Beware of Hidden Fees: A Case Study

Written by Principal Steven Karsh, MBA and CEO & Co-founder Richard Todd

As a popular insurance commercial states, “We know a thing or two because we’ve seen a thing or two.” The same can be said for Innovest. In our 23 years of providing investment consulting services to families, nonprofits and retirement plans, we’ve seen just about everything. To share our knowledge, we are including client case studies in our newsletters. In the following case study, we examine how Innovest uncovered hidden fees for a potential clients’

Background:

A few years ago, Innovest was referred a potential client who had recently sold their business and was working with a broker/dealer (B/D) to diversify their portfolio. The B/D disclosed their management fee for managing the portfolio but told the client they would manage the fixed income (municipal bonds) in the portfolio “for free”. In other words, the B/D would only charge management fees on the assets other than bonds.

There are three main ways to manage a municipal bond portfolio:

(1) Invest in a mutual fund that invests solely in tax-fee bonds. Vanguard Intermediate-Term Tax-Exempt is an example.

(2) Hire an independent manager that specializes in investing in municipal bonds. The manager would design a portfolio tailored to a client’s situation taking into consideration time frame, tax bracket, state of residence, etc. The manager typically would charge an annual fee (approximately 0.10% to -0.30%) to manage the portfolio of securities. Importantly, the manager would not earn any additional money on the purchase or sale of bonds in the portfolio.

(3) Use a broker/dealer to manage a portfolio of individual municipal bonds, but instead of being charged a defined management fee, the client would pay a “spread” or commission on the purchase and sale of each bond (typically around 0.5% on each bond). Prior to new regulations being implemented on May 14, 2018, clients did not see the dollar amounts of these spreads; they were hidden fees. Even though spreads must now be disclosed after the purchases and sells are made, B/Ds earn more money the more often they buy and sell bonds, an incentive that is in direct opposition to what is best for clients.

Example client:

For a $5 million portfolio, hiring a municipal bond manager like Innovest, described in the second scenario (above), would cost the client about $5,000 to $15,000 per year.

In the third scenario (above), the B/D fees for the same $5 million portfolio with commissions of 0.50% to buy the initial portfolio of bonds, would cost the client $25,000. Additional transactions, either buys or sells, would create additional income for the B/D.

How Innovest Helped the Client:

We recommended that the client sever the relationship with their bid and move to our fee-only structure, saving them from thousands of dollars and giving them peace of mind.

How is Innovest different?

Innovest believes in full transparency when it comes to fees. We are not compensated by money managers to place clients’ assets with any particular money managers, and we do not have any proprietary investment products. The only compensation that we receive as a firm is from the fully disclosed fees that our clients pay us. Additionally, our manager scorecards in each quarterly report discloses all the fees each money manager charges. Managers hired by Innovest on behalf of our clients are paid a defined fee to manage the portfolio. We require these managers to act in the best interest of the client when buying or selling securities; they don’t mark up any securities transacted for the portfolio and thus do not earn any undisclosed compensation.

Moral of the story: beware of hidden fees and undisclosed conflicts of interest!