The Tricky World of Broker Commissions

Mutual funds typically do not disclose much information about commissions, yet brokers make a commission on every transaction. One significant problem with commissions is the perverse incentive it creates for advisors who only make money based on transactions to recommend a transaction even if the more prudent course is to do nothing. Equally problematic is the incentive for advisors to upsell products, thereby generating the higher-paying commissions.

To learn about commissions (and some hidden fees), be certain to request a Statement of Additional Information, which mutual funds are required to provide free of charge upon request.

Some disclosures in the Statement of Additional Information will likely come as a surprise. For example, some mutual funds have “soft dollar arrangements” that enables the fund to pay for research costs through the commissions it pays to its broker. By moving research costs to commissions, the fund manager gets to keep a larger portion of the management fee while making the fund’s expenses appear lower.

In 2004, the Wall Street Journal commissioned a study that found that brokerage commissions “can more than double the cost of owning fund shares.” One thing to keep in mind is that fees are not waived or reduced if your account performs poorly. Rather, fees and commissions can compound your losses. If your fees and commissions total 4%, you must earn 4% just to break even – and that’s before accounting for inflation! So, if your money earned a return of 6% in 2014, but your fees totaled 4%, you’d have a net gain of 2%, beating inflation by only 0.4% (and underperforming the S&P 500 by 9.5%). And that’s before those gains are taxed.

Little by little, fees and commissions—whether disclosed or hidden—chip away at that bottom line and can even turn what appears to be a profit into a loss. That doesn’t mean all mutual funds are bad—it just means you have to be savvy when choosing one.