To counter the perception that their interests are fundamentally misaligned with their clients’, a number of financial services firms are advocating the benefits of asset-based-fees. Instead of charging commissions based on how much you trade, asset-based-fee accounts charge an annual fee as a percentage of assets in your account, much like a mutual fund charges an annual fee as a proportion of assets you have in the fund. The advantages of this are clear: in the long run, the broker’s revenues from you are tied to the value of your account. If your account does well, your broker does well. If your account plummets - say your broker fills it with lousy investments - his fees plummet. Hey presto! Your interests are now aligned with your broker’s.
Not so fast. Perhaps there’s something a little too convenient that the push for asset-based-fee accounts has coincided with the steepest drop in individual stock trading (and thus the steepest drop in commissions from stock trades) in recent history. From the perspective of the financial services firm, the move to asset-based-fees means that even in a down market when trading volumes and commissions shrink, the firm can still earn fees. From the client's perspective, even when your investments are down and you’ve stopped buying or selling anything, you still get hit with quarterly fees.
One of the surprises of the 2000-2003 stock market decline was the strong profitability of mutual fund companies and other asset management firms whose income was derived from asset-based-fees. While their profits were down as fees shrunk in line with assets under management, their absolute profitability was nonetheless impressive given the downturn. Transaction, commission-based businesses, in contrast, were skinned alive as transactions and thus commissions plummeted. And in reaction to that, savvy managers of fee-based brokerage businesses began the push into asset-based-fees. After all, if a mutual fund could bill as a percentage of assets under management, why couldn’t a brokerage firm bill as a percentage of assets in your brokerage account?
There are three reasons, it seems to me, why brokerage firms love asset-based-fees:
- Asset-based-fee accounts are highly profitable for brokerage firms. They generally bill about 1.25% of assets per year; the exact number tends to vary with the size of the account. The more brokerage firms can push clients from transaction based fee accounts to asset based fee accounts, the more profitable they will be.
- Asset-based-fees are predictable. Account assets may decline in a down market, but they fluctuate a lot less than trading commissions.
- Asset-based fees rise over time. In the long run the stock market rises at least in line with inflation, so linking fees to the value of accounts guarantees that they rise over time. This is in stark contrast to transaction-based fees which have fallen over time due to technology, market deregulation and increased competition (particularly from online brokerages).
Armed with a little skepticism about the true motives for the introduction of asset-based-fee accounts, we can now consider whether they are really such a great, interest-aligning deal for investors.
The first problem with asset-based-fees is that they don’t solve all the conflicts of interest that cripple the objectivity of broker’s advice. Yes, they generally incentivize the broker to work to raise the value of your account, and thus her recurring fee. But asset-based fee accounts incentivize brokers to discourage clients from moving assets out of the account, for example to pay down a mortgage or credit card debt, or to start a tax-advantaged college savings plan, even when that’s the most sensible course of action for the client. This is particularly dangerous if the brokerage firm is also in the business of making loans: the broker can encourage the client to leave the maximum amount possible in the asset-based fee account, and to fund expenses (such as the purchase of a house) with a loan.
Crucially, brokers can still push their own firms’ products into asset-based-fee accounts. That includes their own mutual funds, irrespective of their historical performance and fees. Terrific! The broker can now earn double fees on your money: once for the asset-based account fee, and once again for the mutual fund fee.
The theoretical calculation for the broker considering this “double dipping” is simple: how much is the fee on the broker’s own product compared to the reduction in the asset-based-fee due to underperformance of the account? If the latter exceeds the former, the broker is incentivized to push his own high-fee products despite their underperformance.
Not all asset-based-fee accounts allow “double dipping”. Some asset-based-fee accounts offer discounts on the company’s own mutual funds, while others refund the entire fee. But even those accounts rarely refund sales commissions the broker receives on other firms’ mutual funds. So if you ask, I’m sure you’ll discover that in many cases your broker will at least try to dissuade you from choosing a no-load, low cost mutual fund from a competing firm, such as the Vanguard 500 fund, even in an asset-based-fee account.
The second problem with asset-based-fee accounts is more subtle, but perhaps more important. While they may go some way (but as we’ve seen, not all the way) to incentivizing the broker not to act against your interests, asset-based-fee accounts may not go far enough in incentivizing the broker to work in your interests. How’s that? Well, from your perspective, the broker seems to be incentivized to maximize the value of your account by working hard to put you into great investments. But from the broker’s perspective, things aren’t so clear. The broker’s fee income is a function of total assets under management, and she can raise these in two ways: she can work her guts out to service her clients well and try to beat the market, or she can attract more clients or more funds from existing clients. Guess which has a bigger impact on assets under management? You guessed right: quarter to quarter, investment performance doesn’t vary that much from the benchmark. But attracting new accounts has a big impact. For this reason, most brokers spend large amounts of time prospecting for new accounts rather than servicing their existing accounts.
The underlying problem here is the incentive structure. Conceptually, the asset-based-fee can be broken down into two constituents: a recurring fee, and a positive or negative performance fee (the change in the asset-based fee if the account value rises or falls). Problem one: the performance fee is too small relative to the recurring fee, so the broker is incentivized to devote too much time (from the client’s perspective) to prospecting for new accounts. Problem two: the performance fee isn’t a genuine performance fee, since the broker’s fee will rise if the broker’s stock picks rise, even if they rise less than the market or the correct benchmark for the broker’s stock picks.
It’s interesting to compare asset-based-fees for brokerage accounts to the fee structure for mutual funds and hedge funds. Mutual funds also charge asset-based-fees. But inflows to individual mutual funds are strongly correlated with recent performance. So the mutual fund manager knows that her ability to increase assets under management and thus her (conceptually) recurring fee income is highly dependent on published investment performance versus a benchmark. So the fund manager’s projected future asset-based-fee in fact has a large performance element to it. In contrast, brokers generally don’t publish independently audited track records (or even show prospective clients how they have done in their own personal accounts), so their ability to prospect for new customers is entirely unrelated to performance.
Hedge funds charge both asset-based and performance based fees, normally 1% of assets per year and 20% of the annual profits. The asset-based-fee should cover costs, not provide profits. Hedge fund managers should generate profits entirely from performance fees. They are thus incentivized to work hard to generate exceptional profits. And, as with mutual funds, hedge funds attract new capital (and thus new asset-based-fees) largely due to their performance track record.
So asset-based-fee brokerage accounts do not remove all the conflicts of interest plaguing the broker, and actually incentivize the broker to spend time prospecting for new clients rather than servicing current clients. Asset-based-fee accounts also inflict severe damage on clients’ investment performance. But before we see that, we need to reconsider the second bedrock assumption of private client services: that your wealth level requires and justifies financial products tailored specifically for you.