A Horse of a Different Color

Clear as Mud
As I've written twice now, there's little blood to be drawn from continued discussions about mutual fund expenses. U.S. investors have learned the lesson, such that low-cost funds receive nearly all fund inflows. I don't quarrel with the massive amounts of ink (and cyberink) that have been spilled on the subject, because it's a very important subject. But that deal has been closed.

On the other hand, ain't nobody writing about the new fee structure levied by financial advisors. The previous, commission-based model had the advantage of being open and explicit. A mutual fund's front-end sales charge was printed right there in the prospectus, as were its 12b-1 fees (if any). Exchange-traded funds, too, had an explicit charge, in the form of a commission on the trade. However, now that the financial-advice business is galloping toward fee- and asset-based charges, the waters have become murky.

Very murky. Veteran industry observer Bob Veres surveyed 1,050 financial planners and advisors about their pricing practices. His conclusion: "Fee structures may be the least standardized, least logical part of the financial advisory business."

Everything about the new pricing model is unsettled. Veres found that advisors charge asset-based fees with a very wide range, from 0.5% to 1.5% per year. Sometimes these fees are all-in. Sometimes they are not, with financial-planning activities separated from asset-management work. The relationship between the size of the asset-management fee and the amount of services delivered is far from predictable. Often, advisors with cheaper fees bundled many services into their price, while those with higher fees delivered only the single service of asset management for their cost. Writes Veres, "This is miles away from an efficient market."

Breakpoints for larger clients also vary widely. Veres observes that while the standard media report assumes that fee-based advisors levy a single percentage across all accounts, in reality most advisors offer breakpoints for larger clients. But these breakpoints occur at very different levels, in some cases for figures as low as $250,000, and in other instances only kicking in for amounts of $2 million or even more. States Veres, "It is highly unlikely that a client with $2 million in assets to manage would pay the same exact quarterly AUM fee to any two advisors who participated in the survey."

Per data from the Investment Company Institute, 80% of assets in mutual funds outside of retirement accounts come with partial or full assistance from financial advisors. The asset-based fees are larger than fund expense ratios, and they vary widely, implying that there can be very large savings from moving from one advisor to another. Yet this subject goes almost without discussion. I don't get it.

Take My Word for It
Shortly after I wrote about TNT's basketball analysts being overly sure of their predictions, comes this article about financial advisors who show confidence. The article is based on a recent academic study. Its angle is a bit different than my argument, which was that highly confident analysts are less likely to be accurate than those who phrase things more cautiously. Instead, the study looks at how people respond to high levels of confidence. It turns out that, yes, they are susceptible to such claims. The more sure an advisor seemed of himself, the less that potential customers felt the need to check on his past performance.

I suppose that Chuck, Shaq, and Kenny operate under the same principle.

The Word From Jack
Predictably, "The Eye That Does Not Sleep," aka Jack Bogle, noticed Friday's column on "The Vanguard Anomaly." Excerpts from his Sunday email to me:

"The world, at last, is beginning to understand that, so long as elementary arithmetic applies, and gross market return minus cost equals return to investors, cost matters. Unlike hotel rooms, cars, and haircuts, where value is largely in the eye of the beholder (you got that right!), in the financial field--mutual funds, bank deposits, insurance, and hedge funds (OK, maybe some snob appeal there)--it's all about how and to whom the rewards are distributed."

 "I do think that you're right on Dodge & Cox and GMO (to which I'd add that idiosyncratic Longleaf), largely because they're managers (if inevitably imperfect) rather than marketers."

"As indexing grows, the cost pressures will increase. No longer, "we're expensive but we're good." Because in indexing, "good" isn't in the equation. Just match the darn index like everyone else, and if you deliver the best net after-cost return, you've got my money, and my confidence."

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.