When Your Financial Advisor Hates ETFs

 | Apr 04, 2012 | 11:30 AM EDT  | Comments
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This article originally appeared earlier today on ETF Profits.

As you may have noticed lately, ETFs are becoming an increasingly big deal in the financial world, and I'm personally a huge proponent of these vehicles as tools for building long-term wealth through a balanced, diverse and cheap portfolio. ETFs are superior to mutual funds in countless ways. So it's a bit surprising to me to hear that there are folks who are resisting the ETF movement, clinging to the vehicles of yesteryear in order to accomplish their investment objectives.

It's downright shocking, moreover, when I hear that many financial professionals are advising their clients against using low-cost ETFs or index funds. But that's exactly what was found by a recent study conducted by Harvard, the University of Hamburg, and MIT. Fictional investors were sent to financial advisors with portfolios comprised of low-fee index funds, and the researchers found that, about 85% of the time, the financial professionals tried to shift their holdings toward more expensive actively managed products. In other words, many financial advisors are doing their best salmon impression, swimming against the current and trying to move from low-cost indexing strategies back to active management.

So today, I'd like to explain why this type of behavior might occur -- or, at least, why I suspect it might be occurring. It's actually a pretty simple explanation: For financial advisors, it's much easier to make money off of mutual funds than it is with ETFs. Through various fees, such as 12b-1 expenses and front-end loads, financial intermediaries can earn commissions by investing client assets in certain products. But those cuts don't exist in ETFs.

If you've recently been talked out of purchasing ETFs in favor of more expensive mutual funds, it might be time to consider the motivations of the individual giving you the advice. I'm realistic about the fact that there are certain situations for which ETFs aren't the best tool, and have written here numerous times about scenarios in which mutual funds or other types of securities are preferable. But it's frustrating to think that many investors out there are being steered in a direction that might not be optimal for them because ETFs don't offer a cut of the pie to the financial middlemen.

Understanding the underpinnings of various financial products can help to understand why you're being herded in one direction when you may want to go another -- and this knowledge can be extremely useful when evaluating potential money managers.

I'm not advocating a mass exodus from financial advisors. Investors can often derive significant value from getting an expert opinion on financial matters. But it's important to make sure that your incentives are aligned when ironing out an arrangement. If there weren't such a big incentive to steer investors away from low-cost ETFs, I'm guessing that the industry would be quite a bit bigger than it actually is -- and that's something that would be good for all.

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