The Great Financial Advisor Deceit
The Most Common Way Financial Advisors Charge Fees Is A Scandal and a Grave Disservice To Their Clients
The most common way financial advisors charge their clients is by AUM fee.
An AUM fee (AUM is an acronym for “assets under management”) is calculated by multiplying the dollar amount of a client’s managed portfolio (the assets under management) by some percentage that the advisor charges.
So, the more money one has, the more fees one pays.
Financial advisors argue that’s a good thing, and that AUM fees align their clients’ best interests with their own. “We do better when you do better,” is a common advisor refrain.
But simple math and common sense tell a different story, one that is clearly not in any client’s best interest, but one that is immensely profitable for advisors.
Simple Math + Common Sense = “You’re Charging Me How Much…And For What, Exactly?”
If a client has $500,000 under the management of an advisor who charges a 1% AUM fee, the client will pay that advisor $5,000 for the year. A client with $1 Million will pay $10,000; a client with $3 Million will pay $30,000; and so forth.
Now consider this: the time and effort required for a financial advisor to professionally service a $3 Million client are not materially more than the time and effort required to professionally service a $500,000 client.
In fact, because of the economies of scale that modern technology provides, the $500,000 and $3 Million clients receive the very same service, the very same investments, the very same performance, the very same statements, and the very same amounts of the advisor’s time and effort.
So why should the $3 Million client pay six times the annual fee?
“That Doesn’t Make Any Sense.”
AUM fees, based as they are on the arbitrary factor of how much money one has (which does not determine the amount or difficulty of the advisor’s work), simply don’t make any sense. They are the equivalent of a dentist charging for a filling based upon the patient’s height, or a restaurant charging for its special of the day based upon the patron’s weight.
Nevertheless, they’re charged for this reason: they pay financial advisors staggering amounts year after year for work they don’t do and value they don’t provide.
But good luck getting a financial advisor to admit that, or even understand it. As the French philosopher René Descartes said way back in the 1600s, “A man is incapable of comprehending any argument that interferes with his revenue.” Three hundred years later, author Upton Sinclair affirmed, “It’s amazing how difficult it is for a man to understand something if he’s paid a small fortune not to understand it.”
Remember the “We do better when you do better” claim, that AUM fees provide advisors an incentive to grow their clients’ accounts?
When advisors say that, they’re implying that they’re responsible for the investment returns in clients’ account.
But that is not true. Advisors don’t provide investment returns. Advisors can’t provide investment returns. Markets provide investment returns.
Moreover, advisors have absolutely no control over markets. Markets go up, down, or sideways in reaction to world events, not in reaction to any advisor’s “incentive.”
Nor do advisors know which markets will go up, or when. That is because, as common sense tells us, the future is unknowable, so no one can predict it.
When a client’s accounts increase in value, it’s because markets increased in value. That’s a good thing! But it’s good luck; it is not the result of advisor skill.
Therefore, the notion that AUM fees give an advisor some incentive to grow a portfolio is deceptive nonsense. The only true incentive AUM fees provide an advisor is to gather more assets, and to keep those assets from being spent, lest the advisor’s fee income go down.
The Final Straw: The Tyranny of Compounding Costs
Recall from the earlier example that the $3 Million client would pay six times the annual fee of the $ .5 Million client, for the very same work done.
Six times the annual fee means, of course, six times the fee, year after year after year.
In persuading investors to invest with them, financial advisors are quick to point out the magic of compound interest, which is a gift that keeps on giving to patient investors. Advisors are much less quick to point out their AUM fees’ tyranny of compounding costs, which is the ‘take’ that keeps on taking.
Consider that $3 Million client who lets her money grow untouched for 30 years. (Note: this example applies to any amount of assets that are managed by an advisor; don’t throw the baby out with the $3 Million bathwater if $3 Million seems unrelatable to you.)
Assume that $3 Million grows for 30 years at an assumed average 7% return (note: we hate using average return assumptions, as they never prove to be right, but it’s easy math here, so please bear with the example). That $3 Million will turn into almost $23 Million ($22.837 Million, give or take), a result of the magic of compound interest.
But if she was charged a 1% AUM fee, it would grow to $17.230 Million.
So, she would have supplied 100% of the investment capital, taken 100% of the risk, and gotten 72% of the reward…a result of the tyranny of compounding costs.
Into whose pocket did the missing 28%, or $5.607 Million, go? “I really, really appreciate your business and your trust, Ms. Client. Thank you very, very much!”
(In reality, it’s typically considerably worse than that for the client. It’s common for advisors to place clients’ money in funds charging another 1% or more on top of the 1% AUM fee, rendering the deal this: clients puts up 100% of the money, takes 100% of the risk, and receives 50% of the profits.)
The cherry on top of this advisory deceit is that, in a case like the one above, the advisor would no doubt claim that the 1% AUM fee is a fee for advice, and that because he is not charging her commissions, he is therefore, somehow, acting in her best interest.
But, of course, that is doublespeak.
And that’s why it’s a scandal.
Starting Over From The Beginning
What’s the job of an adviser, really? It’s to exercise stewardship over the client’s holdings. It’s to offer prudent advice that is in the client’s best interest. It is not to extract exorbitant amounts from the client’s accounts. The client’s best interest must always come first.
And it is imperative that what the financial advisor charges be clear, simple, easy to understand, and fair.
An AUM fee, based as it is on an arbitrary factor, requiring a calculation that changes day-by-day to determine it, and increasing or decreasing based upon dumb luck, is none of those things.
If Not An AUM Fee, Then What?
What would be better? A flat, fixed annual fee would, one that is a function of the time, energy, and skill required of the adviser, plus a reasonable profit margin, just as fees are priced in all other service businesses.
Such a flat, fixed fee would be so much more sensible. It would be so much simpler and clearer, requiring no calculations to determine it. And, if priced reasonably, it would eliminate the conflict of interest of grossly excessive AUM fees.
Above all, it would give clients what all clients deserve: a fair shake.
For example, in the above case of the $3 Million growing over time, were the client to pay a fee more fair and more in line with the advisor’s work actual work done-let's call it $5,000 per year and not growing-her final tally after 30 years would be $22.364 Million. That would be $5.134 Million more than the 1% AUM fee left for her.
That would also be 98% of the reward, rather than 72%. And the advisor would still be very handsomely paid, just not exceedingly so (actually, 92% less than an AUM fee would have paid). And the client would have gotten every ounce of service she deserved.
Which would be more in her best interest?
The moral and ethical imperative on all financial advisors is to first and always serve the client’s best interest, not their own.
There is plenty of money for advisors to make in doing right by their clients.