The way that most financial advisors charge their clients makes no sense. In this case, I’m talking specifically about the typical assets under management (AUM) fee structure.
To illustrate this, let’s consider an example1 I saw recently on Twitter from Rick Ferri, a noted critic of AUM fees.
This may come as a shock to many people who work with AUM based financial advisors. Under Ferri’s assumptions, the client is taking ALL of the risk, but the financial advisor and investment fund managers recieve ALL of the rewards (after the government and inflation get their cut of course).
If you assume a higher investment return above inflation, then certainly a client can start to accrue some benefits relative to the advisor. But under the typical AUM model, most clients need a return in the neighborhood of 7-9% per year to capture even the simple majority of the benefits from their investing.
This fundamental unfairness has always been an issue with investment managers. And it’s the main reason that the landscape for pooled investment funds (mutual funds and exchange-traded funds) has changed so much in the past 20-30 years. Active investment managers have been forced to lower fees in the face of low-cost, passive investment funds, or else they simply lose assets over time (unless they have a client base “locked-in” due to potential taxes).
However, when it comes to most financial advisors the unfairness persists. The average fee for financial advice remains fixed around 1% per year.
One question this brings to mind for me… when you hire a financial advisor, are you looking to take on a quasi-partner in your investment portfolio, or are you looking for sound financial advice at a reasonable price?
1 If you are checking the math, you’ll notice a 0.50% error. Ferri forgot to mention his assumption of 0.50% of fees attributable to mutual fund or exchange traded fund investment holdings in his original tweet.
