The Unknown Unknowns: Three deceptive practices of the financial industrial complex

“There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don’t know. There are also unknown, unknowns. These are things we don’t know we don’t know.” Former Secretary of Defense, Donald Rumsfeld

This quote, describing the post invasion chaos of the Iraq war, has a sobering message for individual investors. There are many “unknown unknowns” (or things we don’t know we don’t know) that are the real weapons of mass destruction for the retail investor. While these WMDs were never found in Iraq, the same cannot be said for what is about to be exposed. Trading costs, 12b-1 fees and municipal bond markups silently and secretly ravage the returns of many innocent clients.

Trading Costs – In a study published in Financial Analysts Journal (Edelen, Evens, Kadlec), it was found that trading costs put a significant damper on the returns investors take home. This study looked at 1,758 domestic equity funds. It found that many investors paid an astounding 1.44% in trading costs!. Small-cap growth funds came out on top with an egregious 3.17%! These costs are mainly from bid/ask trading spreads and brokerage fees. To put this in perspective, on a long-term average annual return of 10%, these costs can steal anywhere from 14%-31% of a fund’s return. What is most shocking is that mutual fund companies are not required to disclose these fees to investors. If one calculates inflation at 3%; reported fund fees at 1.5%; and unreported trading costs at 2%; then a conservative investment return of 7% would virtually be wiped out. No wonder this is kept a secret. Barry Ritholtz once said, “Fees are the cholesterol of the investing world.” Trading costs are worse because they are a silent killer. Maybe the industry is afraid trading costs would be classified as crimes against humanity and they would meet the same fate as Saddam Hussein if they were uncovered!

12b-1 fees – Unlike trading costs, 12b-1 fees are fully disclosed. The problem here is they are not fully explained in plain English to the retail investor. They are considered an operational expense for purposes of marketing and distribution. Here is where things get sneaky and misleading. Many discount brokerages offer hundreds of funds for no transaction fees. Though it seems investors are buying these without paying commissions, these ‘free” funds have a price. The 12b-1 fee of 0.25% is kicked back to the discount brokerage which charges 0.4% for the price of being on the NTF platform. The fund companies charge the individual investor 0.25% to partially cover this cost. They would charge more, but if they went above 0.25% than they could not consider their funds “no load”. In plain English, the investor is paying a fee for a no-transaction fee fund which goes to the fund company to help get other people to buy more of the fund. When funds get larger, returns usually suffer. In effect, the investor is paying for something that may likely decrease fund returns, but add to the profits of the fund company! Donald Rumsfeld would have a field day trying to explain this.

Municipal Bond Markups – While 12b-1 fees are disclosed but not explained, municipal bond prices can be more difficult to locate than brokers selling index funds. Most municipal bond prices are only seen after the trade has been consummated. Municipal bonds don’t trade very much and there can be great variations in prices. Often brokers will charge huge markups and charge investors 5%-10% more than what the bond cost them. If the bond only pays a coupon of 2%, this markup could amount to 5 years’ of investors’ interest! According to the Wall Street Journal: “Researchers at Securities Litigation and Consulting Group found that investors paid $10.6 billion in markups across 2.5 trillion worth of municipal bond trades since 2005, more than half of which were excessive.” To put this in perspective, it would be like a person going to the grocery store and having the cashier assign a price to all the purchased goods. There would be a markup above real price based on the commonality of the item. While the milk would be assigned a 5% markup, caviar would sell for 20% above retail. The customer would have no idea what the bill would be in advance and they could not go to another store to see if they were being ripped off! Only in the financial industry could this be considered a common business practice.

The unknown unknowns that face individual investors are as lethal as a stealth bomber. Like the technology this plane uses to avoid radar detection, segments of the financial industry have created their own infrastructure to deceive the public. In both cases an unsuspecting victim will pay the price. While our military creates weapons to defend our country’s freedom, the same cannot be said for certain segments of the financial industry. Their unknown unknown practices target the most vulnerable. While Saddam Hussein would have been impressed with their cunning, the customers who find out about these dirty secrets certainly will not be.