The Investment Advice Business: Stockbrokers, Mutual Funds, Financial Planners and Investment Advisors

 Stock Brokers 

Traditionally, small individual investors have used stock brokers.  Stock brokers generally work for large investment bank/brokerages like Morgan Stanley, Goldman Sachs and Merrill Lynch.  Stockbrokers generally pitch stocks recommended by their research departments and mutual funds, frequently their own.  They make money through commissions which vary depending on what product they sell you.

Stockbrokers’ reliance on commissions leads to conflicts of interest.  The stockbroker’s incentive is to sell you the product on which he gets the largest commission not necessarily the one that is the best investment for you.

Let me give you an example from my own personal experience.  When I was a senior in college I worked as an intern to a stockbroker at Morgan Stanley.  At the time Morgan Stanley was coming out with a new mutual fund called the Next Generation Trust.  The strategy was to invest in those companies selling products to teenagers since the purchasing power of teenagers was increasing rapidly.  Sounds like a reasonable idea.

The problem was that this fund had close to a 5% front load.  That means that 5% of your investment was taken out immediately.  Some of this money went to the managers of the mutual fund and to cover the expenses involved in running it. 

But a large part of it went to the stockbrokers and investment advisors who sold the fund.  Morgan Stanley was especially keen on selling their new fund and so they provided a large commission, taken from your front load, to their brokers who sold it.  The broker that I worked for had me call a bunch of contacts and recommend the fund to them.

Mutual Funds

This conflict of interests was one of the reasons for the increasing popularity of mutual funds, especially in the 1980s and 1990s.  Many mutual funds are “no-load” funds – though many are not.  They make money by charging management fees, almost always a percentage of the assets under management.

However, there are a number of problems with mutual funds. 

The first problem is that they are too big.  As a mutual fund becomes larger the universe of stocks it can select from becomes smaller.  For example, the famous Fidelity Magellan fund now has about $51 billion under management.  One of my favorite stocks currently has a market cap of around $700 million. 

For this stock to have any meaningful impact on the Magellan fund’s return it would practically have to buy the entire company!  Even then, doing so would be impossible because buying shares in such large quantities would push up the price.  Similarly, when the fund wanted to exit the position, selling such large quantities would push down the price.  Large mutual funds are therefore limited in the stocks they can pick from, hindering their flexibility and ultimately their performance.

Second, because they are so big, and out of a misguided desire for diversification, mutual funds tend to own too many companies.  Most of the big mutual funds own more than 100 companies in their portfolios.  The problem with this is that it minimizes the impact a great pick can have on overall investment returns.  If a stock doubles but only makes up .5% of the portfolio, that translates into a barely noticeable .5% increase for the total portfolio. 

A better approach is to concentrate your investments in your very best ideas.  You can achieve diversification with 20-30 stocks from different industries and geographic locations without diluting the impact of great picks.  Of course, the massive amounts of money many mutual funds have under management make it hard for them to invest it all in so few companies. 

Third, mutual funds get paid based on the amount of assets they have under management, not on how they perform with those assets.  The incentive is to gather as many assets under management as possible and not necessarily to perform best with those assets.

Fourth, mutual funds are unable to give the personal attention many individual investors desire – this is one advantage of stockbrokers.  When you invest in a mutual fund you are limited to reading its quarterly and annual reports and speaking with customer service representatives who don’t really understand what the fund managers are doing.

Financial Planners and Investment Advisors

One way to combine the benefits and eliminate the disadvantages of stockbrokers and mutual funds is to go with a local financial planner or investment advisor.  Many financial planners work on an hourly plus assets under management model thus avoiding the commission conflict you get with stockbrokers.  You also get the personal attention and smaller size you don’t with large mutual funds.

But there are problems with financial planners and investment advisors as well.  Many of these financial planners are, to be frank, not especially competent investors.  They lazily invest your money in the big mutual funds , incurring the above mentioned size problem plus tacking their own assets under management fee on top of that already charged by the mutual fund.

In addition, like mutual funds, because these financial planners get paid based on assets under management their incentive is to gather as many assets under management as possible and not necessarily to perform best with those assets.

Top Gun Financial Planning

That’s why Top Gun Financial Planning is your best choice.  I have spent years honing my investment philosophy and I am constantly searching for and analyzing new investment possibilities.

I generally invest 60-70% of your money in individual stocks I personally favor.  These individual stock investments avoid the management fees charged by mutual funds.  Because I use Scottrade, you pay only $7 per trade.  

In addition, because of the relatively small amount of money I have under management I am not limited in the universe of stocks from which I select.  I can pick the big stocks held by the large mutual funds.  And I can buy smaller cap stocks that the large mutual funds are unable to.

I selectively use mutual funds for sector investing in areas in which the managers’ expertise exceeds my own.  However, I generally avoid the big mutual fund companies such as Fidelity and Vanguard that tend to buy the same big, well known stocks.  Instead, I use boutique fund companies that specialize in a certain kind of investing, such as value or a specific geographic area, and have a few billion dollars per fund at most.

Performance Based Fee Models*

I also work on a performance based fee model where legal.  This fee model means that I don’t get paid unless I make you money and keep making you money. 

I abide by what is known as a “high water mark” provision for performance based accounts meaning that I only charge performance fees when a current quarter’s ending balance exceeds the highest ending balance for any previous quarter or the initial investment, whichever is higher.  For instance, if in the first year I increase your account balance from $3 million to $5 million but then lose $500,000 in the following quarter, you won’t pay a performance fee again until I end a quarter above $5 million.

Compare Top Gun’s performance based fee model with a traditional financial planner’s assets under management fee model.  Consider a client with $2 million under management.  Assume both Top Gun and the traditional financial planner lose 10% the first year.  The traditional financial planner will charge, say, 1% of assets under management at the end of the year, or $19,000 (1% of $1.9 million).  Top Gun, by contrast, won’t charge you a cent.

Now assume that both Top Gun and the traditional financial planner have a flat year and end with the $2 million under management that they started with.  The traditional financial planner will charge 1% of assets under management, or $20,000.  Top Gun won’t charge you a cent.

Continuing with our example, assume both Top Gun and the traditional financial planner return you 9% during the year and your account ends with a $2,180,000 balance.  The traditional financial planner will charge 1% of assets under management, or $21,800.  Top Gun will charge 12% of the profits, or $21,600 (12% * $180,000).

This fee model aligns my interests with yours.  I have a strong interest in preserving your capital because of the “high water mark” provision.  If I lose money, I won’t be able to charge a performance fee until I’ve first earned it all back.  Some financial planners will tell you that a performance based fee model is a bad idea because it causes money managers to take excessive risks.  But the “high water mark” provision ensures that this isn’t the case.

Second, I can’t make money simply by gathering a lot of assets under management like a traditional financial planner.  I actually have to perform with your money to make money.  Think about it: are you hiring somebody just to watch over your money or to make it work as hard as it can for you?

* Performance based fee models are generally illegal for accounts under $1 million.

Greg Feirman
Founder and CEO, Top Gun Financial Planning

Call Top Gun today at 916-224-0113 to set up a free initial consultation.