If you ever wanted proof that rational economic man is a myth, look no further than the pricing of financial services.
How and what we decide to pay for securities and banking services is much more a function of psychology and irrational bias than it is of logical thought. Consider the 2-and-20 pricing of hedge funds. Is there any logical reason other than custom that a fee of 2% of assets and 20% of performance has become the standard?
It's likely that
hedge fund pricing stems from the “you get what you pay for” line of thought that seems to be rooted in our brains. That kind of thinking explains why we believe that merchandise at Neiman Marcus, for example, is inherently better than what's available at Kmart.
In financial services, however, paying more doesn't necessarily mean the buyer is getting more.
Take the bond market. When buying a bond, many people are happier paying a wider spread than paying a fee on top of a better trade. Somehow, a “commission-free” trade — even it costs more overall — seems like a better deal than one in which each cost is identified.
In most financial transactions, in fact, only a small percentage of people (engineers, “Bogleheads” and RIAs who look under the rock of securities pricing) seem to care much about the real costs of transactions and services.
The mutual fund world has accommodated the preference for pricing irrationality by coming up with share classes to suit everyone's preferences. Want to pay the no-frills price? There are shares like that. Want funds with advice you pay for overtly? There are shares like that. Want funds with advice you get “free” (wink, wink)? There are shares for that, too.
Of course, there's disclosure for all this. So in theory, no one is actually tricking the public. In reality, however, very few shareholders read all the disclosure documents they receive, and most wouldn't understand it if they did.
Wednesday's first steps by the Securities and Exchange Commission to end 12(b)-1 fees are a good effort to bring more rationality to fund pricing. I know that position will spark comments from readers calling me an idiot or a socialist or an idiot with socialist tendencies. But I believe that straightforward pricing of financial products is a worthwhile effort even if consumers are irrational.
While many brokers will argue otherwise, I strongly doubt that the $9.5 billion paid in 12(b)-1 fees last year bought $9.5 billion of advice. Some of that money did pay for advice, but a sizable share simply went into fund company management and brokers' pockets as a kind of annuitized income. Is that terrible? No. Does it benefit investors? Not really.
Sure, eliminating 12(b)-1 fees may make some clients uneconomical for some brokers to serve. But if clients believe that the advice they receive has real economic value, perhaps they won't mind writing a check.
