KEY ELEMENTS OF OUR INVESTMENT APPROACH /
An Investor’s Guide to Management Fees
Investors face many choices when selecting an investment advisor. The variety of advisory compensation arrangements is nearly as broad as the breadth of service offerings, making the selection process all the more complex.
Complexity itself is not a problem, but it tends to cloud value assessment. A large segment of the investment management industry capitalizes on this complexity, where comparisons among advisors are difficult and costs are frequently unknown and often virtually un-knowable. Without cost transparency, investors make decisions based unduly on intangibles: the sense of personal trust, perceived cachet of the firm, or connection they feel with an advisor. This is unhealthy for the field of investment management, and certainly—crucially—for investors. Trustworthiness should be a given; likewise competence.
Compensation: Types, Opacity, and Layers
Commission-based advisors are compensated for producing transactions. As such, advisors charging commissions are financially incented to generate activity in their clients’ portfolios. Commission-based advisors have historically been held to a different standard than fee-only advisors. That is, they are only required to make investment recommendations which are suitable for their clients. They are not held to a true fiduciary standard to make recommendations which put their clients’ interests first, though this may be changing.1
Commissions can be explicit (the “load” paid to buy a mutual fund, a stock commission, etc.) or sometimes less observable. A prevalent example of an opaque fee is known as 12b-1: a “trailing commission” paid to the advisor out of the annual expense deduction in a mutual fund. 12b-1 fees may discourage trading on the part of the advisor, to some extent. The investor pays this ongoing commission (or “trailer”) to the advisor in addition to applicable front-end or deferred sales commissions, significantly hindering net—or true—performance.
The charging of commissions in and of itself is not wrong, and commissions are not going away. Investment trading services are almost universally supported by commissions. The ascendance of discount brokers like Charles Schwab offers investors very cost effective commission rates without compromising trading execution, an advantage enjoyed by major brokerage firms until recently. Actually, most investors pay some commissions, whether explicit or hidden. Even no-load mutual fund investors pay commission costs associated with the trading activity initiated by the manager within the fund. We feel strongly that advisors should orient their compensation structures to align their interests as closely as possible with those of their clients. High commissions, we believe, thwart this important goal.
Fee-only advisors, like Peloton, are most commonly compensated based on a percentage of assets under management.2 Fee schedules are generally structured to scale down at specified breakpoints, so that as client assets grow, the marginal cost of investment management declines. Fee-only advisors are financially incented to grow the value of the investment portfolio, not to produce transactions. Similarly, their personal financial ambitions are tied directly to their fiduciary duty to their clients. That is, at every turn, they must only make recommendations which reflect their clients’ best interests.
While the main investment advisory fee is disclosed in the management contract and is observable in custodial statements, clients whose advisors utilize mutual funds or third-party money management platforms pay an added layer of fees to compensate the fund manager. By contrast, clients of advisors who primarily utilize individual securities (the most basic building blocks of an investment portfolio) pay no management fees for owning stocks or bonds directly. In the case of Exchange Traded Funds, internal fees are usually very low.3
The total cost of hiring an advisor who uses funds or third party managers is the sum of the advisory fee plus the investment management fee. In these cases, rarely do the total combined fees represent less than 1.50% of assets under management. In fact, total costs in excess of 2.50% are not uncommon. In this model, the main analytical question facing investors is: can the advisor reasonably expect to add sufficient value to justify the added layer of fees?
What are You Buying?
One means of understanding what you are buying with your investment management fee is by simply asking the question of your advisor: “How do you spend your day?” Many advisors emphasize the amount of time they spend with clients, as opposed to researching and analyzing their investments. These advisors are essentially selling trust, dependability and friendship.
Another class of advisor will emphasize the ancillary services they provide: tax preparation, financial planning or insurance management. Or, more accurately, advisors in this category normally offer investment management as the ancillary service to their primary field of expertise. These advisors play the role of organizer for investors, making sure that other aspects of their financial profiles are adequately integrated with their investment management.
Pure investment advisors operate much more like highly specialized CPAs and attorneys: they recognize the limits of their professional capability and tend to emphasize their professional skill in specific areas. They also tend to work well with a client’s other professional advisors, including trusted CPAs and estate planning attorneys. Discretionary money managers practice the science of investment management, spending their time on economic forecasting, financial statement analysis, security valuation, portfolio management, cash flow structuring and so forth.
The reason to define what you are buying from your advisor is that it better equips you to determine whether the cost for the service matches well with your desired benefit. Advisors who provide a personal connection and who practice investment management as ancillary to their core competency generally utilize third party managers or mutual funds, which carry an added layer of fees. Again, the additional layer is not necessarily bad, but you must ask yourself whether the “all-in” fee matches the value added by the advisor.
Achieving Cost – Value Alignment
We offer the four principles that follow as a guide for investors who desire to match the price paid for investment management with the value received.
- Understand the exact cost of investment management. Do you pay commissions and, if so, do you know how much they are? How many layers of fees are you paying? Do you know the “all-in” fee percentage? Ancillary services, when actually peripheral to a core investment management competency, can provide added value for investors. However, we recommend segregating the value of ancillary services provided from the investment management fee. This will more precisely define the exact costs of the value being provided.
- Hire a money manager, if investment management is what you want. Managing investment portfolios is a complex profession, requiring academic study and years of analytic experience to be successful. Some financial planners, CPAs and insurance agents have added investment management services simply as an additional revenue source. But often times these advisors, who purport to “manage the managers”, have no experience managing investments themselves. We find this phenomenon hard to understand—like an orchestra conductor who doesn’t read sheet music. To the extent that your advisor offers services which are ancillary to investment management, be sure that they are related to investing and thus within the advisor’s sphere of competence. Also key in this area: be clear about how much of your fee goes to pay for investment management vs. other services.
- Recognize that the higher the cost for investment management, the lower your expected return. The probability of achieving your target return is diminished by high fees and low manager skill.4 A 2004 Moss Adams survey indicates that advisory fees fall into a wide range, with a median of approximately 0.80%.5 This fee is in addition to any layer of management fees collected by mutual fund companies or separate account managers, which drives the “all-in” cost well above 1.00% on average.Our cost objective over many years has been to keep “all-in” fees for investment management under 1.00% of client assets per year. Within that limit, we believe we can staff our operations to provide high quality, disciplined investment management as well as other critical professional investment services for our clients (including cash flow planning, integration of various investment accounts into a single cohesive portfolio, direct access to decision makers, etc.).
- Beware of investment products. Whereas complexity is used to distract investors when selling high-cost “managed manager” solutions, packaging and jargon sell many investment “products.” Variable annuities, for example, are simply menus of regular mutual funds bundled together and surrounded with a portfolio insurance policy, which is paid for by the investor via “mortality charges.” Tallying the various charges built into these products often reveals total costs exceeding 3% annually. And stiff early withdrawal penalties known as “surrender charges” all but eliminate the owner’s flexibility because they usually start at 5% of the total investment and can remain in place for 10 years.Nothing in investing is guaranteed, so when a product is touted as such, investors should proceed with extreme caution. Annuities are guaranteed simply because the investor is paying an insurance premium to protect against dying when market values are depressed, in which case the “guarantee of a level of value” is exercised. At Peloton, we structure client portfolios to provide stable, consistent cash flow and excellent opportunities for long-term appreciation and total return, without unnecessary costs or impediments to investment flexibility.
Managing integrated investment portfolios to satisfy each client’s unique needs and preferences remains at the heart of Peloton Wealth Strategists. To our dismay, the business side of investment management has contorted to emphasize “mass-customization” as a way to achieve scale and grow firm revenues. We have adamantly leaned against this trend, and our belief remains that wealth management, when practiced appropriately, is not product-centric but is instead oriented toward satisfying the specific financial needs of individual investors. For a much lower cost than most alternatives, Peloton’s highly individualized portfolio management and transparent fee offer an uncommon value for our investors.
1 The Dodd-Frank Act, passed in June 2010, charges the SEC with enforcing a fiduciary standard for all financial advisors. Peloton’s position is that there should be a single fiduciary standard for all advisors, regardless of compensation structure.
2 Fee-only advisors may utilize custodians which charge commissions, but the advisors are not themselves paid a portion of the commission.
3 Exchange traded funds (ETFs) are passively managed index based securities designed to provide exposure to special segments of the market. ETFs commonly charge a low internal fee for fund administration. Peloton uses ETFs selectively in portfolios where we cannot otherwise gain exposure to markets through individual securities.
4 Richard M. Ennis, CFA, “Are Active Management Fees Too High?” Financial Analyst Journal 61 (2005): 44-51. In this article, Ennis offers a means of judging the probability of investor success (defined as value added management), where success is a function of 1) investment advisor skill and 2) fee level.
5 FPA Financial Performance Study of Financial Advisory Practices, 2004.