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These days, there are a number of problems in the financial world that can cause problems for the casual investor. And by casual, I mean people who don’t understand finance or economics, choosing instead to pass that burden on to someone else. I’ve mentioned before that one of the biggest problems in finance (or any industry for that matter) is the idea of doing business with someone you know, like and trust. The far more important thing to consider, though, is how you can be certain that this person knows what they’re doing.

The truth of the matter is that almost all financial advisors can tell you how certain investments have performed in the past and, based on that, extrapolate a prediction of how they will perform in the future. They can tell you about the correlation of risk and return and tell you what to invest in according to that. They can guide you through a process of understanding your risk tolerance, making sure you don’t take on unnecessary risk. While I have my own problems with these dogmas (problems which are topics for another day), they have given rise to a number of investment tools that take up room in our portfolios and I want to shed light on one in particular today: Profile funds.

You Can Bet You Have Them

If you’ve ever sat down with an advisor to talk about investments, as mentioned above they will have talked to you about your tolerance for risk and historical returns. And after you fill out a simple questionnaire, based on your risk tolerance they can tell you what type of investment is right for you. Risk tolerances usually come in five categories: conservative, moderate, balanced, advanced and aggressive.

Profile funds are funds that aren’t specialized in anything except for the exposure to risk they provide. So if you had a conservative profile fund, it would be made up of conservative investments. And if it was an aggressive fund, it would be filled with a selection of equities. You have to understand that the amount of constant research and study it takes to make informed investment selections is so huge that many advisors default to using profile funds. If your conversation with your advisor never went beyond the above topics, I can guarantee that this is what you have in your portfolio.

Where’s The Bush League Part?

Before we get to that, I need to introduce another product. Meet ETFs (electronically traded funds) or index funds. These funds follow an index like the S&P 500. Because they’re just copying an index, you don’t need a huge staff of people managing the pool of money. This is why it can be traded electronically. Simply invest in an S&P 500 index fund and you have exposure to 500 stocks. That’s pretty diverse if you ask me.

So, let’s get back to profile funds. The basic principle of profile funds is that they are mutual funds made up of other mutual funds. A mutual fund, as we know, is a fund made up of different stocks. A profile fund is a fund made up of a bunch of those. They are heavily diversified. So what’s the problem?

First, mutual funds have fees. Profile funds have to pay those fees and charge fees on top of that to pay for the guy who picked the funds. You’re basically paying bigger fees than any other fund to have exposure to a wide array of stocks and no one’s really doing any work. The “fund manager” is just picking the funds that other fund managers have already picked. Typically, you’re looking at about 3%-7% in fees. Now let’s compare that to an ETF, which is just as, if not more diverse than a profile fund. Fees are usually less than 1% too. Hmmm…

And There’s The Other Problem

So why would an advisor sell a profile fund instead of an index fund that does the exact same thing but costs way less?

There is the commission to think about. There’s next to no money to be made with selling index funds. Commissions on profile funds, however, can be as high as 5% on the dollar amount invested. This may be distressing, but to me the worst part is that these advisors may simply be ignorant. As I mentioned before, talking about risk tolerance, the correlation between risk and return and the historical gains of investing are all clever ways of enabling the advisor to wipe their hands clean with no onus on them to actually provide advice. But that’s for another post for another day.