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For the Future of Financial Advice, Look to Mutual Funds

Like it or not, the cost wars are coming.

John Rekenthaler, 05/09/2017

Upsetting Tradition
For years, the industry charged its customers an annual fee of 1% of their assets. Few complained. The levy seemed reasonable, and the financial markets were rising, thereby boosting portfolio values. Those who stayed invested for several decades became wealthier than they would have imagined.

Then came a new competitor, which priced its services far below the norm. Its initial sales were modest. Existing firms argued that cost was but one factor of many that customers should consider, and far from the most important. After all, buyers generally get what they pay for.

This argument was aided by the industry’s revenue model. Whereas businesses in most sectors must prod their customers for payment, thereby prompting ongoing purchase decisions, this industry needed only to collect its money but once. After that, its payments would be collected automatically. Better yet, that charge was expressed as a small percentage—only one cent in each hundred!—rather than as a large dollar amount.

Over time, customers began to believe the newcomer. As time passed and the evidence mounted, customers could judge whether the old guard was correct when asserting that its higher fees led to better services. For the most part, the answer was no. Cheaper did not mean shoddier. Quite the contrary; that which cost less tended to deliver more.  

As this lesson permeated, customers began to change their buying habits. No longer was cost one of many items to weight. It became the factor to consider. Consequently, new sales disappeared almost entirely for the highest-priced 80% of the industry. Some of its existing customers defected as well. All the action lay with the cheapest 20%. The traditional pricing model was thoroughly, irrevocably busted.

From Funds to Advice
I write, of course, of the mutual fund industry, and of Vanguard as the disruptor. (In that endeavor, Vanguard now has several rivals, including some of the traditional companies, who have reluctantly opted to compete against their existing businesses by offering extremely low-cost funds.) That story has been well told. The cycle is complete; the hypothesis has become demonstrated fact.

The question now is whether financial advisors will follow funds’ lead. I believe that they will, albeit with some significant differences.

To begin with the similarity: Every word in this column’s first three paragraphs applies just as well to financial advisors as to mutual funds. Advisors, too, charge about 1% per year, with that request supported both by rising financial-market prices that have padded portfolio values, and a revenue-collection scheme that avoids asking customers to write checks. Until recently, that fee structure went unchallenged.

is vice president of research for Morningstar.

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