There are some big changes coming to the investment industry, with one of the most important being an increased level of transparency when it comes to fees. Starting January 2017, investors will start seeing how the fees they pay are calculated, not only to their advisors but also on their investments.
This is great for clients, as they’ll have access to more information at their disposal, regardless of field or industry.
I’m already seeing two prominent reactions in preparation to the increased transparency. First, advisors are beginning to move from a commission-based form of compensation (getting paid to trade) to a fee-based one. Second, mutual fund companies and ETF providers, to a lesser extent, are scrambling to lower—or at least appear as though they are lowering—their fees. As this second reaction is a very important issue in itself, I’ve dedicated an entire blog to it.
Both of these trends are a net positive for clients. While the benefit of lower fees on investment products is self-evident, the transition from commission-based to fee-based requires more explaining.
I’m a big believer in the power of incentives. If you get the incentives right, good things often happen, and vice versa. Unfortunately, the British learned this the hard way during their occupation of India when, in an attempt to reduce the cobra population, they offered a bounty for every dead cobra.
When it comes to compensation for financial advisors, a fee-based method is superior because it means an advisor’s pay is directly correlated to the advisor’s client’s portfolio level, aligning a client’s interests with the advisor’s. This gives the advisor a positive incentive to manage a client’s wealth prudently.
Compensation via commission, on the other hand, pays an advisor for trading. The more the advisor buys and sells securities in a client’s portfolio, the more they usually make. Although I have seen it happen in my 20 years as a wealth manager, this is not to say all commission-based advisors take advantage of their clients through meaningless trades.
That being said, there is one potential downside to having an advisor compensated through fees: The advisor could do little to nothing to collect their fees. Most clients who eventually leave their advisors, do so because they received little to no service from them. It’s unfortunate, but bad service, or even no service, happens more than it should.
If you like the idea of working with a fee-based advisor but aren’t sure what you should be receiving for your fees, here is a good guideline:
Although not exhaustive, this list should give you a fairly good idea of what you should expect from an advisor when you’re paying fees.
Compensation is rarely discussed, but it’s one of the most important subjects when it comes to investing. Feel free to contact me if you have any questions, I’m always happy to discuss this topic with investors who are concerned about the best way to increase their net worth!