How much is your financial adviser charging you? You might not know, and if you think you know, you might be wrong. The industry is rife with deceptive pricing practices and it’s easy to miss details, even if you read the fine print. In some cases, advisers can even structure fees to be completely invisible to the client.
Fees your adviser is actually telling you about
First, let’s take a look at disclosed fees, which your financial adviser has a mandate to communicate to you. At a minimum, you can find these fees in your adviser’s SEC Form ADV Brochure. You can find the brochure for Luther Wealth here.
Assets Under Management fees
AUM fees are the most common financial adviser fees. They are based on a percentage of a client’s assets invested with the adviser and billed periodically. For example, a 1% AUM fee assessed monthly for a client with $1,000,000 invested will have a monthly AUM fee of:
$latex \frac{\$1,000,000 \times 0.01}{12} = \$833$
These AUM fees are very common and range from 0.25% for most robo-advisers, up to 2% or 3% for the priciest human financial advisers and hedge funds. Most brick-and-mortar financial advisers charge 1% or so.
So now, the client is secretly paying 1.6% in annual fees, without knowing it. And the adviser and the fund are pocketing the extra fee, 0.3% each. This can be structured legally, it’s just horribly unethical.
Performance based fees
An adviser may also charge a fee for beating certain performance benchmarks, although this is less common outside of the hedge fund industry. In a typical structure, an adviser will assess a fee for any client gains above an appropriate benchmark. For example, the adviser may benchmark against the S&P 500 stock market index, charging a benchmark performance fee of 20% for any gains above the benchmark return. Then, if the S&P 500 index earned a 10% return, and the client earned a 15% return in a managed account with $1,000,000 invested, the benchmark performance fee for that year would be:
$latex \$1,000,000 \times (0.15 – 0.10) \times 0.20 = \$10,000$
A widely used fee structure in the hedge fund industry is known as “two and twenty” or 2-20 fees. This combines a 2% AUM fee and a 20% performance fee with a zero return benchmark. This structure is much less common for financial advisers though, and if you see pricing like this you should find a different adviser.
Other fees that your adviser isn’t telling you about
AUM fees and performance fees are the most commonly quoted fees. But many, if not most, advisers also charge other hidden fees. In fact, they are so hidden that the adviser representative that works with you may not even be aware that these fees exist.
Mutual fund and ETF fees matter too
The funds that your adviser selects for your investments almost always carry their own operating fees. Fund operators do not invoice these fees directly. Rather, fund operators periodically withdraw their operating fees from the fund itself. So you do not specifically pay an invoice for these fees, you pay them indirectly by earning slightly lower returns than you would earn otherwise.
For example, if the S&P 500 index earns 8.05% on a total-returns basis in a year, and your index fund that tracks that index perfectly has a 0.04% operating fee, your fund will earn you an 8.01% return for that same year. You won’t ever pay an invoice for that amount, but you did pay that fee through lower realized performance.
Viewing fees holistically
So, it’s important to combine these mutual fund and ETF fees with your financial adviser fees to see what your full fee structure is. For example, if you have a 1% AUM fee, and you are fully invested in 5 mutual funds that each have a 0.05% annual operating fee, your true fee structure is 1.05%.
That’s not a big deal! And in fact, most large index funds charging 0.03% to 0.07% for many of their most popular products. So normally we shouldn’t have to worry about this factor all that much. However, if you look at the funds that most financial advisers pick for their clients, the fund fees are much higher. 0.50% up to 3.00% is quite common. If there are so many funds out there operating more efficiently, why do advisers select funds that are more expensive??
The completely legal kickback structure at the heart of many financial advisers’ businesses
The answer is simple. Oftentimes, expensive mutual funds and ETFs will pay financial advisers to use their funds preferentially. So you, as a client, pay more overall, while the adviser and the mutual fund provider pocket the difference. Here’s a concrete example.
A client asks an adviser to invest mostly in U.S. stocks. The advisers agrees, and they decide to set the AUM fee at 1%. The adviser will not charge any other fees. Both the client and adviser can reasonably state that the client is paying 1%, and nothing more.
The adviser can now choose to invest client funds in a low cost S&P 500 index fund, charging 0.04% in operating fees. Or, they can choose to invest client funds in a more expensive fund that also tracks the S&P 500 index, which charges 0.60% in operating fees. The second fund will never outperform the first, because they are both passive index funds, simply tracking the index as closely as possible.
Marketing fees
However, the second fund is willing to pay the adviser a “marketing fee” to help market their crappy, expensive index fund. The second fund will pay the adviser 0.30% of any client money that the adviser invests with the second fund.
So now, the client is secretly paying 1.6% in annual fees, without knowing it. And the adviser and the fund are pocketing the extra fee, 0.3% each. This can be structured legally- it’s just horribly unethical.
And just to be clear, Luther Wealth does not, and will never, do this.
But my adviser is so nice! There’s no way they are doing this to me
Oftentimes the human adviser at a big firm has no idea this is going on. At large investment firms, adviser representatives are provided with a menu of the firm’s investable funds and they pick from amongst them. They likely have no idea how their firm selects the list. And they also probably don’t realize that the list is influenced by legal kickback arrangements between the adviser’s firm and the mutual fund providers.
And in fact you will probably have trouble finding documentation about these arrangements yourself. But you don’t actually need to, you just need to research how expensive your adviser’s mutual funds and ETFs are. If the fund fees are high, your financial adviser might be ripping you off. And if the fund fees are low, it’s much more likely that your adviser is acting in your best interest with your investments.
One Reply to “Avoid Sketchy Financial Adviser Fees”