Advisors have good intentions, but many of them seem pre-disposed to focus on the wrong things. The evidence is clear that cost correlates negatively to performance and that past performance is of virtually no value in determining future performance. In spite of this, many advisors consistently recommend high-cost products with strong recent past performance at the expense of low-cost products that are likely to produce strong future performance. Ultimately, retail clients are the unwitting victims of these advisors’ misguided beliefs.
The ongoing use of embedded compensation has not only impeded meaningful progress regarding investor education and protection, it has also created a culture of indifference toward product cost amongst many advisors. As it now stands, many advisors would happily recommend high-cost products that pay embedded compensation over low-cost products that do not. This is sometimes mischaracterized as a debate between active and passive approaches or between mutual funds and ETFs. Neither of these false narratives captures the real problem. The real problem is that many advisors focus on the false narratives at the expense of what ought to be their primary concern: minimizing product cost on behalf of their clients when making product recommendations.
I have spoken with dozens of people in the industry who agree with me that if expensive mutual funds did not pay embedded compensation and less expensive products like ETFs did pay them, advisors who recommend them would likely and overwhelmingly switch to recommending cheaper products. In other words, those advisors claim to make recommendations that are best for their clients when, in fact, they make recommendations that are best from the limited options that conform to their preferred business model. An advisor’s preferred business model should never be the primary driver of product recommendations. This switch in product recommendations is exactly what happened in the UK when embedded compensation was banned. As soon as the ban went into effect, there was a massive shift to low-cost products.
Here’s what I would love to see—an advisory company that recognizes the huge importance of product cost by integrating it into what it allows advisors to charge. By incorporating the sum of both advice cost and product cost into a maximum allowable fee for clients, the indifference to product cost is suddenly driven home in a very real and personal way.
As people generally understand, the business of giving financial advice is “scalable”, meaning it is not four times as much work to deal with a $1 million client as it is to deal with 4 clients with $250,000 each. Accordingly, fees (expressed as a percentage of assets) should drop as household accounts grow in size. Here’s a simple illustration of what that might look like:
|Market Segment||Account Size||Total Cost (Advice + Products)|
|Emerging Affluent||Under $250,000||2.00%|
|Mass Affluent||$250,000 to $1,000,000||1.75%|
|High Net Worth||$1,000,000 to $3,000,000||1.50%|
|Ultra High Net Worth||Over $3,000,000||1.25%|
Advisors would be free to charge whatever fee they wanted (within reasonable limits), but the sum of that fee and the pro-rated cost of the products recommended would not be allowed to exceed the total cost as spelled out in legally-binding documentation that is signed when the account is opened.
In essence, advisors would still be allowed to charge whatever amount they wanted and to use whatever products they wanted, but the impact of using high-cost products would be felt directly because the additional product cost comes out of their pay. For accounts under $250,000, advisors could use individual securities and pocket the full 2% for themselves—or they could use low-cost products that cost (say) 40 bps and keep 1.6% for themselves—or they could use expensive products that cost (say) 120 bps and keep 0.8% for themselves. They could mix and match. The choice would be entirely up to the advisor and his or her clients.
As it now stands, many advisors don’t seem to really care about how much their recommended products cost because it is the clients who pay and not them. The behavior would change massively if advisors were forced to take personal responsibility (in the form of a pay cut) for recommending high-cost products to their clients. This misalignment of interests is almost certainly a huge contributor to the misguided beliefs that persist to this day.
John J. De Goey, CIM, CFP, FELLOW OF FPSC™ (the author) is a registrant with Wellington-Altus Private Wealth Inc. (WAPW). WAPW is a member of the Canadian Investor Protection Fund (CIPF) and the Investment Industry Regulatory Organization of Canada (IIROC). The opinions expressed herein are those of the author alone and do not necessarily reflect those of WAPW, CIPF or IIROC. Investors should seek professional financial advice regarding the appropriateness of investing in any investment strategy or security and no financial decisions should be made solely on the basis of the information and opinions contained herein. The information and opinions contained herein are subject to change without notice.
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