What are retrocessions?
A retrocession is a commission that fund managers pay to financial intermediaries for distributing and advising the purchase of certain financial products.
Retrocessions: Simple explanation
In other words, retrocessions are commissions that investment fund managers pay to banks or financial advisors for recommending and selling their financial products.
Basically, if a bank suggests you invest in a certain mutual fund, the bank may receive a commission from the fund manager for recommending it. Although this commission is initially paid by the fund manager, the cost is ultimately covered by the client, i.e. you, as part of the total costs of the mutual fund. This is why the classes of funds that have retrocession usually have much higher commissions.
Kickbacks are private agreements between fund managers and financial institutions and are generally not disclosed to the public. This type of commission is common in Spain, although in other European countries such as the Netherlands or the United Kingdom, they are prohibited due to stricter regulations.
The European Commission is also working to eliminate kickbacks and other similar fees, seeking greater transparency in the financial industry.
How does a retrocession work?
Let’s take a practical example to explain how retrocessions work. Everything will start with a fund manager, who will create an investment fund. In order to market this investment fund, it will need to have a financial institution willing to recommend the purchase of its product.
It is also common for financial institutions to require their clients to pay a management fee for operating with investment funds. Depending on the fees to be paid for contracting investment funds, we will distinguish between clean and non-clean classes.
- Clean class: It is not necessary to pay the retrocession, although a small management fee must be paid, as in any investment fund.
- Unclean class: In addition to the management fee charged by the clean class, there is also a retrocession fee. This is why the dirty class of a fund is always more expensive than the clean class.
What can an investor do to avoid paying kickbacks?
First of all, before deciding to take out an investment fund, it is essential to be fully informed. To do this, it is essential to pay attention to the prospectuses, which will provide all the information relating to the investment fund.
The key is to hire the clean class of that fund, which is the one that does not include a retrocession fee.
With the clean class fund already selected, it is necessary to find an entity that markets investment funds of this type. However, finding entities that market clean-class funds is a complicated task, since few banks market funds without retrocessions. All this is due to the fact that retrocessions represent an important source of income for banks at the expense of a decrease in profitability for the client.
Index funds or ETFs almost never include a retrocession fee. So if you want to avoid paying this fee (and save on other fees) this type of fund can be a good alternative.
How do kickbacks harm investors?
There is no doubt that kickbacks have detrimental effects on investors. Kickbacks are commissions to financial institutions that represent real monetary incentives. Therefore, the higher the commission, the greater the bank’s interest in recommending a particular investment fund.
In fact, rebates usually account for the majority of the management fee for investment funds. This fee must be paid by the investor, which ultimately harms their profitability. It is true that if a high incentive is established to sell an investment fund, it is possible that, given its quality, said fund may not be the most advisable investment option.
Key points
- Funds are classified as ‘clean’ and ‘non-clean’ based on whether or not they require retrocessions.
- Although the retrocession is paid by the managers, the cost ultimately falls on the client.
- The retrocessions are private agreements and lack transparency.
