Is it a coincidence that seemingly every prospective client’s taxable account currently managed by a brokerage firm includes the same two security types; expensive actively-managed equity mutual funds and individual municipal bonds?

Viewed through the lens of massive conflicts of interest, it’s easy to see why the former would tend to land in client accounts.  Expensive actively-managed equity mutual funds generally include an assortment of sales loads and trailing commissions that place everyone’s interests ahead of the client’s.

The case of why we so frequently see individual municipal bonds in client portfolios may seem a bit less clear.  Is it possible that brokers are doing the right thing for their clients by purchasing relatively safe and conservative municipal bonds?  Ahhh…no.  The answer again can be found, albeit not easily, via the actions driven by the broker’s inherent conflict of interest.

The average spread (the difference between what a broker buys and sells a bond for) in municipal bond transactions in December 2013 was 1.73% according to a Wall Street Journal article, Muni Bond Costs Hit Investors in Wallet – WSJ.  That amount is roughly 1400% higher than the management fee on a Vanguard municipal bond fund1,2.

The decision to invest client assets in a small of number of individual municipal bonds rather than a low-cost municipal bond mutual fund3 is a concrete example of how broker conflicts of interest negatively impact their clients.

 

1 As of 3/10/14, the expense ratio on the Vanguard Intermediate-Term Tax Exempt Fund Admiral (VWIUX) was 0.12%

2 Vanguard and other low cost municipal bond funds have the additional benefits versus individual bonds of liquidity, diversification and institutional buying power for the benefit of the investor.

3 As of 1/31/14, the Vanguard Intermediate-Term Tax Exempt Fund Admiral (VWIUX) contained 3,832 bonds.