Financial advisory fees are a huge controversy at present. After all, there is significant evidence that paying higher fees for asset management services is detrimental to your portfolio. And while the average fee for portfolio managers has fallen significantly the average financial advisory fee remains pretty much where it has been for the last decade at 1%. What explains this and will it persist?
When I started in the world of financial services we were mostly commission based. You were only as good as what you sold. Over time it became clear that this model created lots of conflicts of interest because you were most incentivized to sell things that generated fees rather than things that were in the best interest of the client. So the business slowly evolved. The growth of the Internet and low cost ETFs and index funds put a huge amount of pressure on the industry to evolve and create a fee structure that better aligned with performance so that the advisor or manager made money when the client made money. So we started using wrap accounts and fee only services. There were still conflicts, but fewer of them.
Slowly but surely, Vanguard and BlackRock decimated the active fund management space as the evidence on active management became noncontroversial and active managers failed to protect clients from the devastating collapse of the financial crisis. But as those portfolio management fees changed the advisory fees didn’t budge. So, a commission based account where the client paid ~1-2% per year in fees via commissions slowly evolved into a C-share active mutual fund account (or wrap account) where the client was paying ~1-1.5% in fees. As Vanguard ate the world and RIA’s grew that slowly changed into a world where advisors charge a 1% fee on top of the ~0.25% in underlying fund fees index funds charge. In other words, while the cost of fund management has cratered from 1% to 0.25% the cost of an advisor has only fallen from ~2% to ~1.25%.¹ Said differently, for people using an advisor the fee structure has changed, but most of the savings hasn’t gone to the end customer.
Now, what makes this all very strange to me is the way these fees are divided. For instance, a recurring (assets under management) AUM fee is specifically derived from portfolio management because an investment management firm cannot charge flat fees. It is a business that is impossible to scale under a flat fee format so the AUM fee structure is a virtual necessity if you’re a big fund company like Vanguard or BlackRock. But why do financial planners and advisors charge an AUM fee structure? The answer is that most people don’t know that most advisors aren’t portfolio managers so they can get away with charging an asset management fee structure without doing much in terms of actual asset management. In other words, while the world has evolved the cat is still very much in the bag on why these fees have evolved the way they have….
Of course, the kicker here is the value add from financial planning is hard to quantify. We know, pretty definitively, that most people shouldn’t pay 1% or more for asset management services. So, the question is, if you’ve got $1,000,000 in assets and you’re paying a 1% advisory fee on top of 0.25% in underlying fund fees how much of that $10,000 advisory fee should be wrapped into an AUM structure? Is that advisor really adding 1% of value through the portfolio management and planning? Or is most of the actual portfolio management being done in the 0.25% section of the fee that Vanguard is earning while the advisor is basically charging a huge premium for financial planning services with a dollop of actual portfolio management (like rebalancing, tax loss harvesting, etc)? The answer is obviously complex and different for everyone, but it’s an important one to try to quantify if you are paying a 1% fee for advisory services because there’s a very good chance you’re basically paying 1.25% for a somewhat fancy looking version of a 60/40 stock/bond portfolio with a dollop of financial planning and actual portfolio management on the side.²
So, what do I think will happen over time as this reality seeps out into the public?
- There will be a sweeping change in fee structures as the 1% fee structure comes under attack as clients realize they’re paying an AUM fee structure for advisors who aren’t really portfolio managers.
- Flat fees will become increasingly common as advisors who are putting together indexing strategies are induced to move away from the AUM structure to a flat fee structure that is more similar to the way accountants and consultants charge fees.
This is going to be life and death for many advisors. Legacy firms with massive overhead and fixed high fee AUM structures will struggle to compete with the coming change in fee structures. Firms that are able to move to a leaner and more tech based platform will outperform as they make up for lost revenue with fatter margins.
NB – I realize that some advisors and managers will view this post as an attack on their business. It is most definitely not. In fact, it is an opinion based warning about what I believe is coming and those who heed the warning will use this constructive criticism as a way to better service their clients and prepare themselves for the coming war on advisory fees. 3
¹ – These are rough numbers, but they’re pretty darn close.
² – Industry insiders call this “protecting the point”. There is a strong argument that the advisory space is a lot like an oligopoly that binds together refusing to cut costs from that 1% fee structure. That’s starting to change especially as the Robo Advisors shake up the space.
³ – There is a high chance that my opinion based forecast is completely wrong. After all, I know how badly informed the average person is in basic financial matters and that’s part of why high fee structures persist. People simply don’t care enough about these matters to do their own homework so they remain willful prisoners in high fee platforms. 4
4 – There will be many cases where the advisor is short-changing themselves. Especially in the case where planning is extensive and turns out to be more expensive than an AUM structure, however, I suspect the average fee structure will drop in most cases since most customers do not require thousands of hours of planning.