What Do You know About The ITCS Principle?

Forbes featured an interesting piece with the title “Brokers Behaving Badly.” Here are a few snips:

Brokers deserve to be compensated, but the ways they are compensated deserve very close scrutiny.

There are two predominant methods of compensation. The first is commissions; the second is the so-called “fee based” account. In the old days, brokers charged commissions and advisers charged fees, but today, with the line between these two roles having been blurred, the matter is not so simple.

Commissions-based accounts are transaction-driven. Money is earned by the broker based on the size and quantity of investments sold to the client. Of course, the client will be more concerned with the quality of the investments, and that is where the client’s interest and the broker’s interest sometimes diverge.

Commissions can quickly add up to big money. Excessive trading of an account is called churning, and it is a fraudulent practice (see “Suitability Claims”). Usually, churning manifests itself in high turnover of the account’s assets, but, in fact, it’s the cost of the transactions, not the turnover that’s the evil. High costs diminish the likelihood that an investor will profit from investments being made.

Commissions on securities transactions are sometimes referred to as “markups” on purchases or “markdowns” on sales. When it comes to stock transactions, the law requires brokers to disclose the amount of any markup or markdown. But sadly, that is not the case for bonds; the law does not require bond brokers to disclose these things, as incredible as that sounds.

The rule allowing bond brokers to hide their fees can lead to abuse. I have recently been involved in several cases where the markups and markdowns were greater than the interest the investor earned from the bonds. The investor had no way of knowing that, however, because the markups and markdowns were not disclosed. When a broker recommends selling one bond to buy another, the ITCS principle is often at work.

Investment advisers, who are distinct from brokers, charge fees based on a percentage of the money in the account–the amount “under management.” An annual fee of 1% to 2% seems modest, but even that amount–paid year-in and year-out–is a drag on performance. Whether the management fee is a good deal depends on the quality of the services being provided. A manager whose responsibility is to watch and manage an account every day deserves compensation for sleepless nights. But it should not go unnoticed that the manager gets paid regardless of whether the account was profitable.

In the 1990s, the brokerage firms, under regulatory scrutiny for excessive commission-based sales, developed the so-called fee-based brokerage account. In a fee-based brokerage account, the broker earns a percentage of the money in the account, the same way an investment adviser is compensated. But a fee-based brokerage account, despite appearances, is not a managed account. If something goes wrong, the brokerage firm will not claim any responsibility for managing the account.

[My Emphasis]

While individual bonds may be the right investment for you, you can’t be sure what the markups are. As the article stated, sometimes they are higher than the interest earned. If you are holding a bond to maturity, it may not matter much to you, but if you suddenly need to liquidate a position, you may receive less than what you had anticipated.

The last paragraph emphasizes the difference between a fee-based brokerage account and a fee-only adviser managed account. I have talked to my share of investors in the past who did not know the difference.

To pay any kind of “management” fee to a broker, who puts your account in a canned asset allocation scheme with no exit strategy in case the markets head south, simply does not add value to justify that type of compensation. With no fiduciary relationship nor any responsibility, it does nothing but support the ITCS principle.

What is ITCS?

It’s The Commission, Stupid.

About Ulli Niemann

Ulli Niemann is the publisher of "The ETF Bully" and is a Registered Investment Advisor. Learn more
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