If Your Broker Sells Mutual Funds, Run, Do Not Walk, To The Nearest Exit

In a perfect world, stock brokers would actually earn their money. If they recommend individual stocks to their clients, those stocks would do better than the ones chimpanzees choose by throwing darts at the Wall Street Journal stock tables. If they recommend mutual funds to their clients, those mutual funds would be above-average performers. After all, if you have thousands of options and a professional helping you choose from them, you should be able to tell the good from the bad.

Ah, but the world is far from perfect. Research has shown that sell side investment recommendations provide investors with more volatility and lower returns than a broad market index. In addition, a study done by a trio of college professors from the Harvard Business School and the University of Oregon shows that between 1996 and 2002 brokers who sold mutual funds actually cost their clients billions of dollars. This conclusion was reached by comparing returns for two groups of funds, those that brokers sold and those that individuals picked on their own.

If we take a step back and think about brokers who sell mutual funds, and how they are compensated, we can understand why they might not provide the best advice to their clients. Brokers get paid to sell certain funds. Those funds are not chosen based on how good they are, but rather on which fund companies give kickbacks to the brokers selling them. So, if brokers are getting paid to sell "Fund X" and that decision has nothing to do with how good Fund X is (but because Fund X is thowing money at the broker), there is little reason to think Fund X would be any better than alternatives such as "Fund Y" or "Fund Z."

As a result, logical minds might conclude that mutual funds sold by brokers will perform no better and no worse than the average mutual fund. If performance is not a yardstick that is being given any attention, how well the fund does in the future will be pretty much a coin flip.

Interestingly, the aforementioned study (which tracked more than 4,000 mutual funds over a seven year period) showed that broker-sold funds actually do far worse than average. How striking were the results? Very striking indeed.

Investors working on their own to pick mutual funds earned an average return of 6.6% per year. Investors who used a broker and bought the funds they recommended earned 2.9% annually. The public outperformed supposedly "knowledgeable" brokers by more than 100 percent. To make matters worse, the people working with brokers actually lost money after factoring in inflation and taxes.

If you are using a broker and are invested in mutual funds that they recommended to you, you might want to take a close look at your results and make sure your broker is working for you, not the mutual fund company subsidizing their paycheck.