Why We Like Flat Fees
We Are Exuberantly Rational
As you know, First Ascent provides portfolio management services to financial advisors for a flat fee of $500 regardless of account size. Recent discussions of different fee structures in the press present the issue as though there is a right and a wrong fee structure. Our adoption of flat fees does not come from a belief that flat fees are morally superior to AUM based fees.
We adopted flat fees because we believe there is a lack of rationality underlying the AUM fee approach for our business model. In our world, it does not take any more work to manage a $1 million account than it does to manage a $100,000 account. Accordingly, we are at a loss to justify why larger accounts should pay so much more than the smaller account.
We Don’t Take Credit for Value We Didn’t Add
Some have attempted to justify the AUM fee approach for asset managers by pointing to the fact that when the markets go up, larger accounts benefit more in dollar terms than smaller accounts. They assert that this constitutes “added value” for which the manager should be compensated. But we see this as a specious argument.
Certainly, when the market goes up the $1 million account benefits more in dollar terms than the $100,000 account. But this has nothing to do with anything the manager did. Managers don’t control the direction of the markets or the size of the accounts they manage–the two factors that resulted in the larger account benefiting more.
The lack of merit in this “added value” argument is further demonstrated by the fact that when the market goes down the large account still pays more than the small account even though the larger account lost more in dollar terms. If the AUM fee approach was truly designed to reward (and presumably punish) managers for the “value” we add (or subtract) in dollar terms, then the large account would pay less than the small account when the market goes down because the large account loses more money. This is not how AUM fees operate.
We Don’t Charge Clients for Our Mistakes
Others justify the AUM fee approach by pointing out that trade errors result in greater liabilities for larger accounts than for smaller accounts. They argue that this justifies higher fees for larger accounts to cover the potential cost of trade errors. From a strictly economic perspective this argument has logic, but some of us pause at the notion of, in effect, asking clients to pay an insurance premium that protects us against our own incompetence.
We’ll Work Hard No Matter How We Are Paid
Some point out that many clients, if asked, express support of the AUM fee approach because they like the idea that their manager’s income rises and falls with their own fortunes. But I fear that this opinion is based on a misperception on the client’s part of how things work in the investment world.
Portfolio’s do not go up because the manager worked harder or was more motivated by the AUM fee to perform better. Nor do portfolios typically lose value because the manager was lazy or disinterested because of the nature of the fee he or she received. This is a cartoonish version of how things work that clients unfortunately cling to more out of ignorance than because of any factual basis. The AUM fee schedule plays to this misperception.
When AUM Makes Sense
The financial advisor business model is different than our business model and the differences are relevant to the fee discussion. Advisors often find a greater correlation between larger accounts and more work. Larger accounts often come with added complexity.
The AUM fee structure can also help financial advisors smooth out some of the differences between large and small accounts so they can serve both the “whales” and the accommodation accounts that inevitably come along with them.
Using an AUM fee approach is not an all or nothing proposition. Advisors can tailor the AUM fee schedule to address issues that might otherwise arise. Imposing tiers or even a cap or maximum fee for very large accounts can make AUM fees more palatable for very large clients. Mixing AUM fees with flat fees or hourly fees for certain types of work can also interject flexibility into the fee discussion.
The Key is Linking Fees to Value
We are in favor of any fee schedule that ties the amount of value delivered to the magnitude of the fee. The only caveat is that the value delivered (and charged for) should be value that the advisor actually creates through his or her effort and that advisors should not take credit (get paid) for things they don’t control or have influence over.
There is a lot of discussion around fees these days and it is important for advisors to stay tuned to these conversations. Clients are rapidly being educated about fee issues and are starting to ask more questions and seek more rationality in how they are charged. The AUM approach has been a fine vehicle for the industry for many years and will last as the predominant fee approach for advisors for years to come. But the world is changing and we are choosing to get out in front of the change rather than trying to catch up to it.