitigate the risks of recession might place a proportion of her savings in bank deposits.
If she wants to cover the risks of inflation, she should invest a portion of her savings in an asset that mitigates the risks of inflation - such as an inflation-linked government bond where the government guarantees her a return that is adjusted for inflation plus her capital back. And then there is the dreaded economic risk of deflation as represented by a structural and prolonged contraction in economic activity most probably resulting in severe declines in equity and property prices over an extended period. Fixed income government bonds offset this risk. The investor will get a guaranteed income over a set timeline irrespective of the prevailing economic conditions and a guarantee of her money back when the bond matures.
A teflon-like investment portfolio might be invested 25% equities, 25% bank deposits, 25% inflation-linked government bonds and 25% fixed income government bonds as such a portfolio allows the investor to benefit from prosperity while also covering the major economic risks. Sound investing is about mitigating the risks, not avoiding them. Over the long-term, equities have generated the best returns and an investor's job is to decide what proportion of her assets should be in risk assets (equities) and what proportion should be in non-risk assets (bank deposits, inflation-linked government bonds and fixed income government bonds).
Of course, these days, returns on bank deposits, inflation-linked government bonds and fixed income government bonds are practically zero. So, mitigating the major economic risks these days means little or no return for a sizeable proportion of a conservative portfolio. So, covering all the risks is a choice for the consumer to make alongside his/her investment advisor (should they employ one).
You can't get blood out of a stone and, today, low risk assets mean low to no returns. No product wrapping can change that. A guaranteed product offers to cover the downside risks. But it does so at considerable cost. There's the product manufacturing costs and the distribution costs (selling costs) and, in our view, they are both considerable and opaque. The alternative to a guaranteed product is our 'teflon' portfolio. If you simply buy assets that mitigate the risks and 75% of your portfolio is invested in risk-mitigating assets (bank deposits, inflation-linked bonds and fixed income bonds), why do you need a third-party to buy you 'insurance'. The answer is you don't. We did a critique of a typical guaranteed product being marketed in Ireland back in June 2017 in a Featured Article titled Avoid Structured Products. Click the link to review that article.
In the case of absolute return funds, they became popular post the Global Financial Crisis as they promised returns comparable to bank deposits plus 4-5% annually and with little volatility and much less downside than general equities. Our research highlights that returns from such funds have not, on average, even matched inflation since 2002 (as the chart highlights). In addition, returns from absolute return funds have not matched our simple 'teflon-like' portfolio outlined above. In our view, the reason why they are failing to deliver is because they are trading the asset classes (speculation) rather than owning the asset classes (investment).
In our view, neither guaranteed funds nor absolute return funds are a real asset class and they look distinctly inferior to some combination of the four traditional asset classes. Our January 2019 Featured Article titled Hedge & Absolute Return Funds is well worth a reading for a more thorough discussion on the merits or otherwise of hedge and absolute return funds.
Yet, these two products proliferate in Ireland either because the up-front commissions encourage their marketing or because brokers don't actually understand the basics. Either way, is it any wonder that the consumer has very little trust in the financial services industry in Ireland?
To finish off, it is our view that it is not enough for the Irish Regulator to insist on greater disclosure of such costs/commissions as it has done in its addendum to the Consumer Protection Code announced in late September last. To truly change behaviour the incentive itself (up-front commissions) should be removed.
If you are invested in such products either personally, through your pension or in a company structure, then come and talk to us. Better alternatives exist in the marketplace and part of an impartial, well-informed advisor's role is to know where they are!
1st November 2019