Financial Fortress Radio 4-11-10 Secrets of the Smart Investor
Patrick: Welcome to Financial Fortress. This is your host Patrick Dougher. Richard, we have a great show in front of us. I know that some of the things that you want to talk about to share how the smart investors really, not just make money, but they actually will retain their wealth and carry it through the other generations.
I know you came up with some stuff this week in one of the articles you were reading on a man from Duke, a Professor from Duke. So, tell me about that.
Richard: Sure. Let me tell you a little bit about Professor Dan Ariely. He’s a psychology and behavioral economics professor with 30 years’ experience; recently wrote a book called Predictably Irrational talking about how investors are far less rational than all standard economic theory assumes.
In other words, economic theory assumes that the market is efficient and we all know it isn’t. That’s why we have such rapid volatile rises and declines in this market without warning. And not just self investors are irrational, everybody assumes that.
We all know of a lot of people that have put money on the market themselves, tried to manage it themselves after being frustrated with their brokers, and lost a lot of money and didn’t want to admit it.
In fact, over 90% of the self-investors lose money consistently in the market and don’t even meet the stock market index returns.
Patrick: I understand.
Richard: The surprising thing though is that the fund managers, the guys that run the big funds – not just the hedge funds – but the big mutual funds and pension funds, as well as the stock brokers, routinely make irrational decisions.
Patrick: I wouldn’t think that that would be the case in New York or any investment because these are sophisticated investors, aren’t they?
Richard: Absolutely. And they have some of the best degrees from some of the best schools in the country. But, what he found from his research is that most people that handle large funds have so much money at stake that they actually become a cause of these financial meltdowns that we’re seeing more and more frequently in the markets. And why? Dishonesty? No. Incompetence? No. Conflict of interest? Yes.
Patrick: Now, how is it a conflict of interest?
Richard: Well, if you knew you could make tens of millions of dollars more a year simply by viewing a financial product, let’s say a subprime mortgage portfolio or something more complex like credit default swaps as something good when, in fact, maybe too complex to really be understood or it may not even be good at all. Odds are, you will be persuaded to go ahead and make that recommendation.
Patrick: So, everything is based on greed.
Richard: Unfortunately, it’s human nature. And he did a little research on greed. It’s kind of funny how it works. He started out with experiments with community refrigerators that students had access to and he would put a case of Coke in there and just see how long it took for it to disappear even though it was marked “do not take this Coke.”
Patrick: But it was a community refrigerator?
Richard: Sure, everybody had access to it. It was a common break room. You’ve probably seeing those kind of refrigerators.
Patrick: At the college.
Richard: Right.
Patrick: Okay. So, how long do they last?
Richard: Well, typically, a day whether it was 6 of them in there or 24. It didn’t matter. They pretty much disappear in a day. So, the next experiment, he took an equal number of dollar bills and laid them out on plates in the refrigerator. What do you think happened?
Patrick: I would think those would be picked up pretty quick, personally. I just think college kids; that’s lunch money sitting in the fridge.
Richard: Sure. So, the answer was none of the cash disappeared.
Patrick: Okay, that’s a disconnect.
Richard: Isn’t that something? So, the real reason for that is he thinks that we are taught not to steal and we recognize cash is something of value. But, when it comes to complicated financial documents and prospectuses that are 100 pages long that nobody really wants to read anyway, guess what? I don’t really want to read that thing. Somebody I trust told me it’s good. So, I’ve got a lot of money riding on this being good. I don’t really want to find out if it’s not good, so I think I’m going to recommend it.
Patrick: Okay. So, what you’re saying is they get a lot of emotional investment in that particular vehicle, a lot of emotional investment into that investment and they don’t want to give up. They just dive in because they’re scared not to take it.
Richard: They just don’t want to believe it could possibly be bad.
Patrick: So, they’re persuaded that it’s good no matter what.
Richard: They will take the advice of someone they trust, just like you take the advice of someone you trust. When you trust your broker who has large commissions at stake to make a recommendation on where to put your money; which stock, which bond, which mutual fund, which variable annuity, how can you be sure they’re making that recommendation with your interest only at heart?
Patrick: Well, one of the things I’m curious about just didn’t make sure that the audience understands the difference in the terminology, broker versus the other category I know is the Registered Investment Advisor. There’s a huge difference in the definition. Can you go over that again?
Richard: Certainly. So, a broker is a salesperson. They’re compensated for selling brokerage products with commissions from the brokerage house. Their primary duty is to generate the maximum commissions for the brokerage house and themselves, and their only duty to their client is to pick up product that is suitable. Well, “suitable” is kind of a vague term; very vague.
The wealthy people back in the 30s decided they didn’t want to have anything to do with brokers. So, Congress came up with a new category of advisor for them called the Registered Investment Advisor.
And the difference is a Registered Investment Advisor has a fiduciary duty to the client first and foremost. So, he has to take the client’s interest at heart first and foremost, and that’s the big difference.
And the scary part is 95% of the Registered Investment Advisors also carry a Series 6 and Series 7 license. They’re also a broker. And what that means is they operate every day under a conflict of interest in all these large firms out there, and medium-sized firms, and even small firms.
So, if your advisor is carrying a 6 and a 7 license, the only reason they carry those licenses is to collect a commission which means they have a conflict of interest. I highly recommend you read Professor Dan Ariely’s book about conflicts of interest.
Patrick: Very good. One of the things that I know a lot of people may want to do is join the conversation and to call in to speak to Richard. It’s 972-299-5759 if you’re in the local area. If you’re outside the area, you want to use the 800 number. It’s 866-660-KSKY on your phone.
And just join the conversation. Call us. Talk to Richard about well, is your broker, if you have one, doing you right? That’s a real key. A lot of people do not see that there is a huge difference in credibility to a great degree when you’ve got a conflict of interest there.
Richard: And not just credibility, but accountability. Don’t you want to be able to have an advisor that you can hold accountable? That’s the big difference. And if you want to find out more, we’re holding a seminar April 27th at Brookhaven Country Club at 6:30 at night. It will include a dinner if you’re interested in dinner. Hopefully, you’re just interested in investment information.
But, if you can’t make it there before you get to dinner, come on by. We’ll feed you, 972-325-1700. The seminar will be April 27th on a Tuesday and the following Tuesday on May 4th also, 972-325-1700 North Dallas, Brookhaven Country Club.
Patrick: Now, the people that really should be coming to that seminar, are there some qualifications?
Richard: Well, basically, our minimum client has 250 in investable assets. So, if you have less than 250, you might come just for the dinner, but you probably will hear some things that may or may not pertain to you.
Clearly, if you have over 250, you will hear things that will pertain to you whether you’re an aggressive investor, or very conservative investor, or just someone that doesn’t want to take any risk whatsoever.
Patrick: I will tell you, folks, that I’ve been to this seminar and I was really stunned at the quality of material that Richard was offering. I was really impressed with the fact that he’s bringing to the table solutions to many of the strategies or conflicts that people have in building and transferring their own wealth and their own investments to their next generation.
I know that we want to make sure that you have the opportunity to call in. It’s 972-299-5759 or 866-660-KSKY. Call in and join us at Financial Fortress Radio.
Richard, I know that we also want to make sure that we get to some of the key strategies. And I know, before the break, we want to cover a couple of strategies that smart investors use.
Richard: Well, obviously, the investors are always looking for high return, low fee investment solutions and we cover those at the seminar; all the full range of investment solutions that are there.
We also see a lot of investors looking for high returns without stock market risk. But, a lot of the things that are being sold out there today actually have other types of risks that aren’t being talked about and we’re going to talk about that in our next segment just in a few minutes.
They’re also looking for safe and hidden income opportunities and we will get to that. Many people are interested in passing things on to the next generation, or just to their spouses, correctly and minimizing their estate taxes. I think we’re going to see a huge amount of swing and the amount exemptions that are going to be allowed in estate taxes by the current Congress since they are looking for ways to generate taxes.
Patrick: One of the things that we want to do is encourage you to call in. It’s 972-299-5759 to join the conversation. If you’d like to get registered for Richard’s seminar, it’s 972-325-1700. We’ll be right back.
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Patrick: Welcome back to Financial Fortress. I am really excited about the stuff in the news this week, Richard. We’ve got some of the things that go with that Professor from Duke.
Richard: Yes. We have a lot of news all the time that talk about conflicts of interest. After all, it was conflicts of interest that caused the financial meltdown back in the 80s with the savings and loans crisis. It was the same conflict of interest that caused the meltdown with the subprime mortgage crisis.
And we’ve got more conflicts of interest occurring in the market today as we speak. Just this week, there was an article in the paper about a Dallas/Fort Worth area firm that’s been barred from selling life settlements. You may have heard of these things.
So, you’re probably asking yourself why, and the answer was these products are very thinly regulated and, as a result, they don’t have to follow the same rules and regulations that other types of investments follow. They’re not really considered a true investment by the SEC. So, they don’t have to disclose the full range of risks that there are out there.
Patrick: Well, one of the things that some of the audience might be asking is, “What’s a life settlement? What are you talking about?”
Richard: So, life settlement is basically the purchase of an existing life insurance policy. You go in with a pool of investors to buy one of these things and you have an expected life expectancy on this person because they take a medical exam. You buy this thing hoping that this person – they call it maturing – matures and the policy matures within the range of time that you expect it to.
Patrick: Okay. Let’s decode that because I know that general populous – if I was out there listening and I’ve never heard of a life settlement before – maturing if the person dies?
Richard: That’s pretty much it, yeah.
Patrick: Okay. So, you’ve got these folks that may have what? Are they smaller policies or are they really large policies?
Richard: They tend to be policies of $500,000 to $1 million or more.
Patrick: Okay. So, somebody that’s maybe 75 or 80 years old has a policy that’s $500,000 or $1 million or more and a group of investors purchased this at some discount.
Richard: Right, exactly.
Patrick: Okay, because the person is expected to live no more than how many years?
Richard: Typically, three to five years are the most common policies that are purchased, but they go out to seven years. So, the range of investments for this thing, period, is five to seven years.
Patrick: Okay. So, the expectation is that this person will live five to seven years or less, maybe three years, they buy it at a discount. When it matures, when the person passes away,, then the policy becomes…
Richard: Paid.
Patrick: It is paid, so whoever purchased that policy now gets $1 million?
Richard: They get the profit.
Patrick: This pool gets the $1 million and they split it back out to the investors.
Richard: Right.
Patrick: It would seem that there would be a lot of risks or illiquidity in something like that. Is that what you’re seeing?
Richard: Well, certainly, it’s illiquid. In life settlements, you really can’t determine when someone’s going to pass, can you?
Patrick: No.
Richard: You can guess. You can take an educated guess. That’s what these examiners do when they look at medical files.
Patrick: Well, the fact is this that, to the best of our knowledge, there’s only been a couple of people that didn’t die. I hate to say that, but it’s there. So, what are the risks?
Richard: Right. So, the risks that typically aren’t talked about much; the biggest one is that unknown amount of time until the policy is paid. And as a result of that, if the insured lives past the life expectancy, the rate of return that you expect can drop dramatically and the investor could have to ante up more money for a premium call.
And if they don’t want to ante up money for a premium call because they’ve been in this thing seven years and it hasn’t paid, they have to give up the amount of money a 100% that they’ve already initially invested in that policy. In other words, on each policy, you could lose both your principal and your returns potentially.
Patrick: Okay. So, they could lose it at all.
Richard: Exactly.
Patrick: But that’s never talked about. I’ve never heard anybody say you’d lose anything because they figured everybody’s going to die. And even if it’s out five to seven years; everybody just figures this person is going to die eventually.
Richard: It’s glossed over. It’s just glossed over. It’s in the fine print somewhere. But, it’s glossed over by the guys that sells these things because the rates of commissions on these products are even higher than mutual funds which the SEC limits at 8.5% per fund. Did you know you could pay 8.5% commission on a mutual fund?
Patrick: Well, in the old days, I mean back when – I have to admit – I was in that industry, that was about right.
Richard: Yeah, and the average is still around 5.8%.
Patrick: Okay, right. And even if you were to buy what they call – what is it? B-Share where you’re not paying an upfront fee, it’s kind of built into the internal things where you don’t pay anything, but if you pull it out early, you’ll get a penalty.
Richard: Right. It’s a five year to seven year investment typically on a B fund and you’re paying it over five to seven years. Now, if you take it out early, it has a surrender charge and you end up paying the rest of it then; just like an annuity has a surrendered charge.
Patrick: Well, I know a lot of people might have heard a lot about these things. They sound amazing. They may have even invested in it. I know you have some people that you’ve seen that have invested in it and there was not a lot of diversification.
But, you might want to join the conversation. It’s 972-299-5759 or if you’re outside the area, it’s 866-660-KSKY. That’s 5759 in the end there, 866-660-5759. Call in. Join the conversation. Ask Richard about what is your broker doing.
And if they really are putting your interest ahead of their own which, really, we’ve already kind of talked about that, the conflict of interest is there if they’re selling you a security that has a commission. Is that correct?
Richard: Or in this case, it’s not even considered a security and the rates of commissions are even higher than they are on mutual funds; much higher. So, in life settlements, you really can’t determine the risk, nor can you determine the liquidity. So finally, guess what they focus on when they try and sell you these things? The potential rate of return.
And anytime you focus only on the rate of return on an investment, what do you tend to be driven by? The irrational emotion of greed. And if you need the money for an emergency, can you get your principal back quickly? And if so, what is the surrender charge? The answer to both is uncertain. Let me tell you a story.
I heard recently from an investor. She retired from a major Fortune 500 company here early. She took her pension rollout fund of almost $500,000. She took that money to an advisor that put over 95% of her money into these life settlements.
And she came to my seminar about six months later and she was in distress. I said, “What’s the problem?” She says, “My husband has a rare heart condition, needs an operation and the insurance company won’t pay anything towards the procedure because they consider it experimental.”
She keeps calling the guy that sold her these things. He’s on another radio station for two hours in the morning on another day, and he won’t return her calls. She keeps asking, “How can I sell these things? How can I get rid of them? I need $100,000 to save my husband’s life and I’ve tied up almost a half of a million in these things. What can I do?” And there’s no good answer for her.
Patrick: Because if she goes to resell it, what will happen?
Richard: Well, there’s really no market to resell it. It’s not like a stock exchange; you can’t list it on the NASDAQ, you can’t list it on the New York Stock Exchange. There’s nowhere else you can go with this thing except to call the company that created it and they have about a 30% cost of sales and administration in these products. So, let’s face it. They’re probably not going to offer more than what? 70 cents on the dollar for it.
Patrick: If that.
Richard: So, if you’re thinking about a 30% potential surrendered charge, does that sound like the kind of place you want to put your money? Is that really an investment?
Patrick: Well, I’m curious because I sit there and think IRA –you think it would be a longer-term investment and yet, how many times when people retire, now they’re having to draw off of that, so that becomes their liquid pool and that’s where they see all their money is.
So, if they need it, you’re stuck. One of the things that I want you to do is I want you to call in at 972-299-5759 to join the conversation. You can also, if you’d like to hear Richard speak on all of this successful and smart money investing, I want you to join us at the seminar. It’s 972-325-1700 to get registered for this upcoming seminar. You will not want to miss it. Thank you so much. We’ll be right back.
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Patrick: Welcome to Financial Fortress. This is your host Patrick Dougher. Richard Jordan, you have some more information about the difference between brokers and Registered Investment Advisors.
We want to talk more about this. I call it lemming approach to investing and kind of follow the herd off the cliff. So, we talk about the smart investor. It’s the person that understands that there’s a lot of ways to buy things, but the least conflict of interest is somebody where pay for the advice, you get the advice. Wouldn’t you agree?
Richard: Absolutely.
Patrick: So, why don’t you to go over real quick the difference between a broker, Registered Investment Advisor. And if you have questions for Richard, you want to call in at 972-299-5759 to join the conversation. Go ahead, Richard.
Richard: So again, Pat, a broker is a salesperson. They are more highly educated than the guy down at the Cadillac or Lexus store, but his duty is the same. It’s to derive commission. It’s their primary duty. If they want to keep their jobs, that’s what they have to do.
So, the kinds of investments that they’re going to put clients in first are the kinds of things that allow them to keep their job and make a good living. It makes sense, doesn’t it, Pat?
Patrick: Well, you’d think, knowing that that industry is driven by that, but when we started this show, we were talking about how so many investors – and when I say investors, I’m talking straight across the board all the way up to fund managers.
Richard: That’s right.
Patrick: They make their decisions because of an emotional buy-in without taking into consideration the rest of the story. Is that what you were saying?
Richard: Well, the conflict of interest causes people that are normally very smart and very educated – I see it all the time. It’s not just the fund managers that are this way. We do a lot of business in the Plano area, although we’ve got offices throughout the Dallas and Fort Worth area. We see a lot of the engineers that work in that area, in the telecom area and up in the Plano area for EDS trying to self-manage making obviously irrational decisions. And these are smart guys, probably smarter than me.
But as I tell them all the time when they first bring me their account information, do you remember the story of the tortoise and the hare? Well, you’re the hare. You’re the guy that’s trying to spend two hours a week to figure out how to do it while you’re working your full-time job or while you’re working on full-time retirement and I’m the guy that studies 30 hours a week and you may be smart than me, but I keep moving.
Patrick: Right.
Richard: And because I keep moving, you may get ahead of me for an hour on a given day, but you won’t stay ahead of me. By the end of the day, I’m going to be back ahead of you.
Patrick: Very good. I know that a lot of brokers though – well, they’re supposed to do research.
Richard: Well, they don’t. They basically are told to spend 97% of their time in a selling mode and only 3% of the time do they have an information gathering mode and that mode is the branch meeting. The branch meeting is where they’re told what stuff to sell.
In other words, a broker/dealer is not just a broker that carries that does buying and selling for you. They’re a dealer that carries inventory. And when they’ve got too much inventory and they want to get rid of it because they’re scared the value of it is about to drop in the market, they start paying extra commissions and spiffs to the brokers to get rid of it, creating an additional conflict of interest.
Patrick: Well, how do you identify the, one, the Registered Investment Advisors, but even beyond that, how can you find the right people to help you? I know the wealthy and the smart money, they have some, let’s say, litmus test, they have some queues that they follow. What’s some of the wisdom they have?
Richard: Well, their queue is that they’re only interested in dealing with someone that is a registered advisor who has a fiduciary duty. Nobody else do they want to do business with. That’s the way the smart money does it because if they can’t hold them accountable, if they have a conflict of interest, obviously you can’t trust them because they can’t even trust themselves.
That’s what this good Professor found out is that even the smartest people in this business make mistakes because of the potential amount of money that’s at stake.
Patrick: Now, when you say fiduciary, what are some of the examples – I know a lot of the more affluent will understand that immediately. They get it. But, there are a lot of listeners that are going, “What do you mean by fiduciary?”
Richard: So, a fiduciary is the same as the person you trust most in the word like your spouse. But if your spouse passes away, who would execute your will? Who’s the executor? If you and your spouse both pass and you have a trust, who is the first successor trustee, the one you trust the most after that?
That person is someone that you trust to take a fiduciary interest to follow your intentions to the letter what your goals are, the amount of risks that you’re willing to take. They’re going to follow that closely and they’re going to get you the maximum rate of return for the amount of risk you’re willing to take, not for the amount of risk that the broker thinks you should take. Maybe the broker thinks it’s more suitable for somebody at your age to take more risk and he puts you in something that you don’t really want to be in.
Patrick: Now, you’re going to be covering all of these in your workshop and more.
Richard: Absolutely.
Patrick: When and where is that again?
Richard: We’ll be at Brookhaven Country Club as our next one, April 27th. That’s a Tuesday. Or May 4th that’s the following Tuesday at 6:30 p.m. All you have to do is call 972-325-1700 and leave us your name, address, and phone number and we’ll be glad to send you a confirmation.
Patrick: What was the number again?
Richard: 972-325-1700. And by the way, of course, it’s not open to other advisors or agents that are out there.
Patrick: Okay, so 972-325-1700. Come, hear you talk about how really the smart investors, the more astute money in the marketplace are using their wisdom, their keys, their secrets to get great returns with the right amount of risk.
And one of the things that I know is that these guys don’t hang around in investment. They move their money around, don’t they?
Richard: Well, we use a lot of different algorithms, that’s formulas, mathematical formulas, to make decisions for people because the numbers don’t lie. I’m a person that happens to love numbers. I’m a numbers guy. And I can tell you that the numbers don’t get emotional.
So, if you can find a formula that works in a different type of a market cycle and obviously the market moves through multiple cycles as we go from bear to bull, the bear to bull.
Patrick: That’s up to down, up to down.
Richard: Exactly. Then, you’re in a much better shape than somebody that tries to do buy and hold.
Patrick: Now, that’s kind of going against the grain, but I want to make sure that people understand we’ve been taught forever, it seems like, for the last almost 100 years that buy and hold would have made a 10% or so rate of return over the last 100 years. What do you mean that buy and hold doesn’t work?
Richard: Well, buy and hold only works for certain periods of time and that’s why the brokers only like to quote time periods that it works in. So, if they quote you the last 20 years and tell you you could have been making 11% a year in it. What they don’t want to tell you is that you’d have lost in there with a 2% or 3% a year over the last ten years.
Patrick: That’s the key and I know that there are expenses internally and stuff like that that even erode more, and then there’s certain amount of inflation. So, there’s lots of things that are hitting your money.
I know that a lot of people may want to ask a question, so I encourage you to call 972-299-5759. Richard, I know people may want to call you after the show like next week and connect with you. Can they get your direct number?
Richard: Sure. You can reach me if I’m at my desk, and not in a conference with a client, you can reach me at 972-758-4484. And your best bet is to call earlier late in the day because I’m always trying to maximize returns for my clients when the market is open.
Patrick: Very good. So, that’s 972-758-4484, your desk right to you. And if you want to register for the event that’s coming up, it’s 972-325-1700, right?
Richard: Correct.
Patrick: 972-325-1700 and connect with Richard and come to this event where you can learn really what the smart money – one of the things I’m really surprised with is that you didn’t sell anything in that event. You weren’t selling. This is not about – there’s no pitch fest here. This is just information.
Richard: Not pitching any particular product or approach. Every client has a customized portfolio that is based on their attitude towards the market, the amount of risk they want to take, the amount of returns that they need to make.
We consider their budget and their cost of living raises. We build that all into 30 year plan so that we can be sure that their money is going to last longer than their retirement.
Patrick: That’s really a key. Call in. Join us here at the Financial Fortress Radio at 972-299-5759. And call Richard at his desk next week. It’s 972-758-4484.
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Patrick: Welcome back to Financial Fortress Radio; Patrick Dougher, Ricahrd Jordan. Richard, we’re talking about the conflicts of interest that many brokers have with their own clients and why, so many times, their investments don’t work out, that buy and hold doesn’t work, that because there are time periods when it’s 0% or less than that. And one of the things that I look at; my question is, really, why is it that the vast majority of mutual funds fail?
Richard: Well, again, the research done by the Professor indicates that there’s a conflict of interest even at the mutual fund manager’s level. And as a result of that, Lipper, an analytical firm that studies the stock market and the performance of funds, determined that 82.6% of the mutual funds did not beat the S&P 500 Index in the last 20 years.
Now, these are guys who are getting paid tens to hundreds of millions of dollars to do so and yet, only about 17% of them can do it.
Patrick: Well, I would figure that those guys with that much, essentially, revenue, that they would have the best information, the most researched, the most current, up to the second research about every single investment.
Richard: They do.
Patrick: That they would be able to make, you would think, the best decisions and yet, you’re saying that only 17% of the analysts out there, or the mutual funds out there, are beating just the norm of – just bought the S&P 500.
Richard: Exactly. And what’s worse is most people in the United States are scared of buying anything but a domestic stock fund. So, they stay away from the international funds. There was an article in The Dallas News just prior to the last bear market starting that said only 6% of the domestic stock funds beat the S&P 500 Index. So, that’s a 94% failure rate.
Patrick: You know what’s really said is that, again, you think these guys have the best information.
Richard: It’s not a question of information. It’s a question of enough time to process the information and a question of a conflict of interest. So, let’s talk a little bit now about what kind of returns the investors actually receive.
Patrick: Go ahead.
Richard: So, Morning Star did an analysis just before the last bear market occurred and they asked investors to send in the data on the funds they had owned for the last 20 years. And they asked them by sending out over 20,000 applications and they got over 2,000 of these surveys back, which makes it a scientific survey with a validity +/- 3%, about the same you see in the best polls in these Presidential races.
And what they found out is the top 50% of the mutual funds in that time period that ended in ‘06 generated an advertised rate of return of 9.65%, which is good. You could double your money in eight years with a 9% rate of return. Many investors would be ecstatic with that.
But, they also went through and read the prospectus. Oh my God, the prospectus. And what did they find out when they read the prospectus? They found all the costs because that’s where they buried. The SEC allows them to advertise the gross rate of return, but the bottom line – what the investor actually earns – is buried in the prospectus with the expenses.
And what they found was the rate of return on the top 50% of those mutual funds ending in ‘06 for the previous ten year period, which was a really good ten- ear period, after expenses, 1.45% a year.
Patrick: Well, what would contribute to that much; almost 80% of the gains?
Richard: Isn’t that sad?
Patrick: What would contribute to the expense that you’re talking about there?
Richard: Okay. So, the average fund commission right now is 5.8%. That’s what Morning Star discovered.
Patrick: Okay. So, they’re paying a broker 5.8%.
Richard: Right.
Patrick: Then what?
Richard: Well, their expense ratios to run the funds; that can range up to 2%. Then there’s 12 B-1 fees.
Patrick: Now, those are what just ongoing internal fees that they’re –no, those are things they’re paying brokers, aren’t they? Would they call them trails?
Richard: No, that’s actually a little more complicated than that. What it is is it’s a fee that gets paid out of the fund that allows the fund to do marketing and advertising so they can make the fund larger by doing more marketing and advertising.
Patrick: So, what you’re telling me is that you’ve got 5.8%, plus a potential 2%, plus a potential almost 1%?
Richard: Mm-hmm.
Patrick: Okay. And then, what else would go into that factor?
Richard: Well, there’s turnover cost. Obviously, there’s the cost of actually buying and selling the stocks that they buy and sell every year. And then, the other hidden cost that’s in their prospectus is capital gains taxes. Who pays the taxes on the funds when something that’s sold that’s held longer than a year?
Patrick: Well, is it within the year or just whenever something sold with a gain?
Richard: Well, if it’s held more than a year, it’s called a capital gain. If it’s held less than a year, it’s ordinary income. And obviously, the investors pay all that.
Patrick: Well, I know that a lot of brokerage firms, a lot of mutual funds that have a big turnover, they all turn over their inventory almost on a quarterly basis. Now, the sad part is that what do they sell first? Is it the losers or what?
Richard: Well, it’s kind of funny. What happens is that the redemptions that occur when we get a bear market and investors get scared and they start selling their funds off as fast as they can is they don’t follow Finance 101 and sell the deadwood first. They sell the winners first. Why?
So, they can advertise a higher rate of return than the competing funds that are in the same category as them, allowing them to keep less money going out the backdoor. Why does the fund manager want less money going out the backdoor? Because his primary method of compensation is the size of the fund – not the performance of the fund –the size of the fund.
Patrick: So, if I understand you correctly, they buy maybe 1,000 stocks or they may buy 300 stocks and they’ve got so much money in each of them in their pool of say $10 million, or $200 million, or whatever. Let’s say $200 million and they’ve got 300 stocks in there. And you were saying that, let’s say there’s 12, or 15, or 18 of them that shoot up a pretty good amount, 30%-40%.
Richard: Right. Those are the ones that get sold first when the bear market occurs.
Patrick: And they keep their [54:20 inaudible]?
Richard: Right. And what that means is when you get a bear market and you hang onto your mutual funds and you’re watching the value, the net asset value, of that mutual fund fall on your statements every month and then next February rolls around and you get a 1099 because they sold some winners.
And that’s called the cash distribution to you, to the fund rather, and those cash redemptions, when they have to pay people back in cash because they want to sell of their mutual funds, they do it by selling the winners first and you pay the taxes on their bad behavior which is really a direct result of what? Conflict of interest.
Patrick: Boy, I tell you, that seems like a good way to hurt a lot of people.
Richard: So, how do you get around that? Well, a lot of people say by no-load funds. But, here’s what happens with no-load funds. If you compare the top 25% of the performers in no-load funds to the top 25% of loaded funds, you would expect a difference in performance to be that average commission of 5.8%, would you not?
Patrick: Well, I would, yeah. I would expect that.
Richard: It would be too logical. The actual difference is about 0.5%. Where’s the other 5.3%?
Patrick: Marketing I would imagine.
Richard: No, it’s not marketing. If I pay you 100% based on sales volume, that’s called a commission. If I pay you 90% based on sales volume, but only 10% based on a customer satisfaction survey, that’s called an operating expense and it gets buried in the prospectus.
Patrick: Okay. So, their operating expense is then for managing and running the stuff, the show or the mutual fund, that’s just being not – it’s not visible to the public, is what you’re saying.
Richard: Even though it really is a commission, isn’t it?
Patrick: That is amazing. Well, one of the things that I encourage you to do is hear Richard speak. Come to his seminar. You said it’s April…
Richard: April 27th on a Tuesday or May 4th the following Tuesday at Brookhaven Country Club in North Dallas.
Patrick: And how will they connect with you?
Richard: 972-325-1700 to register for the seminar.
Patrick: Okay, it’s 972-325-1700. And they also can call you this next week at 972-758-4484, correct?
Richard: That goes direct to my desk. I don’t pick it up a lot during the day because, again, I’m trying to maximize returns for my clients while the market is open up until about 3:00 PM. So, the best time to catch me at that number is after 3:00.
Patrick: Okay, and you’ll call everybody back that has a question or concern about their broker and really the difference between what a broker is and what you do. Is that correct?
Richard: Absolutely. And if they want an independent objective analysis of what they’re currently holding, we’ll do that free of charge.
Patrick: Very good. So it’s 972-758-4484, or come to this seminar April 27th or May 4th. Register at 972-325-1700.
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