Thursday, May 17, 2012

Should Investors Favor "Fee Based" Advisors?

Recently writing about the selling and buying of investment ideas caused me to consider the most common source of stock and bond investment advice:  the stock broker or financial advisor.  As I will describe, the manner in which these investment professionals market, and get compensated for, their services is evolving.  Careful investors will consider these changes and decide whether the trend is likely to benefit portfolio performance.

Before we address the investor's need to carefully consider the motivations of the seller, let us examine the history of the broker-client relationship.  Brokers have received bad publicity over time by developing a reputation for "churning" accounts, or generating commissions through the frequent buying and selling of shares with a lack of consideration for the effects of such behavior on investors' returns.

The brokerage industry's response to these concerns has been to charge clients a specified percentage of the assets being managed.  The message to the investor is that, through this "fee based" compensation arrangement, the goals of the investor and the advisor are aligned.  After all, the investor's general aim is unquestioned: growth in total assets.  And the advisor's pay rises and falls with the value of the client's account.

But consider the choices available to the advisor in this scenario.  He can spend the majority of his time studying investment alternatives, taking every opportunity to squeeze out every bit of return possible for clients' accounts.  And through such "active management," assuming extraordinary results, which by definition cannot be relied upon from the majority of advisors, the portfolio is likely to outperform "passively managed," or index based, accounts by 2-3 percentage points annually over the long term.  Assuming the fee charged is significantly less than 2-3 percentage points, this scenario would certainly benefit the owners of the accounts managed by this hypothetical, astute advisor.  And absent an alternative method of maximizing his income, the advisor would be well served to follow this path.

But a more lucrative alternative (to the advisor) does exist.  And this method simultaneously holds the potential, compared to the prior scenario, to dramatically increase the broker's income and to ensure that the consistent extra attention that may lead to enhanced performance for existing clients will never materialize.

This alternative is the result of the comparatively new "asset based" or "fee based" pay structure.  The broker's pay will dramatically increase, far more than the 2-3 percentage point annual increase associated with actively and astutely managing existing clients' assets, by gaining new clients and, therefore, new assets.  An advisor who can double the assets under management can double his income.  So is the broker likely to be focused on increasing assets under management or increasing the return in the portfolios of existing clients?

To be sure, investors whose accounts are being churned are not being properly served.  But blindly believing that a change in the compensation scheme of advisors will align the interests of brokers with those of investors is not a formula for successful investing.