Mutual funds are popular investments that many people use to diversify their portfolios. But how do financial advisors make money from mutual funds? The answer is, there are several ways that financial advisors can earn a living through mutual fund investing. In this article, we will explore the different methods of compensation and what investors should know before working with a financial advisor.
Commission-Based Compensation
One common way that financial advisors make money from mutual funds is through commissions. This means that when an advisor sells a mutual fund to a client, they receive a commission based on the investment amount. There are two types of commissions: front-end loads and back-end loads.
- Front-end loads: This type of commission is paid upfront as a percentage of the invested amount in the fund.
- Back-end loads: A back-end load is charged when the shares are sold, and the fee decreases over time. For example, if an investor sells their shares within one year, they might pay a 5% back-end load fee. If they sell their shares within five years, the fee might decrease by 1% per year until it reaches zero.
Advantages:
- Advisors have a financial incentive to work with clients to select investments carefully
- Commissions may be lower than other types of compensation models
Disadvantages:
- Front-end loads reduce the amount of money available for investment
- Back-end loads can create a conflict of interest if an advisor encourages investors to hold onto poorly-performing mutual funds to avoid penalty fees
Asset-Based Compensation
Another way financial advisors make money from mutual funds is through asset-based compensation. This means that they charge a fee based on the assets under management (AUM). The fee can range from 0.25% to 2.00% depending on the type of mutual fund and the amount of assets being managed.
Advantages:
- Advisors have an ongoing financial incentive to help clients achieve their goals
- Advisors can provide additional services, such as financial planning or portfolio management, with the fee covering those services
Disadvantages:
- Higher fees can reduce overall returns
- Advisors may not have a strong incentive to help clients decrease their investment holdings, which in turn reduces the amount of money under management
Fee-Only Compensation
Fee-only compensation is a model where advisors charge clients a flat fee or hourly rate for their advisory services. They do not receive commissions or any other type of compensation from mutual fund companies. This compensation model is considered free of conflicts of interest and is often used by fiduciary advisors.
Advantages:
- No conflict of interest with mutual fund companies
- Clients have a clear understanding of what they are paying for services
Disadvantages:
- Fees may be higher than other compensation models
- Clients may feel that they are not getting enough value for their money if their investments aren’t outperforming the market
Revenue Sharing
In some cases, mutual fund companies may offer revenue sharing as a way to incentivize financial advisors to recommend their mutual funds. Under this compensation model, advisors receive a percentage of the revenue generated by the assets invested in the fund.
Advantages:
- Advisors have an ongoing financial incentive to recommend certain mutual funds
- Advisors may be able to offer lower fees to clients due to the additional revenue generated through revenue sharing
Disadvantages:
- The financial advisor’s recommendations may be influenced by revenue sharing agreements
- Investors may not benefit from the best possible investment options if the advisor is incentivized to recommend specific mutual funds
Understanding how financial advisors make money from mutual funds is essential for investors looking to diversify their portfolios. Advisors can earn money through commission-based compensation, asset-based compensation, fee-only compensation, and revenue sharing. Investors should evaluate their options carefully when choosing a financial advisor, considering factors such as fees, investment strategy, and level of experience. By understanding the different compensation models for financial advisors and weighing the pros and cons of each, investors can make informed decisions about working with financial advisors for their mutual fund investments.