The other day I asked a money manager I was getting to know whether his firm charged a lower fee for managing bond portfolios than it charged for managing stock portfolios. He said no — that his firm charged the same for both.
I asked him about this because some money managers do indeed charge lower fees for managing bond portfolios than they charge for managing stock portfolios, and because bond mutual funds typically charge fees considerably lower in aggregate than stock mutual funds charge in aggregate. And, as this piece explains, asking this question can also give you a good chance to peer into the soul of the person to whom you pose the question.
Signpost: this is a fairly long, fairly wonkish piece.
What follows is about a thirty-minute read for most folks. It’s also inside-baseball’y, in that it talks about the way investment advisors, money managers and financial planners and the like calculate their compensation, and then receive it, and suggests some alternatives.
This piece can also be a good and worthwhile read for other folks, too, especially those who are curious to know more about (a) business models and revenue models generally, and (b) the business models and revenue models the financial services industries use, and (c) some of the more clever ways those industries get people to part with their hard-earned dollars, sometimes without those people even being aware that those dollars are departing for other parts unknown.
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Pricing Floors and Pricing Ceilings: Both are Lower for Managing Bond Portfolios than for Managing Stock Portfolios.
For a bunch of different reasons, many money managers charge less for their services running bond portfolios than they do for their services running stock portfolios. I’ll only mention two of those reasons here — chosen by moi because they set up distinctly different floors and ceilings (what, no walls?) for pricing stock-oriented money management services vs. bond-oriented money management services.
We begin with the floors. When it comes to determining the low end of the pricing range businesses are willing to charge for their goods and services, internal costs matter a lot because businesses are typically unwilling to charge prices that do not cover their internal costs (as in, you cannot make it up on volume). As it happens in the specific business of money management, managing a bond portfolio usually involves considerably less ongoing work than managing a stock portfolio, and, since ongoing work tracks closely with internal costs, money managers can charge lower prices managing bond portfolios than for managing stock portfolios while still maintaining a nice profitability. So that sets the respective floors, with the pricing floor for managing a bond portfolio considerably lower than the pricing floor for managing a stock portfolio.
Ceilings are quite different. When it comes to the upper ranges of what businesses will charge for their goods or services, business typically charge whatever the market will bear (not to be confused with bear markets). So Ferrari and Rolex set their prices primarily according to their customers’ willingnesses to pay — and that’s a whole lot of willingness to pay a whole lot of money — and pay far less attention to the direct costs of building and marketing and distributing their cars and watches.
Applying this concept to the money management and stocks vs. bonds realm, it’s a fact built into the very fabric of the financial universe that, over the long-run, the overall return on bond portfolios is considerably lower than it is for stock portfolios, and that means that there is simply less ooomph — less headroom — out of which money managers running bond portfolios can take their vigs over time vs. money managers running stock portfolios. And that means that customers are a whole lot more willing to pay higher fees when it comes to stock portfolio management services than bond portfolio management services.
Think of this in terms of the last four years, during which we lived in a less-than-4%-long-interest-rate world, with most of the last two years seeing long-ish interest rates hovering around 2.5%, while all the while the stock market was generating double-digit percentage annual returns (i.e., with the stock market having roughly doubled since 3/9/09, that works out to a compound annual growth rate of about 18%). Given that chasm-ing disparity, you better believe that clients are far more amenable to paying their money managers the big bucks for managing stock portfolios than they are for managing bond portfolios.
Given these lower pricing floors and ceilings (still no walls . . . ), it makes good sense for us to pay money managers lower fees for managing bond portfolios than we pay them for managing stock portfolios.
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The Money Manager’s Perspective Differs: As Seen from There, It’s “One Price to Rule Them All, To Stop Us from Doing Wrong.”
The money manager’s response to my question about pricing came from an entirely universe. His answer was that his firm charges the same fee for managing bond portfolios as it charges for stock portfolios — it charges the quite common 1.0% AUM fees per year for both (AUM fees = Assets Under Management fees) — because, by doing so, the firm can “retain its neutrality with respect to whether our clients invest in stocks or in bonds.”
His point was that, if his firm charged, say, half a percent in AUM fees per year for managing a bond portfolio but charged double that — a fee of a full one percent — in AUM fees per year for managing a stock portfolio, then, by gum, people in his firm would have an incentive to steer clients away from bonds and towards stocks, right? And that would be bad, yes?
Think about that: for every $10k a client was convinced (the passive voice is intentionally used here) to transfer out of a bond portfolio and into a stock portfolio, the firm’s revenues would increase by $50 per year (here’s the too-many-zeros-and-decimal-points-to-keep-straight calculation: 10% of $10k is $1k, so 1% of 10k is a tenth of that, or $100, which means that 0.5% is a half of that, or $50). So when a firm is managing, say, ten thousand of those $10k chunks (which is $100 million, a number considerably less than the assets this fellow’s firm had under management, and less than the assets most decently successful firms have under management), a wholesale switch of every managed dollar for every client from bonds to stocks would increase the firm’s revenues by half a million dollars per year — essentially forever — and that’s real money my friend.
So his firm felt it was best to charge 1% per year regardless of what stocks vs. bonds mix the client was using.
Hmmm, I thought. How very conveeeeeeenient.
And hmmm also: Beware of those who seek to protect you from their own bad motivations by charging you more money.
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The Rise of the AUMers: The Machines Have Killed Off their Predecessors.
Investment advisors charging AUM fees are taking over the money management joint these days. This is particularly so for money managers serving affluent and wealthy clients.
The days of stock-brokers charging commissions for buying and selling investment are, by most people’s thinking, numbered. True, machine-based brokerages are doing well enough, but the human-based, retail version has been trampled, replaced, by and large, with investment advisors charging AUM fees of about 1%. Sporadic commissions, it appears, are OK when generated by machines, but when there’s human-touch involved, it seems that a more constant, more pervading compensation scheme is in good order — as if machines need to be fed only when they do something, but humans, when they’re involved and in some ways responsible, need to be fed constantly, even when they’re asleep or taking Augusts off or simply being lazy.
AUM fees typically come bundled with a payment mechanism in which clients sign off once, at the onset of the working relationship, on their money managers having the right to unilaterally pay themselves directly out of the client’s managed assets. So AUM fees typically get paid out of A’s Under M — by the money manager taking them out of the client’s assets the money manager is managing.
Given that we’re talking here about clients who are also human beings, and given that, once these human beings agree to that payment mechanism upfront, they never again have to give a single thought to paying a penny of AUM fees, you better believe that, before long, some (many?) clients forget all about the AUM fees and also become unaware of the amount of AUM fees they’re paying. And then there’s also the format of many investment advisor statements, which do a good job of not exactly drawing attention to the AUM fee deduction (is the second to last page of a thirty page statement the least likely to be looked at . . . ?).
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The Fee-Only vs. Fee-Based Debate: All AUM All the Time, or Just Part of the Time?
The labels in this field — those of money managers and investment advisors (and investment advisers) and financial planners and wealth managers is all a jumble and all a confusion. No one knows what any of it means. And I think this state of disrepair is at least, in part, intentional. Confusion obfuscates, and obfuscation allows fudge factor and excess rents (“excess rents” = financial wonkese for “getting paid too much”).
Worthy of mention here is the difference between “Fee-Only” and Fee-Based” advisors.
Investment advisors who make 100% of their money by charging AUM fees, and nothing-but, call themselves “Fee-Only” advisors, while those who charge AUM fees but also do some sales that generate commissions call themselves “Fee-Based” advisors. Many of these Fee-Based folks do a little bit of everything: to earn commissions they’ll sell some insurance (medical, life, long-term disability, long-term care, annuities) and, while they’re at it, since they’re already doing all that stuff already, they’ll also sell some group benefit plans, plus they’ll do some buying and selling of stocks and bonds and mutual funds on behalf of their customers, etc., and then, to balance out those lumpy commission-based revenue streams, they’ll throw in some AUM’ing for good measure since AUM fees are smooth man, smooth, compared to lumpy commission revenue streams. Because, while commissions arise from the closing of a sale, which in itself is often a one-off event, AUM fees arise from a different kind of close, which is the client signing off on the advisor managing the assets and auto-dinging the AUM fees out of those managed assets, after which the AUM fees continue for as far as the eye can see.
It’s safe to say that the Fee-Onlies and the Fee-Baseds do not always see eye to eye, with the -Onlies typically being a bit younger than the -Baseds, and with the -Baseds feeling, rightly so I think, that the -Onlies have a bit of a holier-than-thou attitude.
In fact, the -Baseds and the -Onlies are absolutely duking it out in DC these days, and have been for years.
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Fee-Only and Fee-Based Revenue Models (with a Nod to the Hourly and Flat Folks): All Have Flaws.
Personally, I think both of their revenue models are flawed and, for that matter, that pretty much all revenue models in financial services are flawed in some ways. The flaw in the revenue model of the AUMers — the Fee-Only folks — is that they have an incentive to work as little as possible while still keeping the client decently satisfied (I say “decently” because assets under management are quite sticky, so looked at from a purely economic short-term perspective, there is little for the -Onlies to gain by taking a “decently” satisfied customer all the way up to, say, a “stupendously” satisfied client) (and, yes I am ignoring good will and referrals and such here). It can also be argued — what with so many AUMers charging essentially the same 1% per year fees — that price competition is wanting in this field, or more jadedly, that signaling and tacit collusion work very well indeed when all the competitors are behaving well, especially when they’re all behaving well because they’re mostly making too much money! Kinda like in real estate brokerage.
And what of the everything-but-the-kitchen-sink’ers — the Fee-Based folks? What is the flaw in their revenue model? This one is obvious, and something akin to the flavor of creepy that people feel about used car salespeople and movies about clean and sober looking Charlie Sheens stockbrokering, i.e., they have an incentive to sell clients whatever is paying the best commission that day, while also still building up their AUM bread-and-butter revenue stream. And then there is the very real problem that the Fee-Based folks are also simultaneously wearing two contrary hats: one is the hat of a salesperson, subject to a standard of care comparable to that of a shoe salesman, and the other is the hat of a fiduciary, subject to a very high standard of care comparable to that owed by a trustee to a beneficiary.
And then the hourly and flat-fee folks — like me and a handful of others! — too have our own revenue model crosses to bear in that, while working on an hourly-fee compensation basis, we have an incentive to provide too much service, and while working on a flat-fee compensation basis we have an incentive to provide too little (to counter that, when working on a flat fee I talk very s l o w l y and when working on an hourly I talkveryfast).
So each revenue model has its problems.
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My Response to the AUM Fee-Only Guy: You’re Seeing Only Part of the Picture.
The money manager I was speaking to the other day about stock vs. bond compensation works very much in the Fee-Only world, and when he said that he charged the same AUM fees for bond portfolios as for stock portfolios in order to maintain his firm’s neutrality, I could not but help myself from then saying something (mostly internally!) along these lines:
So if you want to retain neutrality while also charging a percentage, why not charge a percentage of your client’s entire net worth? That way you can be neutral with respect to how the client chooses to store any given dollar of the client’s wealth. It could be stored in business assets. It could be stored in cash-value insurance that someone else sold to the client. It could be stored in an art collection. It could be stored in a house. It could be stored in several houses. But regardless of where a given dollar of the client’s wealth might be stored, you’d look at it as a part of the whole, and your compensation would be aligned with what most of us think is the fundamental goal of the work, which is to help the client smartly shepherd his/her/their/its entire net worth through time.
Because, while charging the same AUM fees against stocks and bonds allows you to be neutral with respect to a client’s decision about how much to invest in stocks vs. how much to invest in bonds, it does not allow you to be neutral with respect to a clients’ decisions about how much to invest in stocks-and-bonds vs. how much to invest in not-stocks-and-not-bonds.
Because when you charge AUM fees, you’re only getting paid if the client utilizes financial assets. What’s’up with that? So basically, if it has a CUSIP, you like it, and if it doesn’t, you don’t? What’s neutral about that?
And tell me this: if a client tells you that s/he wants to take $1 million out of the assets you are managing for him or her to buy a house, how long does it take you to try to not say to yourself, Hmmm . . . . if s/he does that, then it’s gonna cost me $10k per year forever? And it’s true, isn’t it, that when you try to not say it to yourself, you are, in fact, saying it to yourself, n’est ce pas?
I did not hear a good retort to that question.
My point is this: AUM fees can definitely get in the way of being neutral. They are not the Holy Grail of conflict-free-dom.
And also this: a payment mechanism that helps clients forget that they are paying for something, and that frees them from ever having to think about taking a single proactive step to pay for the services they are receiving, is great for the firm or person receiving the payment, and not great for the person making the payment. In fact, a lot of scams have that characteristic.
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The AUM Fee-Only Guy’s Best Response: I Am Seeing the Whole Picture, It’s Just that We’re Talking About Two Different Pictures.
The best counter to my reply to the advisor’s comment about remaining neutral across the client’s entire net worth, is, I think, this one:
We are pure asset managers. We manage assets. That’s all we do. And we get paid for the work we do. We aren’t looking at anything else. We aren’t responsible for the entire balance sheet. We are just managing the assets. We are not about to recommend that a client re-mortgage a paid-for house and then invest the loan proceeds with us, simply to increase our AUM fees because we aren’t even going to take a look at a client’s balance sheet. Capiche?
That’s all to the good. I am all for pure money managers, and wish that we had a designation for people who are pure money managers and do nothing else, and for this use in this context I nominate the term “Money Manager.”
The problem is this: many (most?) folks charging AUM fees also call themselves “wealth managers” or “financial planners” or “wealth advisors” or any one or more of a host of other rather vague labels, and most of those folks aim to be the advisor on all things financial for the clients — the first call you make for anything financial, as one wealth manager friend of mine puts it.
In those cases, when the advisor is purporting to advise, or actually is advising, on the client’s entire financial life, AUM fees are an usually ill-fitting revenue model — a bad proxy for the value delivered — because AUM fees pertain solely to assets, and even then, pertain solely to assets Under Management, which is only a part, and oftentimes only a very small part, of a client’s overall financial world.
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Helping Clients Shepherd the Whole Shebang of their Financial Life, and Getting Paid for Doing So: The Idea of a Net Worth Under Management Revenue Model.
So maybe a better approach would be to charge NWUM fees — Net-Worth-Under-Management fees? Using that approach the advisor would help the client be smart about the client’s entire net worth, the entire balance sheet — the assets, the liabilities, etc. — without favoring one type of asset over another (and, for that matter, without loving liabilities too much).
And then if the advisor really wants to do it up, s/he could have the client pay the NWUM fee during a face-to-face meeting, during which the client and the advisor discuss the work — what’s gone well and what hasn’t, what’s coming up in the future — and during which they also discuss their ongoing relationship, including directly talking about the past and future cost of the client maintaining that relationship, as well as the advisor helping the client be very mindful of the fact that services are being exchanged for fees, and that the two should very directly align with each other.
Or, as a middle ground, the advisor could just have the client agree to the advisor fetching the fee out of the client’s day-to-day cash on hand (which is a far better payment source, by the way, than the cash in the client’s long-term investment portfolios, or worse still, than the rarified magical dollars inside of tax-advantaged accounts . . . ) and emailing or mailing the client a statement showing the payment and the services rendered.
Now it’s true that using NWUM fees would pose some interesting challenges on the Money-In/Money-Out front. What if the client needed help deciding how fat or thin a lifestyle to lead? Could the advisor using NWUM fees be neutral with respect to a spend-it-down-fast approach vs. a let’s-see-how-big-we-can-get-this-total-net-worth-thing-to-be approach?
That would be a bit of a rub, wouldn’t it?
But, still, at the balance sheet level, the NWUM fee approach clearly has more neutrality embedded within it than does the AUM fee approach — especially at the intra-balance-sheet level.
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WAG’ing on NWUM Numbs: What Percentages Make Sense.
And what might a good NWUM percentage rate be?
That’s a matter for another day, but I do have two quick thoughts. The first is that somehow — as a wild ass guess and without thinking it through — 50 basis points per year calls to me (that’s 0.50% or half a percent to most folks). Something keeps telling me that half a percent might be the center of gravity to which the NWUM universe wishes to return.
The second thought — implied in the statement of the first — is that, unlike the uniformity one finds among AUM fees (with everyone and their brother and sister charging roughly 1% per year), NWUM fees would likely range much more broadly client to client, because the way in which some clients hold their net worths requires far more shepherding than do others, i.e., A’s Under Management typically vary much less than NW’s Under Management, so the standard 1% AUM fee would not have a parallel in the NWUM field.
For instance, a person with a 100% CUSIP-based net worth might pay NWUM fees of 1% per year — this is essentially an AUM scenario, because the person’s A’s are the same as the person’s NW. And then at the extremes, a person with a lot of wealth tied up in a business in which the advisor plays no role might pay 0.1% per year, and a person with a very complex net worth who wants a lot of on-call attention to the entire balance sheet might pay NWUM fees of 1.5%.
Of course, valuation becomes an issue. CUSIPs are ever so handy for that aren’t they? Not many folks are in the habit of getting an honest appraisal of the value of their business or art collection each year.
So, terror of terrors, maybe the NWUM approach would require the client and the advisor to on, say, a yearly basis, figure out what a fair base-net-worth would be, and what a fair NWUM percentage fee of it would be? That sounds like a very adult, very evolved, very fair, very fiduciary’y conversation to me.
Surely, this does complicate things quite a bit. But doesn’t the 1% AUM fee per year, one-size-fits-all approach go too far in the other direction?
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And then there is the hourly/fixed fee approach . . .
Who was it that decided percentage-based vigs are the way to go . . . ?