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Opinion: Asset-Based Fees Destroy Value

Readers of our work know that we’ve been outspoken critics of the investment management industry. Much of our criticism has been focused on how investment advice is priced and dispensed (see The Truth About Asset-Based Pricing and Investment Advice is One of the Greatest Scams of Our Time).

Today, the financial services industry is all about recurring asset-based fees. Brokers, investment advisers, hedge funds, mutual funds, and bank trust departments—everyone’s getting in on the act.

We think it’s time for investors to wake up and recognize that the compounding nature of annual asset-based fees destroys value. The financial services industry and/or its regulators need to put an end to the punishing pricing structure. We think there’s a better way.

Investment Advice – Destroying Value

We believe that investors would be significantly better off if they paid investment advisers by the hour for investment advice, the same way that they pay for other professional services. Investment advisers should be well paid, but they should only be paid when they are actually adding value, not destroying it.

Investors need to understand that investment advice and portfolio management services are two distinct functions.

For the most part, investment advice boils down to asset allocation recommendations, and while asset allocations need to be revisited, and accounts rebalanced, it’s not a daily, weekly or even quarterly exercise. Investors who pay annual asset-based fees to investment advisers are paying for investment advice every day, notwithstanding the fact that the advice rarely changes. It’s akin to hiring an attorney to write a simple will and keeping the attorney on permanent retainer, paying him a yearly percentage of the value of your estate.

Some investment advisers advertise hourly rates, however they usually also offer asset-based pricing. Most, if not all, of their clients end up paying annual asset-based fees, it’s a bait and switch. Additionally, don’t get sucked into the idea that a “fee-only” adviser is meaningfully different than a “fee-based” adviser, it’s a marketing gimmick. They both generally charge annual asset-based fees.

Portfolio Management Services – Active vs. Passive, Go Low Cost

I spent the bulk of my career catering to active investment managers—the guys who manage mutual funds, trust accounts, hedge funds and separate accounts. I had a behind the scenes view of how things really work in the active management world, and I knew my clients’ strengths as well as their weaknesses.

I worked with some really great investment managers, but the truth is that they are very few and far between, and good managers often get discounted because their returns are viewed as being too volatile. Unfortunately, you can’t expect real equity returns without real equity volatility.

The vast majority of my clients were just mediocre. They weren’t stupid, mediocre is what they were shooting for, and they got paid to shadow an index while keeping volatility low. Most investors are happy to get index returns, and most investment managers are happy to oblige, for a fee.

This has contributed to the commoditization of equity returns. Active managers will vehemently reject this and insist that they can add value. They’ll babble on with things like, “it’s a stock picker’s market” or “it’s a market of stocks, not a stock market.” The reality is that equity returns have become commoditized.

Another way to think about the active vs. passive management debate is to look at money market funds. Money market returns are a commodity. Who, excluding the largest, cash rich corporations, in their right mind would buy a mix of T-bills, commercial paper and CDs instead of using money market funds? In many respects, active equity mangers are effectively doing just that. They shadow an index and make small tactical trades around the index with the hope of clearing their fees.

The old argument against indexing – that index stocks are overpriced because as money goes into index funds, the price of the stocks in that index get indiscriminately bid up – misses the fact that most stocks are in at least one index. This line of thinking would suggest that the overall market is too expensive.

We completely recognize that indexing is not appropriate in every situation, but the truth is that most investment objectives can be met by using low cost index funds.

The Future

Brokers and advisers have their snouts firmly planted in the fee trough, the name of their game is to turn their clients’ money into their money by charging the highest fee they can get away with. But the fact is that excessive, redundant and unnecessary fees are financial poison for investors and destroy long-term returns.

The future lies in adopting an hourly rate structure for investment advice, combined with the use of low cost index funds. Investors can’t control things like market direction, but they absolutely can control how much of their returns they give away in the form of fees. Annual asset-based fees are a license to steal.

Andrew J. Haigney ismanaging director at EL CAP Investment Consultants. EL CAP, Inc. ( is a Registered Investment Adviser registered with the Securities Division of the State of Vermont. The firm provides investment-consulting services to individual investors, corporations, foundations, trustees, and endowments.

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