Why aren't there advisor fee structures that are more fair to the client?
Is there a financial advisor that has a fee based on the percentage of profit made from the investments that they recommend and make with a client's money? This seems like a fair way to structure client fees. For example, if a client's portfolio sees a gain of $10,000 at the end of the year, the financial advisor takes a pre-negotiated percentage of the profit. If the portfolio has no growth or a loss for that year, than there should be no fee. Right now, my advisor is the only one making money off of our investments, and I am suffering losses from fees on top of losses from investments. Why isn't there a more fair fee structure implemented by financial advisors?
There are two answers to your question. First, perfomance based fees are prohibited except for accredited investors by the SEC. While there are several categories of accredited investors, like institutions a minimum requirement for an individual is $1,000,000 net worth. Accredited investors are deemed by the SEC to be more sophisticated and more capable of understanding investments and investment risk. The reasoning is this: mathematically charging a performance based fee the advisor can benefit from utilizing multiple high risk strategies. Hitting a home run on one portfolio and making nothing on others could still provide much higher compensation then a level, much lower fee. Performance based fees can promote risky strategies and advisors misleading about that risk.
Second reason is more practical. No advisor can control the stock market. Is it fair to punish an advisor for something out of their control? From 2000 - 2002 most indices recorded three consecutive years of losses. While you might argue that the tech wreck was "foreseeable", no one could have been expected to see the events of 9/11. Point being if advisors received no compensation in bear markets, the industry would have been wiped out by the end of 2002. I'll also add that this job is relatively easy in bull markets, but I work my tail end off during bear markets to minimize losses and look for opportunities. If my clients lose say 15% when the index funds are down 40%, isn't that worth payng for?
Not paying in a down market would be like asking for your money back if you went to a baseball game and your team didn't win - why pay to watch your team lose?
On a serious and final note - this is not meant to justify poor long term performance. In the short run some strategies will lag while others lead. More conservative strategies have given way to riskier growth strategies. What's important is that you understand the strategy your advisor is implementing for you and why. If he/she can't give you a clear investment policy for your account, then you should consider moving on.
It boils down to his or her role as a fiduciary. If his fee is based on a percentage of profit each year, it may lead the advisor to recommend riskier or more aggressive investments throughout the year. These investments will have the potential for larger returns (good for the advisor) but also have the potential for larger loss (bad for the client). If you make a good profit he will take a cut, but if you lose in this scenario there isn't much of a downside for the advisor.
If you are aren't seeing the profit you are happy with, it may be time to look for a new financial advisor.
Yes....this SEEMS fair but there is a big problem with this arrangement - actually two probelms.
First, it gives the advisor an incentive to take undue risk because they participate on the upside so risk abatement is not a problem for them - only you.
Second, if your account losses money, lets say 10% and the market losses 20%, does that mean the advisor did a bad job?
Advisors have to pay for expenses no matter what the market does and the last thing you want is to work with an advisor who isn't worried about risk and has a big incentive to take big risks with your money.
I believe that the value that financial advisors should provide to their clients should beyond investment recommendations and financial performance. If this is all you get from your relationship with your financial advisor then you are working with the wrong person. Fiduciary financial advisors could offer a variety of services including but not limited to financial guidance, financial planning, college planning, tax planning, estate planning, exit planning, debt reduction, real estate management and so on.
Hedge funds are the only financial entities I know that are compensated based on performance and they haven't done very well lately. Many of them have underperformed the market for quite some time. If financial advisors start getting compensated based on performance they will turn into stock pickers which should not be their core competency.
Your question implies that a good advisor can select and time the purchase and sale of investments in such a way to always result in rising account values. Let me be the first to tell you that no advisor can do this. No one can predict the future price of any security or market. Investment advice is one area of advice within a complete financial plan; other areas include but are not limited to Cash and Liability management, Insurance evaluations, Estate Planning, and Income Tax Strategies. Within the area of investment advice, the most valuable advice I give is in a bear market, when clients desperately want to sell low.
The model you are describing would result in the financial advisor going out of business in a bear market, precisely when the advice is most needed.
For more insight into the inability to choose investment "winners", research the Efficient Market Hypothesis.