Do you know the different ways an adviser can be paid?
Just last week we saw a new potential client (let’s call him Bob), who brought us his statements/contracts on a fund platform we haven’t seen much about before that he was using through another firm. It was being charged “aggressively” to say the least. It combined practically every fee possible.
Each fee. by itself, was reasonable. Yet in combination the unnamed advice company operating in Shanghai had managed to capture somewhere between 70-80% of the market’s gains over the last 12 months.
In more modest years, it might be more than 100% of the market's gains. Not bad work if you can get it, but not an honest day's work.
Bob was less than impressed. As you can well imagine.
So what types of fees exist for an adviser to charge their client and what should you do about it?
There are several different ways, so here is a quick guide.
Management Fee. Your adviser charges a percentage of profits, say 1% per annum of the overall amount and they take care of the investment for you. Some correlation of interest since your adviser’s income proportionally increases as your portfolio does.
Entry Fee. Up front commissions on placing money into a fund or investment structure. Sometimes the fees hit you on entry or are exit fees that decline over time to nothing. Suits funds that aren’t correlated with markets that are bought and held for years. Worth watching though since these fees can add up and encourage your adviser to “churn”. Believe it or not, some platforms charge an entry fee and then the adviser then is able to place into a fund that charges ANOTHER entry. Double entry costs. Does this seem fair?
Profit Fee. The most common is 20% of the gain. To explain, say your portfolio goes from $100,000 USD to $150,000 (aka a profit of $50,000 USD). Your adviser or manager would be paid 20% of this $50,000 gain, (aka $10,000 USD). This does have the advantage of correlating investment returns with the adviser’s interest. The catch is that the manager of the portfolio is now incentivized to gamble, so you need a fair bit of caution and oversight to ensure the adviser sticks to the agreed risk profile.
Hourly Consulting. Also known as “the fee-based only model” your adviser produces a report for an hourly rate and you implement. No conflict of interest, but you do need to execute it yourself, which can take time and knowledge.
Admin Fees. Some brokers charge administration fees for setting up accounts or for conducting trades for the client. These can range the gamut from the fair $5 per trade, to the unreasonable ($1,000 USD to establish and $50 per trade). As in all fees, the details matter a lot.
What is reasonable? We think that a market based investment should have a flat fee of say 1% per annum (or 1.5% for smaller accounts). That’s it.
We don’t combine a 1% with a 20% management fee (although hedge funds often do). Multiple fees and combining an up-front commission with a management fee, and a profit fee is completely unreasonable. Remember, the more you pay, the less you get to keep.
What did Bob’s adviser do? Bob’s adviser was using a fund platform. The platform in question is itself sound. It can be used fairly and well. Or it can be used to screw clients. It is up to the advisor how they use it.
Bob’s advice company charged him, an entry fee to the platform of 3% (not high but not necessary), a management fee of 1% (average), but also a profit fee of 20% (very uncommon for retail investors).
Each individual fee was OK, but together were adding up to an awful deal.
Worse was to come though. More hidden layers of fees.
The profit fee was, however, weirdly, not based on the overall portfolio value. It was based on the gains of each individual fund. That’s utterly tricky nonsense right there. A financial adviser has no influence over individual fund performance.
Why should they get a performance fee?
If a profit-fee approach is selected (and that's a substantial IF), it should be paid to the underlying manager only. OR based on the overall portfolio returns off a high water-mark.
Worse still for Bob was the advisor hadn't disclosed they were placing Bob's portfolio into commission paying funds ever 5-7 months and earning 5% for each placement. It was hard to say for sure, but it was also possible the advisor was getting a management fee split trail from each fund.
Bob was generating a lot of profit in his funds, but his adviser’s combination of fees ensured the advice company was able to siphon almost all the gains away.
Pay peanuts, get monkeys? More like, pay layers in fees and get slim pickings.
"Pay peanuts, get monkeys" might be a good saying in some sectors, but not financial advice. Many studies over a number of years have shown that the lower cost an investment strategy, fund or pension fund is, typically the higher the return.
Strangely this advice is underreported by advisers and fund managers. Wonder why?
Of course there is no guarantee of higher returns if you choose lower costs, but your odds are improved considerably. The only thing that higher fees guarantee is more earnings for your adviser/fund manager. Not you.
“This advice is practically free!” is usually used by the most expensive advisors.
There is never any such thing as free advice. Advisers who work on hidden commissions like saying their advice are free. That's because many clients like the illusion of avoiding fees or getting something for free. The ugly truth is that commissions are paid to the adviser based on the fees the fund/structure/product is able to charge. Higher commissions equal higher fees. Period. It is a simple linear equation that 10 year old could draw, so worth keeping front and center in your mind when talking to a new financial adviser.
What should I do about my investment? What should the goal be on fees?
As a client, your goal on fees should be three-fold.
To reduce them.
To structure them so that conflicts of interest are reduced and managed.
Finally simplicity, preferably a single one.
That’s why we think a simple 1% per annum with no added surprises is fair for all parties
In other words, ensure there is one fee and make it reasonable and simple and appropriate for your goals and holdings.
Your Key Role? Managing conflict of interest and understanding the charges.
It is vital to ask your adviser how he gets paid and exactly how much. Don’t be shy.
Yes, some advisers will say "their partners don't allow this disclosure". But is that good enough? If you are happy to leave your portfolio with someone who is unable to say how much they earn from it, and how much you are paying, then…well you need to be very careful. Just ask Bob how careful you should be.
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