Investors Should Watch Out for Revenue-Sharing Agreements

Ever notice how when you go to the grocery store, you’re more likely to choose the cereal or frozen pizza that’s displayed at eye level?

It would be nice to think the store employees had you and your neighbors in mind when they placed those products — that they knew their customers preferred particular items, so they put them where they’d be easiest to grab and go.

But that’s not how it works — at least not at a lot of major grocery chains. Many charge manufacturers a fee for shelf space — and more for those prime spots. It isn’t about what’s best for the customer, although sometimes it works out that way. It’s about making money.

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Most consumers probably aren’t aware of those fees, or don’t think much about them. It affects them, though, if prices go up on the products they want — or if they can’t access a product at all.

It’s similar to what happens in the financial industry when you buy a mutual fund.

Mutual Funds Sometimes Pay to Play

There are thousands of mutual funds — an overwhelming number of options. Depending on whom you talk with about making your investment, your choices may be limited.

Just like that prime shelf space at the grocery store, sometimes the mutual fund companies paying the highest fees to brokerage firms get better visibility. Many of these companies pay to get their name at the top of the list of what’s being recommended to clients. Investors might not know about other products that could be a better fit.

Representatives for brokerages, who are often compensated by commission, usually are required to fulfill only a suitability standard when choosing products for a client. They must have a reasonable belief that the recommendations they make are suitable regarding the client’s financial needs and objectives, but their first duty is to the company they work for, not necessarily the clients they’re serving.

How Revenue-Sharing Agreements Work

There are plenty of mutual fund companies out there that try to incentivize brokerage firms to sell their products — especially the larger companies — by offering revenue-sharing agreements. Those firms then urge their employees to focus on those funds.

Revenue sharing can take several forms. Some mutual fund companies will charge additional fees titled 12b-1 fees. These fees can cover a variety of services, including costs for record-keeping, accounting and technology, but they can also serve as a compensation incentive for advisers to pick one fund over another. These fees can be up to 25 basis points annually (a basis point is one one-hundredth of a percentage point). A $100,000 account, for example, would be charged an additional $250 annually on top of an adviser’s management fee and other fund expenses. Other examples of revenue sharing agreements could induce biased recommendations for an adviser to use one money manager over another, regardless of performance or expenses, due to monetary incentives for an adviser.

You can see the draw for the brokerage’s representative, whose job is to sell. It’s easy to get into the mindset of pushing products that earn higher compensation and the boss’s approval.

2 Ways Consumers Can Protect Themselves

I think it’s important to work with companies that do not allow any type of revenue sharing. The sad thing is that many of the big companies do, and most investors are totally unaware of these arrangements.

Ask your financial professional about revenue-sharing agreements and other incentives he or she might receive, as well as how they affect the options you’re being offered and the fees you’re paying. (If he or she talks more about products than your long-range plan, that’s a red flag.)

Also, consider whether working with an Investment Adviser Representative would be the best choice for you going forward. An IAR is held to a fiduciary standard and is prohibited from buying a mutual fund or other investment just because it would result in a higher fee or commission.

Working with an Investment Adviser Representative won’t necessarily protect you from getting bad or biased advice, but it is a deterrent, and it will give you some legal recourse if you feel as though your money has been criminally mishandled.

Kim Franke-Folstad contributed to this article.