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?
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.
That performance fee scheme is what hedge funds use. They have just one purpose – performance. They are structured as partnerships between accredited investors, not SEC registered advisors. Performance fees aren’t allowed for most individual investors because they encourage risk. It may seem to be fairer, but it isn’t really; in the broadest understanding of economics, the only way to increase returns is to increase risks in the portfolio. So, to raise performance, you must increase the percentage of risk assets. Of course, that also increases the chances that the portfolio will suffer at certain times.
Importantly, performance isn’t a good way to measure an advisor’s value anyway. https://www.investopedia.com/advisor-network/articles/investment-performance-bad-measure-advisor-value/ I’d suggest that a good advisor should be seen more as a professional consultant regarding financial matters. He or she provides insight rising from an expensive array or resources … staff, software, research, continuing education, and a smattering of psychology and sociology. Additionally, he or she has zero control over the economic environment. This is a professional relationship; it’s simply unfair to expect one party to cover all costs when times are bad.
I hear your pain, but you have all the power to find the right advisor, whom you find knowledgeable and caring for your needs, and negotiate the fee structure that’s deemed satisfactory to both parties.
What you described it’s a very typical asset management arrangement; the advisor charges you a percentage on the portfolio he/she manages. In a way, it’s very transparent and directly aligns your advisor’s compensation with his/her diligence on managing your portfolio. Your portfolio increases/decreases directly impact your advisor’s fee. For example, if your initial $100k portfolio is charged with 1% fee, which is $1k. By the end of the year, it increases to $120k, your advisor will have $1,200, a $200 increase. On the other hand, the $100k drops to $80k, you advisor will lose $200 to $800. That reduction indeed is a punishment and an alert to remind the advisor what he/she could do differently and how to make the improvement next time.
Here’s some insider’s information. If your advisor works for a broker-dealer (BD), he/she may take a further cut on the fee. That $1k fee of managing your portfolio may only be $600 or less, depending on the arrangement he/she negotiated with the BD. I’m not using the example to make you feel sorry for the advisor or condone any wrongdoings he/she has done to you. If he/she can’t do the job for you, it’s your prerogative to leave and find a better one.
Besides the percentage asset management fee structure, there are other compensation models, such as hourly fee or retainer fee. It’s really depending the complexity of your financial and investment needs, you have the power to decide your next advisor. Best!
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.
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.