Over the past few years, many investors have been quite happy with the returns received on their investments - especially those who weathered the storm in 2008 and decided to stay the course and not sell off their equities. However, we all know that past performance is not a guide to future performance and many economists do not see the high growth of the past few years as sustainable. Although no investor can control what the market will return, one way to increase one's real return is to be mindful of fees and to make sure you are paying the appropriate charges for the advice you are receiving. In many cases, doing so could increase your annual portfolio return by a percent or two. It might surprise you to realize how fast such a small percentage can increase your portfolio value and how much the additional growth can add up to over the long term. For example, a one percent reduction in fees on a $100,000 account compounded annually over ten years would result in an additional $10,462. That's a lot of extra money that doesn't need to be saved to help achieve your financial goals.
A tale of two fees
The difference between AUM (assets under management)-based and commission-based fees is quite simple. An AUM-based fee is determined by applying a small percentage fee on the market value of the portfolio being managed. Some advisory firms have started using a flat rate or predetermined nominal fee that is independent of an account's value. Both AUM and flat rate fees have been growing in popularity because, in many cases, they provide a better match between the needs of both investment professional and client. Another common structure is the commission-based fee, which is a fee assessed according to the financial products being purchased or transacted. Since it is a transaction-based fee, it is product driven and will vary month to month based on a portfolio's transaction activity.
Commission-based fees have been under some scrutiny, since the perception is that they create an inherent conflict between the investment professional and client. Since, with commission-based fees, an advisor can benefit from the purchase or sale of financial products or by making more security trades, they are incentivized to do so whether or not it is in the best interest of the investor. The conflict arises because the investment professional may be motivated to buy financial products that provide the best fee prospects and not those that are best suited for the client. However, some proponents of commission-based fees believe that these conflicts are self-policing. Like most businesses, wealth managers face fierce competition from others in the industry. All advisors are being judged on their ability to grow accounts and any advisor who is not making trades or acting in the best interest of clients won't have clients or a business to maintain in the long term.
Many wealth managers actually prefer asset-based fee structures as it provides a more predictable and stable revenue stream while, in many cases, better aligns the interest of both money manager and investor.
What works best for you?
Investors need to determine not only what is best for their investment style, but which fee structures will mitigate conflicts and portfolio risk. The question you should ask your advisor is why the current fee structure is best for your current situation and why it's preferable compared to other fee structures available. Of course, low-cost models of both fee-based and commission-based are going to be popular, so you need to determine which one will help you reduce costs and, at the same time, be optimal for helping you achieve portfolio objectives.
Many investors that are following a passive investment strategy and are limiting themselves to index funds, such as ETFs, have found that the lowest fees available without losing any services and appropriate advice can be found by using one of the robo-advisors. However using an algorithmic-based advisor is not an end in itself but merely an appropriate tool for someone following a basic investment strategy. While robo-advisors might be the best choice for some investors with a smaller or simpler portfolio, a robo-advisor would hardly be suitable for an investor following either an active management strategy or a more complex portfolio that is invested in less traditional assets like alternatives or hedge funds.
Know your rights
Of course, some investors do not know that they have a choice concerning fees, which is why CFA Institute put fees in the spotlight during Putting Investors First month. Investors should not only be asking their advisors about fees but also about any potential conflicts of interest and how their money managers expect to mitigate them. To help investors determine their rights and what questions can help them asses the ethical commitment of their financial service providers, CFA Institute created the Statement of Investor Rights, a set of ten rights that every investor should expect from their financial advisor.
In addition to understanding how their expected advisory fees are calculated and if they are a source of any potential conflicts, investors must also ensure that their adviser understand their objectives and any other critical investment preferences or constraints. If you are close to retiring or are looking to invest in the short term to build up a deposit for a home, your objectives will be different than a young professional who is investing for retirement. Ultimately your investment preferences such as time horizon, risk tolerance, and investment objectives will impact the level of support, and the fee structure you may require.
It should be noted that with either fee structures, the rules for performance reports and fee disclosure in Canada are changing. In 2016, investors will be able to see clearly what was paid to their advisor for their services. This means that investors will be able to easily evaluate which model works better for them and not be dissuaded by fee structures that seem complicated but could be preferable.
Finding the right investment advice is one of the most important decisions that an investor will make. Often, Canadians feel that financial advice is reserved for those with larger portfolios and that is simply not true. The earlier you start, the easier it is to reach your overall financial objectives. The best part is that it is never too late to get help from an advisor. With a variety of advice available at customized price points, it's worth the research to find a solution that's just right for you.