Adviser Fee Structures - Conflict, Greed and Ethics

One of the most hotly contested debates in financial advice circles is the issue of fees - in particular high fees and commissions.

There is, and always will be, a natural tension between the parties. Investors want to pay less and advisers and investment product providers want to be paid more. Pure greed on both sides. However, if we scrape below the surface what we find is that it is value that clients are really seeking.

The focus of the discussion would be better directed towards issues such as:
• poor service,
• fairness
(am I paying the same as others),
• greed (I don\'t want to pay any fees),
• the structure of fees,
• communication and
• expectations

Alas, it is disheartening that often the focus is so much on fees that investors forget about the real objective - strong net returns over the long term! Nonetheless fees have significant impact on the total investment return. This article examines fee structures and how the structures employed can influence the outcome.

Hourly Fee Structures

This is a common fee structure for professionals such as lawyers and accountants. It is simple and seems fair because investors pay fees
according to the time taken.

However, it has the potential to be in conflict with the clients\' best interests.
Let me explain.

The Inefficient Adviser Conflict
A client being charged on an hourly rate will in effect be \"encouraging\" the adviser to be inefficient. The adviser is in no hurry and is in fact quite happy to see issues drawn out. You only need to look to the legal profession to see how drawn out this process can be.

Poor Service Bias
The other issue with this charging method is that every time the client engages the adviser, the clock (and calculator) starts ticking. This discourages the client to have a full and complete discussion about their investments. This can lead to poorer performance of their portfolio and certainly heightened levels of client stress and anxiety particularly with the current volatile markets.

Strategic Advice
Where this fee structure works best is when the advice sought is strategic and structural in nature. For example, strategic advice regarding the establishment of a Self Managed Super Fund. In other words, where the outcome is not directly linked to investment performance or outcomes.

Commission Structure
The investment advice industry in Australia is dominated by a fee payment structure where commissions are paid upfront and ongoing by product providers though this is being phased out.

The principle is that the adviser is paid for the higher than average workload in the initial stages of establishing an investment and provides a reason to service the client after the initial sale.

Under this model the product provider pays the fees to the adviser and the service is \"free\" to the client. However, it promotes the illusion of \"free\" advice and encourages unscrupulous operators.

Adviser Dependence on Investment Provider
Product providers can \"incentivise\" advisers to sell their investments over competitors by manipulating fees and offering soft dollar incentives. In fact this can occur over entire product types as each provider tries to outmatch the competitor. Look to the now failed Forestry Managed Investment Schemes to see this practised through a whole product group.

Exclusion of entire Asset Classes and Investment Product types
Advisers, through necessity, tend to only actively engage in discussions regarding investments on which they get paid. Typically, managed funds on a wrap platform. Direct shares and property are typically discouraged as they do not get paid to sell these. Hence the range of asset classes and structures can be incomplete.

Advice vs. Product Sale
Financial Planners are perceived to provide financial advice first and foremost.
However, this charging structure aligns with the interest of the large institutions and \"trusted\" brand names. Advisers are most likely to consciously or subconsciously steer clients into investments and platforms they sell
on behalf of an institution.

The Death of Commissions?
Whilst there are changes being put in place to ensure that â\"commissions\" are outlawed on certain financial and investment products unfortunately I doubt that the conflicts will disappear. Certainly the word \"commission\" will disappear
but in all likelihood you will see the practice occurring under a different
name or structure.

Whilst investment advisers are directly linked to the investment product
providers the conflict will remain.

Upfront Transaction Fee
This is the model used predominantly by stockbrokers, buyers� advocates and parts of the main trading and investment banks.

Essentially, the investor pays a one off fee upfront to invest in the product and there are no ongoing fees post sale. Sometimes these fees are openly disclosed such as is the case with a buyers advocate. Other times these fees are not so openly disclosed such as a new Initial Public Offering where it is â\"free\" to the investor but paid to the adviser by the investment bank/floating company.

Trader Bias
On the surface the model is sound with the investor paying once for the investment at the point of sale. However, the adviser relies on the investor trading to generate more income. As such the investor is constantly being encouraged to trade their investment rather than invest for the long term.
Long Term Portfolio Management

Most high net worth investors are seeking accountability and management of their portfolios over many years. This fee structure provides no incentive to manage past investments or take into account long term objectives.

Financial planners and professional investment managers will typically advise clients investing in shares take at least a 5 year view. Stockbrokers\' long term
view is often only 12 months.

Asset Based Management Fee
This fee structure is based on a percentage of funds under management. Sometimes it is scaled depending on the level of funds but not always. High net worth investors need to ensure they are getting the correct level. It is commonly used by investment managers.

Business Stress
The principle is that the base fee is set to deliver a reasonable return for managing clients\' money without putting a business under stress. A business under stress will take risks when desperate that are most likely not appropriate with the clients money - e.g. take a big position in one small stock and hope for a big payoff.

It has a fairness element to it in that as a portfolio rises and falls the adviser\'s income also rises and falls in line with the interests of the client.

Performance Fee
Pure Performance fee structures ensures that an adviser will be striving to achieve the highest return possible for the client over the medium to long term regardless of the asset class or underlying investments. This provides a reasonable alignment with the interests of the client but can encourage undue
risk to be taken in the portfolio.

It is commonly used by hedge funds but rare at an investment adviser level.

Magnitude of the Fees
Criticism of this model has been squarely aimed at the hedge fund industry where it could be argued that the fees are excessive. Typically fee structures are\"2 and 20\". 2% management fee plus a 20% performance fee above a benchmark of 0%p.a. Since the GFC the level of these fees has been rightly put under more scrutiny. However, the principle structure provides alignment
of interest with the client.

Ideal Fee Structure for High Net Worth Investors
Our experience is that the preferred fee model for clients is one that attempts to closely align with the interest of the client. There are 3 key elements to an ideal fee structure:
1. First and foremost a fee structure needs to be built in a strong environment of trust, ethics and high integrity. Without this, any structure is open to manipulation.
2. Fees must only be paid directly by the client. This ensures that the adviser is not influenced by product providers trying to incentivise their sales force\", \"brokerage\"or \"distribution business\". This ensures the adviser continues to provide services.
3. There should be no connection between an adviser and the investment bank, platform provider or investment manager. This includes \"authorised representatives\" that operate under subsidiary companies controlled by investment houses and banks.

Based on the above criteria the best structure is a total portfolio asset
based management fee coupled with a performance fee.

When should fees be paid?
My preferred method is to charge fees in arrears at regular intervals.
This to some extent helps with the problem of a client signing a \"blank cheque\" and hoping for the best when they buy the service. Of course this opens up the fee payment to bad debts and refusal to pay by clients after a bad experience. Here I would refer back to my point that fees and behaviour must be struck in an environment of trust and integrity.

Conclusion
The issue of fees including structure, level and alignment will always be, to some extent, controversial and involve conflict.

However, as long as the structure is sound, aligned to the client\'s best interest, and struck in an environment of trust and integrity there is no reason why fees should become a key issue.

A structure based on a base management fee and a reasonable performance fee across the total portfolio should deliver the best outcome for high net worth investors. Hourly rates in a known environment are best suited for one off strategic financial planning and accounting advice.

Clients and advisers should then be able to focus on the real issue - growing the client\'s investment portfolio!

Peter Jacob - Director
Alphington Private Investor
Services Pty Ltd
Level 7, 454 Collins St,
Melbourne VIC 3000
8319 4019
www.alphingtonprivate.com.au