In my last post I described how Asset Under Management (AUM) compensation does not relate to hours worked. This post describes how AUM compensation may have the opposite effect on your portfolio - the advisors may have motivation to doing something not in the client's best interest. If this isn't a conflict of interest then I'm not sure what is! Investment advisors should be "fiduciaries" - someone who manages another one's assets. This sounds great - however what if this fiduciary has a "stake in the game" or a benefit to managing the assets in a certain manner which may or may not be in the best interest of the owner? Even the news is raising this question. Remember a "financial advisor" is someone who is legally allowed to give a recommendation on what financial product to invest in. How they come to this recommendation can be dependent on their compensation.
For the purpose of this discussion, let's assume a 1% AUM fee and there are no commissions or sales-based charges. That's a big assumption as there are plenty of commission or sales-based charges in the financial world. But for sake of argument let's forget those for now.
1. Getting (and keeping) funds under management
Advisors who are paid by AUM have motivation - not to provide the client with best information, but to maintain as much funds under management as possible. See the following examples:
A. You have a handful of investment accounts, including a 401K with your current employer, an IRA and taxable accounts with the advisor, and a small taxable investment account at a discount broker. You have $20,000 to invest this year for retirement - the AUM advisor would receive an extra $200 per year if you invested with him/her. Would they suggest to invest with them or through your 401K or independent account? If you raise the idea of placing it in your 401K they could argue not to due to minimal fund options, decreased flexibility, poor past performance. All of these may be valid reasons, but the additional $200 additional they will receive if it was in their AUM account gives them motivation to invest with them.
B. One of your goals is to pay off your mortgage before you retire. You have adequate funds to do this in your investment account with your AUM advisor. Would your AUM advisor benefit from telling you not to pay off your mortgage? Yes! The advisor will argue that you will likely earn 5-8 percent on the money if you keep it invested verses the mortgage with a rate of usually 3 - 5 percent, and the mortgage interest tax deduction. Theoretically they are not in violation as a fiduciary, as these are all valid reasons not to pay off the mortgage. But if debt makes your skin crawl and you do not want the mortgage burden in retirement, you would want an advisor who gives you a recommendation free from their personal motivation. IA financial advisor receiving a fee bases on AUM may not look at the psychological and emotional aspect, they will look only at the fiscal aspect of your situation.
C. You have a desire to make a charitable donation. As the stock market is up, you have equities that have appreciated in value, and if sold would incur a significant tax liability, in donating the equities you will incur no tax liability. You also have the cash available to donate. You ask your AUM advisor about the donation. Will the advisor tell you to sell in following "buy low and sell high" and donate the equities? Or will they state the stock is doing well and to ride the current gains and use cash? Remember donating the equities would decrease the AUM account size, thus decrease advisor compensation.
The ideal solution is to donate the securities and repurchase with the cash you were going to donate. You avoid the tax penalty, and the new basis (which future taxes are based on) will be the new, higher price. Instead of purchasing the new equities with the advisor (where you will be paying AUM management fees), doing it outside of AUM fees but under the advice of the manager would produce lower fees.
2. Active management
If you take nothing else from this, remember that active management often produces lower returns than passive management - feel free to read the SPIVA scorecard for the exact figures. Advisors may show reports of portfolio return or comparisons to other funds. The question should be "how did my portfolio compare to the market overall with consideration for asset allocation". Indexes selected for the comparison can frame return - for this reason I prefer to use risk/metric returns for comparisons. See my previous post on this issue for more information.
Other than being placed in active funds, trading can be done to "prove" the advisor is doing work. When I do 6-month and yearly reviews, my clients are often surprised of me not making transactions. They are used to their advisor suggesting constant moves to keep up with market conditions. Remember, the SPIVA research proves that active management rarely, if ever, beat passive portfolios.
3. Complicated portfolios
I had a client who's previous advisor had them in 15 mutual funds within a single account. The overall portfolio had nearly 50 different funds. This may be interpreted as diversified, 15 funds is not needed for diversification. Remember a mutual fund is already diverse - 15 funds in a single account is a bit overextended. The advisors may have done this to create complexity and confusion where the client will rely on (and maintain an advisory relationship) with the advisor.
4. Custodian and Broker-Dealer Relationships
These can be the worst for the investor. The advisor is a representative of an investment firm or bank. Your funds are held at the firm (custodian), where trades are conducted (broker-dealer) and advice is received (financial advisor). Many advisors with this styles recommend, either majority or solely, their firm or banks funds or another company whom they have a relationship with. Read that again - the advisor often cannot recommend what is best for you. The question to this is why would they only recommend funds from their firm. Is this best for you or for the firm? I'd suggest it is due to high fees on the funds or sales charges.
There are advisors who work under a custodian/broker-dealer relationship who are not required to recommend their firm's funds, however the are typically still at the AUM level.
What about wealth based advisors?
Wealth based advisors charge a fee based on client wealth, not assets under management. This can eliminate some of the conflicts of interests. This is a step in the right direction, and many AUM advisors have rightfully gone to a net-wealth based method to avoid AUM fees. However the question of compensation based on net wealth still remains - does a larger portfolio require more hours needed? Does a $1,000,000 net wealth client require less time to manage than a $1,500,000 net wealth client? I'd suggest no.
What about an hourly advisor creating a complicated portfolio/plan, requiring many hours needed per year?
This definitely could occur, and is my conflict of interest. Theoretically I could "pad" my hours. Think for yourself - should it take Sherman Financial 5 hours to manage my account? 10 hours? How much time is actually spent on my account? I'd ask you to compare fees with those of AUM advisors, including portfolio expenses (expense ratios, and sales charges). Yes, this takes some work on behalf of the client. Does an AUM advisor whom does not charge an advising fee have higher portfolio cost expenses than what a flat-rate/hourly advisor charges, and does this AUM advisor give better returns? Will the advisor who's not paid a flat rate give me the best advice? It's a bit to ask you to do (perhaps even do some math!) but is your account worth the work?
This concludes my first and hopefully only post with all text - I promise memes, cartoons, graphs, and maybe videos in the next post!