There is no one right answer to this question. It all depends on your relationship preferences, investing style, amount to invest, time horizon, risk tolerance and other factors.
This is the last in a three-part series on the different ways investment management firms charge their clients. In the first two blogs, we talked about commission-based models and fee-based models with AFAM Capital expert Chris Creed.
In this piece, we’ll pick Chris’s brain to learn the pros and cons of different models, including considerations such as underlying investment classes and wrap fees. By the end of the series, you’ll have a better understanding of what makes sense for you to help meet your individual financial goals.
Interviewer: Now this gets really confusing, and this is where it can really start to hurt my brain. I’m sitting there, and I’m trying to make a comparison against all these different methods. When I think about front loading versus back loading, versus deferred loading, commission-based, fee-based…. If I see that a firm that is fee-based has a particular fee, how do I compare that to other methods to figure out if I’m ahead or behind?
Chris: You have to do a lot of homework, because it depends on the underlying investments they’re using. For example, if we’re comparing a fee-based account that’s using just stocks, it’s pretty easy to compare to a commission-based portfolio that’s using only stocks. That’s doing an apple-to-apples comparison. If you’re comparing a stock-based, fee-based account to a mutual fund wrap account, then that’s not necessarily apples to apples.
So you have to find the underlying cost of each investment. If you’re using a simple asset class like stocks, then there really is no underlying cost. If it’s a mutual fund, or some type of what we call packaged product – where it’s say, multiple securities packaged into a single product – those generally have underlying costs. Then if you’re working with an advisor, they may have an advisory cost as well.
I know that’s a long and maybe even more confusing answer. But the answer is you have to look at the underlying investments, and then you have to look at the cost of the advisor, and that will help you do a cost comparison.
Interviewer: I get that, but that still seems very abstract. Let me frame the question this way. Let’s say one of your fraternity brothers from college, or a lifelong friend comes to you and says, “I need to figure this out.” What’s the homework you would give him, to sit down and come to that answer that you’re talking about? If we kind of paint by numbers, what are the steps that you need to do to be able to do a valid cost comparison?
Chris: Does this fraternity brother already have a competing example from another advisor?
Interviewer: I don’t know. I was thinking of it as a broader question. If you were to give just some generic advice to somebody to equip them so that they can sit down and do this calculation before they ever get on the phone with a firm.
Chris: Well, there are almost an infinite number of ways they could do this, and there are probably a lot of versions that are right. So it’s not as simple as making a table and putting the columns in. Because in fee-based, there are so many different ways that they could be charged. There are different cost levels that each individual advisor can set themselves.
For example, let’s say we charge one percent, while over there is a fee-based advisor that has a wrap fee of one percent, plus a mutual fund cost. Our way is cheaper all day long. But then you might have the same advisor that charges one percent, or maybe they charge 0.5 percent and they’re using ETFs. Well, their way is actually cheaper now. So there’s no uniformity to it. That’s why in the example you used, I’d have to have someone bring me an example to compare it to, because there are literally infinite ways – the variables change based on how much is charged. That’s why most firms ask people who are interested to call and discuss it, because putting a calculator or a spreadsheet out there just isn’t possible with all of the different combinations and factors.
Interviewer: Now I’ve got it. That makes sense. What if you were to take, say, the top five? What you think are the five most common scenarios or methods? If you think about this in terms of how AFAM sets up charges, and then you were to think about the next four most prevalent ways that people come to you. Would you be able to put together a worksheet on how to fill in the blanks on those four and compare them to AFAM?
Chris: Not really, unfortunately, because those other four scenarios can change on a client-by-client basis. But if I had someone in person or on the phone, I could easily tell them how to set up a spreadsheet based on if an advisor charges this for their wrap fund, and their underlying costs are this. Knowing what a couple of those moving variables are would enable them to come up with a comparison.
Interviewer: I think that would be great tool. To enable someone to sit down and put in their own numbers. When they put in the numbers, as opposed to you putting in the numbers, there’s a lot of trust that comes with you being transparent and honest.
Chris: And we’re happy to do that if someone is seriously considering AFAM. We have done that. We want to make sure that clients really want to work with us after making a thoughtful consideration. Another problem I could see with a spreadsheet comparison like that, though, is that it doesn’t take into account personal service, our variety of proprietary investment strategies, experience, historical performance – any of those other benefits of working with us. As we discussed before when we were talking about fee-based models, the value of a financial manager is partly a function of the difference between what the portfolio earns and what the management fee is. In the example of an index fund, somewhere around 85 percent of investment managers haven’t done as well as an index such as the S&P 5001. We’re one of the few that has outperformed our fees over the long term2. Our approach is always about long-term gains over short-term bumps that don’t last.
Interviewer: You’ve provided a fair amount of explanation around the different models of charging for financial management. Before we end, can you tell us why you’re with a fee-only firm?
Chris: Of course. And again, it depends on individual circumstances and factors. But generally the fee-only advisor is considered the most objective, because they don’t have any certain products or incentives to recommend anything other than what they see as best for each individual client. While a fee-based manager still has the ability to charge commissions, a fee-only advisor does not. Our financial success is tied directly to the growth of a client’s portfolio. To me, that’s a very clean and straightforward arrangement. (end of interview)
Clearly, there is much to consider when choosing a financial advisor. This series discussed the pros and cons of financial management firms that use commission-based, fee-only, and fee-based models. You should consider what works best for you based on the specifics of your situation. To learn more about factors other than fees, read our article 23 Questions You Should Ask Before Hiring a Private Wealth Manager.
 The Prudent Speculator strategy has outperformed the S&P 500 (net of fee, on an annualized basis) for 1 year, 5 years, 15 years, and since inception (March 10, 1977) as of 06/30/2017. Select Value strategy has outperformed both the Russell 3000 and Russell 3000 Value (net of fee, on an annualized basis) for 1 year, 15 years and since inception (December 31, 1991) as of 06/30/2017.
Investing involves risk, including risk of loss. Diversification does not ensure a profit or guarantee against loss. Past performance is no guarantee of future results.
The S&P 500 Index is a broad market sample based on the market capitalization of 500 large companies having common stock listed on the NYSE or NASDAQ. The Russell 3000 Index measures the performance of the largest 3,000 US companies representing approximately 98% of the investable US equity market. The Russell 3000 Value Index measures the performance of the value sector of the largest 3,000 US companies representing approximately 98% of the investable US equity market.
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