After a great meal, we generously tip the waiter. The dentist soothes our toothache and we happily pay for the relief. We don’t mind paying for services when the benefits justify the cost.

Similarly, we don’t mind paying investment fees if performance warrants the expense. However, there are two reasons why brokerage fees are rarely defensible:

• Historical evidence indicates that the markets are so efficient, beating a simple index fund is next to impossible over time.
• The brokerage industry is so adept at camouflaging their fees most investors have no idea what they are paying for portfolio management.

It’s logical to conclude that reducing expenses will increase returns. But how do you do that when most of the expenses are buried deeper than an Egyptian Pharaoh?

In my years as an advisor, I have frequently performed forensic examinations of investment accounts for attorneys suing brokerage firms on behalf of investors. I have also evaluated hundreds of brokerage accounts at the request of investors seeking to identify expense sources. What I uncovered in these investigations shocked even the most sophisticated investors and attorneys.

The brokerage community gave itself a cosmetic makeover when it converted to “fee-based” accounts. It sounds equitable but in actuality, brokers are masquerading as independent investment advisors. The brokerage contract contains the firm’s stated advisory fee; it’s also the key to determining whether a firm is a fiduciary, as are all registered investment advisors or a salesman, as are all broker representatives. If the firm is a fiduciary, the contract will disclose the fees and conflicts of interest. They must, however, specify if they are not a fiduciary, in which case they are not legally required to disclose fee and conflict information. And that’s where the odyssey of unearthing the hidden expenses — the portfolio assassins — begins.

Investors attempting to navigate this maze should go back and review their previous twelve months of account data, not just to see what their account looks like today, but how it arrived at this point.

The enemy of high returns is high transaction costs, but transaction costs are how brokerage firms make money. My assessments of brokerage accounts typically reveal excessive bond allocations and individual bond holdings — frequently municipals. Why so many bonds? Investors are unaware of the fees hidden in bond bid/ask spreads, which are significantly higher than in stocks.

Investors see bonds in their accounts and assume they paid the market price; what they really paid was the price plus a markup. Money Magazine estimates the typical bid/ask spread on bonds is 3-8% of the principal. That’s on top of the advisory fee! I recently had the unhappy task of telling an investor with a $2 million bond portfolio that he paid his brokerage firm somewhere between $60,000 and $160,000 up front to own it. (The disparity between those two figures is one indication of how difficult it is to resolve brokerage fees.) Given recent bond returns in the 3-4% range, it was not a pleasant revelation.

In examining portfolios, I also typically find individual stocks versus mutual funds. There are inherent economies of scale in investing, and the cheapest way to buy and sell equities and bonds is in large quantities. But brokers regularly convince investors they should own individual small lots of companies in “separate accounts”, so we see lots of trading in small lots, which translates into high costs. Investors are unaware of these costs because they have been told they have a fee account and that the brokerage is picking up the expenses. What the brokerage picks up are the commissions, but not the bid/ask spreads; that’s where the big profits reside.

When portfolios do contain mutual funds, they are usually high expense, actively managed funds that pay 12b-1 fees — marketing fees levied on shareholders, ostensibly to pay for advertising and distribution costs but typically kicked back to the brokerage firm. Portfolios may hold funds where the brokerage does not participate in the 12b-1 fees but these are often funds owned by the brokerage, so they participate in management fees instead. When brokers use a third-party money manager or mutual fund, something called “direct brokerage” funnels all the fund’s trades through the broker that holds the account, rather than seeking best execution in the market, that is, trying to buy as cheaply as possible. Investors are stuck trading though a single brokerage where the profit margins can be as high as the broker wants them to be.

Whatever subterfuge is employed, the fees — although concealed — are there. The whole brokerage universe is constructed on a foundation of hidden fees. It may require a professional expeditionary force to find them, but they are there, trust me. The only sure way for investors to avoid these hidden fees is to use an independent, fee-only investment advisor rather than a broker. Even large accounts at brokerage firms are saddled with undisclosed fees, and typically pay 2-4% per year. Conversely, a large account at Capital Financial Advisors, LLC pays about 1% in combined management and fund fees. For a $10 million portfolio, the difference can be as much as $300,000 annually!

One investor’s unfortunate experience — a costly leap from the frying pan into the fire — illustrates how difficult it can be to separate fact from illusion.

The investor, disgruntled with the way a commissioned broker had churned his $4 million retirement portfolio, transferred custody of the account to a brokerage firm owned by a major bank. He believed his money was now in a safe place because it was a “fee” account. After a year he felt uneasy, however, and asked me to review the account activity. Downloading his information, I was staggered to see there were 680 transactions in 12 months, a 300% turnover! The only explanation for that much turnover was that the advisor had a financial interest in the trades. The portfolio was also bond heavy, inappropriate because of the huge bid/ask spreads on bonds.

Obviously, the poor fellow’s account was once again being churned. And unlike his previous account’s commission structure — where he at least had some awareness of what he was paying because of the end-of-year commission statements — with the bank’s advisor, he didn’t even have that.

When confronted with the evidence, the broker denied having any monetary interest in the trades. The investor was expected to believe that the people sitting on the trading desk at the brokerage were buying and selling securities for free. Naturally, they were not, and the broker was lying.

Here’s the kicker: the investor thought his account fees were 60 basis points, which would have been $24,000 on his $4 million portfolio. My estimate of the actual fees was between $150,000 and 200,000 annually! The investor, a very bright professional person, was furious. He believed the bank would provide a “safe harbor” for his money, but not only was his account still being churned, he was paying about six times as much in fees as he was led to believe. That kind of obfuscation is what makes getting a true picture so difficult for investors.

Beware of brokers doing business under the corporate umbrella of a major bank. They may be trying to portray themselves as an independent firm, but they are not; they are still selling investments. Ditto for boutiques owned by large brokerage firms; they are still stock brokers.

Here’s how this game works. A major brokerage or bank wants to position itself as an independent advisor, so it buys an advisory firm, such as a Registered Investment Advisor. Now the independent RIA has an incentive to drive down trading costs since they are not a broker and can’t profit from the trades in their client accounts. But the brokerage firm that buys them has an opposite orientation; they make their money through transactions, and so they “suggest” the advisor shift strategy to be more transaction-oriented. They encourage the RIA to trade in a way that generates high brokerage costs, and intimate that a hefty chunk of those fees could be returned to the RIA as a form of compensation.

An independent advisor purchased by a bank or brokerage can make a lot of money if they are willing to double or triple the rate of annual portfolio turnover. They can earn even more money from the brokerage if they are willing to make investor portfolios topheavy with individual bonds. And as long as they going to abandon objectivity in the interest of profits, why not discard the index funds they’ve been buying in favor of some of those brokerage-sponsored funds that can generate some additional kickbacks from the parent brokerage company? The brokerage and the advisor, now a single entity, take all those investor assets and start to churn them. Typically, once an independent advisor is purchased by a brokerage, the character of the advisor’s investment strategy is put under tremendous pressure to change so that it benefits the brokerage.

My advice for investors choosing someone to manage their assets is:

1. Ask if the advisor is a fiduciary — a Registered Investment Advisor — or an NASD-registered stock broker; if the latter, don’t give them your money.
2. Do a detailed analysis of your total annual fees, and be prepared for a shock. If you don’t have the time or technical skills to ferret out the fees, you may want to retain an unbiased, independent advisor to do it for you.