This is the second blog in our series about the different ways that financial management firms charge their clients. In the first blog, we talked with AFAM Capital expert Chris Creed to learn more about commission-based charges and how they work.
Now we continue the conversation with him to help investors like you who may have questions about financial management fees. In this article, Chris goes into more detail about different types of fees, static vs. dynamic financial planning, how to come out ahead of fees with index funds, and more.
In the third and final blog of this series, we’ll discuss the pros and cons of different models and what makes sense to meet your individual financial management goals.
Interviewer: You said last time that the two main models of charging for financial management are fee-only and commission-only, and then fee-based would be a hybrid of both of those. Explain what that means? What does a hybrid look like?
Chris: Let me explain the fee-only model first, and then the third, or the hybrid model will make sense after that. The fee-only model is an advisor-based model where advisors charge a fee for their services. The fee could be an hourly fee. Or you could have a fee based on a retainer, like an attorney might do. Or it can be a specific task, for example creating a financial plan where there is a specific cost associated with that.
Interviewer: So one of the scenarios in fee-only is that I go hire somebody who just puts together a plan for me, and let’s say they charge me $1,000 for that plan. Then I go execute that via a discount broker. Does that fall under the fee only model?
Chris: That does. That’s certainly something that people have done. The advantages to that are you get an objective professional looking at your portfolio and making recommendations. It’s generally very inexpensive when you spread that cost over the amount of years that you’ve used their recommendations. The obvious disadvantage is that financial markets and individual situations are fluid; your goals and objectives can change. Certainly something that we, or another manager, recommended now might change in the next two weeks, six months, a year, 18 months. At some point, odds are your financial objectives will change, and that static model will no longer work. So it’s not a one and done situation. You’re either going to pay along the way to update it, or you’re just going to have a plan that ends up being outmoded because you didn’t want to pay again.
Interviewer: When I think about what you’re saying, if I look at just the month or so, we have seen GE replace their CEO of 17 years. Uber’s CEO was put on the bench and then stepped down. All the FANG stocks took a hit recently. So as circumstances like those change, does that change how you guys would advise?
Chris: Yes, it could. The short-term outperformance, or underperformance, of any group wouldn’t necessarily make us change anything. You mentioned the CEO of GE, and we’re not making changes based on that. But that would be something that could cause us to look at changing. When Comey was interviewed in the hearings, that could have opened doors to make changes. The election in France. All these things are events that we have to be aware of, and we have to decide if we’re going to make changes based on the outcomes. If you’re doing a fee-only arrangement where you’re paying for just a plan, or some type of static answer, it’s generally not going to be something that withstands the test of time. With that said, a financial plan is something that you might pay for one time, and get some help on your investments, and pay for that on an ongoing basis. That’s another way that some people handle it. But the most common fee-only arrangement is a fee that is based on assets under management. In other words, if we manage $100,000, and we charge a one percent fee, that’s an asset under management arrangement. As the asset goes up or down in value, since it’s a percentage fee, the amount of money that the advisor would earn would go up or down based on the value of that asset.
Interviewer: I’ve been told that buying index funds gives me the best return after factoring in the management cost. What type of return do I need to pay for the fees when compared to low-cost index funds?
Chris: That’s an interesting question. There’s been a lot of media about index funds beating investment managers. What’s interesting is most individuals don’t get the return of the index themselves1. So there is a pure cost, but there’s also an opportunity cost of not getting guidance. I’ll handle the pure cost point first, and hopefully that will explain more about the opportunity cost of not getting the guidance. As far as a pure cost goes, the amount that you would have to earn with your manager is really a simple calculation – you just add whatever the management fee is to the performance of the underlying index. So as an example, if the S&P 500 earned 10 percent, and your manager charged 1 percent, you’d have to do north of 11 percent to have made that a better decision than just using the underlying index.
It’s really just a function of whatever the index earns, adding the management fee back in to overcome that disparity between the cost of the index fund and the manager in order to come out ahead. Somewhere around 85 percent of investment managers haven’t done as well as an index such as the S&P 5002. We’re one of the ones that over a long time period have outperformed the index by more than our fee3. So based on the net of our fee, we’ve delivered more than the index since our inception.
Interviewer: Let me transition a little bit. I want to be sure and talk about sweet spots for each of these models. Where is the sweet spot where fee-only outperforms commission based?
Chris: Fee-only would provide the lowest cost when compared to a commission-based full service broker that was trading a lot. So we have to speak in generalities because there are two moving parts. One is how often that broker does trades. Then it’s how much is he charging per trade. Then you have to compare that to the fee, and we don’t know what the fee is. So just in general, you might find a sweet spot where you had a reasonably priced fee-only manager going up against a high transaction full-service broker.
Interviewer: Is there anything else you think we should know about the fee model of charging for financial management?
Chris: The other thing we didn’t cover is fee-based, and that was the hybrid model. A fee-based manager can also have attributes of a commission-based broker. They will earn commissions on some products. They may also charge fees. That doesn’t mean that they charge fees and commissions to the same clients. But we feel that generally the fee-only advisor is considered the most objective, because they don’t have any products or ways of generating more revenue that would potentially cloud the recommendation for the client. While a fee-based manager still has the ability to charge commissions to their client, a fee-only advisor, such as AFAM Capital, does not have that ability. (end of this excerpt)
Stay tuned for the last article of the series that talks more about comparisons to help you in figuring out what kind of management fees meet your needs.
 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.
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