The advice industry has been talking about “fee compression” ever since the automated advice platforms, or so-called robos, arrived on the scene seven years ago with their low-cost investment offerings. Fees have been falling or totally evaporating ever since. Here are a few examples:
- Six years ago, Robinhood introduced commission-free trading.
- Recently, Schwab, TD Ameritrade, Fidelity, Ally Invest and a handful of others jumped on the Robinhood bandwagon and eliminated commissions on stock and ETF trading.
- Earlier this year, Fidelity introduced no-fee index funds. SoFi and Salt Financial introduced no-fee ETFs. Salt Financial actually pays investors to invest in its ETFs.
- Investors are paying roughly half as much to own mutual funds and ETFs as they were nearly two decades ago and about a quarter less than five years ago.
- The average financial advisory firm revenue yield dropped from 77 basis points in 2016 to 69 basis points in 2018—a 10% drop in two years—according to the 2018 InvestmentNews Study of Pricing & Profitability.
What the heck is going on here? The obvious answer is that the fees and expenses associated with investing are declining. Advisor fees, asset manager fees and the fees charged by custodians and broker/dealers are all dropping. On average, of course. Not every service offered by every firm is declining. But the general trend is decidedly downward.
There are four reasons that explain this trend. Independently, each one would have contributed to downward pressure on fees, but the convergence of all four seems to be accelerating the rate and magnitude of change.
Technology. Advances in technology are contributing to the downward trend. Quite simply, we are more productive than we used to be. We can do more with fewer people and we can accomplish tasks in less time. Enhanced efficiency reduces the cost of doing business.
Increased productivity gives us choices. We can either keep our prices the same and pocket the savings we generated through improved productivity, or we can share the savings with our clients by reducing prices. In a competitive environment, we often buy loyalty by sharing.
Technology can also spur innovations that result in lower prices. The automated investing technologies developed by robo advisors are a good example. Before they came along, human advisors commonly charged 1% of assets under management for portfolio management and related services. The robos cut out most or all human interaction and ancillary services and made portfolio management available directly to investors online for 0.25% to 0.35% of AUM.
Our firm, First Ascent Asset Management, used the efficiencies gained from technology to introduce flat-fee pricing to the asset management world. In the past, full-service turnkey asset management providers (TAMPs) charged fees that averaged somewhere around 0.50% but could be as high as 1% of AUM. More recently technology allowed some TAMP fees to drift into the 0.35% range. We used technology to disrupt the traditional AUM pricing model and charge a flat $500 annual fee regardless of account size (0.50% for accounts under $100,000).
Facet Wealth developed its own robo-like technology and added online access to human CFPs to introduce flat-fee pricing to the financial planning world. Again, a fee of 1% of AUM was, and still is, common for financial planning services. Facet’s fees range from $480 to $5,000, making financial planning accessible to, and more affordable for, the mass affluent.
Schwab used robo technology and portfolios that include its own ETFs to create a “free” online investment service. Then it borrowed the flat-fee pricing model, added access to human CFPs, and Schwab Intelligent Portfolios Premium was born. And so it goes. Tech-driven efficiencies and innovations build on each other to create new business models that result in lower prices.
The Rise of Fiduciary Awareness. Registered investment advisors are fiduciaries. This has been true for decades. But sensitivity to fiduciary obligations has been heightened in recent years by a number of forces. Even nonfiduciary brokers have been nudged in the direction of acting kinda sorta like fiduciaries by these forces.
The first is the extended regulatory debate over the application of fiduciary duties to advice givers. This debate goes back at least 20 years to the SEC’s proposal of the so-called Merrill Lynch rule. The conflagration over the DOL’s attempt to impose fiduciary obligations on those advising retirement plans and the SEC’s head-scratching contortions involving Reg BI only magnified the discussion. Advisors and regulators are now more focused on this issue.
The tireless work of fiduciary advocates over the years has also heightened sensitivities in this area. People like Don Trone, Knut Rostad, Ron Rhoades, Bob Veres, Skip Schweiss, Blaine Aikin and Barbara Roper, to name a few, have kept this issue in the forefront of our thinking.
The good old free press has had a hand in it too. Both the trade press and the consumer press have raised general awareness of what it means to be a fiduciary and why investors should care. This coverage has changed the normative behavior among advisors and brokers alike.
As a result, client-facing advisors of all varieties have gravitated toward lower-cost investment options as they seek to satisfy their fiduciary obligations to clients. The ever-vigilant product manufacturers and service providers have responded by offering more of what those advisors want—lower fee investment options. It’s a simple matter of supply and demand.
Logic. Old pricing models are under assault because, in many contexts, they simply don’t make sense anymore. The commission model was dominant in our industry for many years. In the 1980s, the inherent conflicts involved with that model spurred interest in the percentage-of-AUM model. The SEC-sponsored Tully Report, issued in 1995, gave further impetus to the move toward fees. The fee-based model is now the dominant model for advisor compensation.
For at least 20 years there have been challenges to the percentage-of-AUM fee model. One of the earliest was in 2000 when Sheryl Garrett founded the Garrett Planning Network and advocated the use of hourly fees. Since then there has been a rise in the use of alternative fee models, including flat fees, hourly fees, percentage of income and percentage of net worth. Alternative fee models are far from dominant, but their use is growing.
All are an attempt to overcome the basic shortcomings of the percentage-of-AUM model. The biggest problem is there is often not a close relationship between the amount of work required and the fee charged. A $1 million client pays significantly more than a $100,000 client, but there may be little to no difference in the amount of work required to service these two clients. In fact, a needy $100,000 client may be far more work than a laid-back $1 million client.
Custodians recognize this and reflect it in their commission structure. A $500 mutual fund trade at TD Ameritrade costs a client $24.95. A $50,000 mutual fund trade also costs $24.95.
Another problem is that AUM-based fees focus attention on the investment management aspect of the relationship and ignore or discount important services like financial planning. From a client’s perspective it may appear that the advisor is being paid for investment management and is giving financial planning services away for free.
Also, the AUM approach does not work well for clients who have yet to accumulate significant assets, but need access to advice and planning services. So-called HENRYs (high earner, not rich yet) may have great need of planning services, but they are not attractive clients under the AUM-based model because they have not accumulated enough assets to generate a meaningful fee.
AUM-based fees are not going away anytime soon, nor should they. Many clients like them for good reason and there are plenty of situations where they make sense. But there are enough flaws in that fee model that many advisors, and even some asset managers like our firm, have adopted alternatives. This trend is contributing to the downward direction of fees.
Education. The final factor driving the downward trend in fees is education. Both advisors and consumers have been educated on the impact that fees have on long-term portfolio value.
Morningstar, Vanguard and other firms have published studies showing how even relatively small differences in the fees paid by an investor can have a significant impact on a portfolio’s terminal value over a reasonable investment time horizon.
Likewise, many sources have published studies documenting how few higher-fee active managers outperform lower-fee passively managed alternatives like index funds and ETFs.
These studies have been covered extensively in both the industry and consumer press. Advisors, too, have helped educate their clients on these topics. Even everyone’s favorite investor, Warren Buffett, included an example in his 2019 letter to Berkshire Hathaway shareholders illustrating the devastating effect fees can have on long-term portfolio value.
The results of this education show up dramatically in the data. According to the Morningstar Fund Fee Study published earlier this year, the asset-weighted expense ratio for mutual funds and ETFs fell 6% from 0.51% in 2017 to 0.48% in 2018—the second largest year-over-year decline since Morningstar started tracking fees in 2000. Investors saved roughly $5.5 billion as a result.
Similarly, the flow of assets into and out of mutual funds and ETFs reflects the increased sensitivity of the investing public to asset management fees. In 2018, the 20% of mutual funds and ETFs with the lowest expense ratios saw net inflows of $605 billion. The other 80% saw net outflows of $478 billion. Advisors and investors are making their preferences clear.
What It Means for Advisors. For advisors, the news is mostly good.
Technology will continue to produce improvements in productivity for advisors who take advantage of it. This should reduce the costs of doing business. Most advisors will need to share some of these savings with clients. But the 2018 InvestmentNews Study of Pricing & Profitability showed that even though advisor fees declined in recent years, profitability did not.
One caveat. The key is to intelligently deploy productivity-enhancing technology. Failure to adopt or effectively utilize the right technologies could cause your practice to become less competitive in the future. Firms that do an exceptional job could improve their position.
The future for advisors who adopt and adhere to strict fiduciary practices will be favorable. Heightened fiduciary sensitivities will work to their advantage.
Advisors who don’t run two risks. First, that the regulatory environment will tighten and there will be negative consequences associated with practices that don’t put client interests first. Second, that an increasingly knowledgeable public will gravitate toward fiduciary-focused firms.
All advisors should study and keep an open mind about alternative fee structures. They will become an increasingly important part of the competitive landscape. Many firms today are experimenting with the use of multiple fee approaches tailored to specific situations or client types. The key is tying fees as close as possible to the value delivered.
Expect to encounter an increasingly educated and fee conscious public. It won’t happen overnight, but expect more conversations about how you add value and why you are a better choice than the advisor down the street. If you do an exceptional job developing your value proposition, creating an excellent client experience and differentiating yourself from other advisors, you will be able to charge a premium for your services.
It has been said that the person who is closest to the client when there is fee compression will be best able to protect their margins. This puts advisors in a good position. Product and service providers further down the chain will experience more pressure on their fees than you will. But the good old days of charging 1% solely for a portfolio of mutual funds are over. Don’t be complacent. The world is changing quickly, and you need to change with it.