Caveat Investor: Fee-free Portfolios Can Come at a Cost

Potential conflicts of interest are hard to ignore.

(Illustration by RIA Intel)

(Illustration by RIA Intel)

This month, JPMorgan announced the launch of its You Invest Portfolios robo-advisor, which waives fees on underlying investments.

JPMorgan will instead charge an annual fee of 0.35 percent of assets, or 35 basis points, to put users into an investment portfolio made up exclusively of the bank’s exchange-traded funds, or ETFs. The firm says this should reduce investors’ costs by roughly 15 basis points.

The service is similar to Betterment’s automated portfolio management service, which offers third-party ETFs, rebalancing of underlying fees and tax loss harvesting for 25 basis points.

But investors should look more skeptically at this deal, says Nate Geraci, president of the ETF Store.

“Waiving fees in model portfolios can create conflicts of interest,” says Geraci. “If you’re a fund company and you’re waiving the fees on the ETFs that underlie [a model portfolio], you have a financial incentive to put your proprietary ETFs in that model portfolio,” he says.

“That doesn’t mean that those ETFs are the best ones for that particular client.”

Geraci cites Vanguard, which waives fees on model portfolios. “Certainly, Vanguard offers a high number of quality ETFs and the portfolios that are constructed are high quality – but if their portfolios are all Vanguard ETFs, are they the best for a given client?” Geraci asks. “I think that’s a higher threshold that they have to meet.”

While Vanguard’s models exclusively contain Vanguard ETFs and mutual funds, the firm insists there is no conflict of interest given how its models are used.

Vanguard says that through paper models, advisors receive the model weightings and methodology and implement them in client portfolios on their own. Through a turnkey solution, advisors use a third-party platform to manage the assets within the model and to handle trading and rebalancing.

Freddy Martino, spokesperson for Vanguard, says: “In either instance, Vanguard is simply providing the methodology by which the model is constructed. It’s at the discretion of the investor whether or not they utilize a model.”

A spokesman for JPMorgan says the question of potential conflict is thoroughly addressed in its disclosures around the portfolios. The company has previously failed to properly disclose conflicts of interest to clients. In 2015, JPMorgan settled charges of improperly steering clients into its own mutual funds and hedge funds without disclosing conflicts of interest at a cost of $307 million.

Even fund companies that do not include their own ETFs in model portfolios can end up with conflicts of interest. By paying to trade commission-free on brokerage platforms like Charles Schwab or Fidelity Investments, such providers have an advantage over competitors not paying for prime shelf space.

Last year, Vanguard dropped ETF commissions on its retail brokerage platforms, both for competitors and its own funds. Vanguard’s Martino says the decision was made to offer shareholders, which own Vanguard through the funds, higher returns by eliminating trading commissions.

“The main benefit the client takes is that it takes one question out of consideration. They don’t have to worry about commission, they can focus on expense ratio, exposure, bid-ask spreads and other implicit and explicit costs,” Martino says.

However, all of this requires extra work for advisors. Daniil Shapiro of Cerulli Associates says that particularly with longer holding periods, the best ETFs, for example, may not be commission-free.

“Advisors should be aware that depending on their time horizon and liquidity needs, the ideal ETF may be outside of the commission-free offerings, requiring additional research to select the best products,” Shapiro says.

JPMorgan’s You Invest does not offer tax-loss harvesting, which hasn’t mattered in an environment of low volatility and steady gains. But over a longer period of higher volatility, or a downturn, the lack of tax loss harvesting could create challenges for investors come tax season. The bank says the feature is being considered as an addition in the future.

Geraci argues that advisors should pay special attention to conflicts of interest when outsourcing investment management.

“You would hope that investors would connect the dots and see that if the portfolio contains all of one company’s funds, that’s not the best situation, but I don’t think that’s always the case,” he says. “If an advisor is using third party models, the sole job on the investment management side is to do the proper due diligence.”

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