What is a trailing commission?

Very simply, a trailing commission is money you pay an advisor each year that you own an investment. The purpose of the fee is to provide incentive for the advisor to review his clients' holdings and to provide advice. But when it comes down to it, it is essentially a reward for keeping you loyal to a particular stock or fund.

So is it fair for an advisor to get a fee simply for keeping you, the investor, loyal? Let's look at the situation.

Suppose you bought a car. It's natural that, after the big buy, you also have to lay out money every year for maintenance, insurance and a host of other things. Now suppose each and every year you owned that car, the salesman who originally sold you the vehicle got a cut of the annual auto-related expenses that you were required to pay. Would it make you mad? After all, why should the salesman get a cut of the action given that he didn't do anything once the car left the lot? And if he didn't get it, would the fees go down for you?

Well, that's how a lot of investors feel about trailing commissions.

Incidentally, fees vary depending upon the investment. However, it is not uncommon for the costs to range between 0.25% to 0.50% of the total investment per annum. That is huge! And remember that as the asset grows in value over time, it means that the advisor that initially sold the investment to you is making even more and more money.

How can you tell if you are paying a trailing commission to your advisor?

One way, quite simply, is to ask. If the advisor is ethical, he'll probably answer the question in a straightforward manner. But if you'd rather do your own homework and find out on your own, consider reading the investment prospectus. And specifically take a gander at the footnotes under the heading(s) "Management Fees."

They can be bad, but that depends on how you would like to look at it. On the one hand ,as suggested above, it seems offensive that an advisor might receive an income in perpetuity based upon a one-time initial investment. However, paying the advisor every year keeps them loyal to you, too. If the advisor is being paid for how well your stock does, he or she will also be actively reviewing your account, and making constructive suggestions – making the extra fee well worth it.

To learn more about fees, see "Paying Your Investment Advisor – Fees or Commissions?"