The investment advisor field is essentially divided into two types: the fee-only and the commission-based. The fee-only investment advisor is a type of financial professional who charges a flat rate (or "à la carte" rate) for his or her services, instead of being compensated by commissions on investment transactions like his commission-based counterpart. Let's take a look at the two types of advisors' place in the financial world, and how they compare.
Defining Fee-Only Versus Commission-Based
Both sorts of advisors' services consist mainly of analyzing portfolios as a whole. They are often schooled in many different asset classes, as well as other areas such as real estate, college financial aid, retirement and tax planning or preparation.
The big difference between a fee-only advisor and a commission-based advisor is that the former collects a flat fee (a flat retainer, or an hourly rate) for investment advice or a percentage of assets under management, while the latter receives payment upon opening an account for a client or on the sale of a financial product by the company offering that financial product.
Fee-only advisors have a fiduciary duty to their clients over any duty to a broker, dealer or other institution. This means they must always put the client's best interests first, and cannot sell their client an investment product that runs contrary to his needs, objectives and risk tolerance. They can be held criminally liable if they violate these rules.
In contrast, a commission-based advisor's income is earned entirely on the products he sells or the accounts he opens. Products for commission-based advisors include financial instruments such as insurance packages and mutual funds. For a commission-based advisor, the more transactions he completes or the more accounts he opens, the more he gets paid.
Commission-based advisors must follow the suitability rule for their clients, which means they can sell any products they believe suit their clients’ objectives and situation – though the yardstick for suitability is a pretty subjective one.They do not have a legal duty to their clients; instead, they have a duty to their employing brokers or dealers. Further, they do not have to disclose conflicts of interest.
Fee-Only Versus Fee-Based
Within the compensated-by-fee realm of advisors, there can be a further, subtle but significant distinction: between fee-only and fee-based.
The sole source of compensation for fee-only advisors is fees paid from the client to the advisor. When recommending investments to clients, fee-only advisors follow the fiduciary standard to always act in the client’s best interest. They must conduct a thorough analysis of investments before making recommendations, disclose any conflict of interest and utilize the best execution of trades when investing.
In contrast, income for fee-based advisors is earned largely by fees paid by a client, although a small percentage of it can be earned through commissions earned by selling the products of brokerage firms, mutual fund companies or insurance companies. While a fee-based advisor can make commission off the sale of investment products, the client makes the ultimate decision as to what types of investment products he wants to purchase. Like commission-based advisors, fee-based advisors adhere to the suitability rule, which means they can sell any products they believe meet their clients’ objectives, but they do not have to disclose conflicts of interest. Because of these additional sources of income, fee-based advisors need to be transparent in their communication of a client's costs.
Problems of Commission-Based
Many commissioned-based and fee-based investment advisors (including full-service brokers) work for major firms, the Goldman Sachs and Merrill Lynches of the world. But these advisors are employed by their firms only nominally. More often than not, they resemble self-employed, independent contractors in the way their advisory services are melded into the firm's operations.
Advisors employed by a firm have access to its facilities and contact with other professionals in other departments (professional traders, analysts, etc.). Also, advisors have the right to use the firm's name to market their advisory services and to assure clients that professional activities are backed by a respected firm.
To receive this support from the investment firm, advisors are held to some important obligations. The most important of these provides the firm with its revenues: Advisors must transfer a certain portion of their earnings to the firm. The advisors generate their income by means of commissions, the fees clients pay each time they make an investment transaction. So, it's in the best interest of both the individual advisor and the firm to generate increased revenue through maximum trading commissions.
The problem with this method of compensation is that it rewards advisors for engaging their client in active trading, even if this investing style isn't suitable for that client. Furthermore, to increase their commissions, some brokers practice churning, the unethical practice of excessively buying and selling securities in a client's account. Churning keeps a portfolio constantly in flux, with the primary purpose of lining the advisor's pockets.
Fee-only advisors are often seen as more expensive than their commission-compensated counterparts. But it's a common misperception is that commission-based financial advisors provide their services for free – because clients aren't directly paying them. Most investors give little thought to the hidden costs they pay when an advisor recommends stocks and later receives a commission when they buy in, or when an expert mutual fund manager picks stocks for a fund that charges significant management fees or front- or back-end payments.
Consider this: Making a $50,000 investment in a fund with 5% load would translate into the equivalent of more than 14 hours of portfolio planning undertaken by a fee-only advisor at $175 per hour. If you were to hire an advisor for 14 hours at that rate, you could expect him or her to accomplish a great deal of work that would produce a more balanced portfolio, returning a potentially higher rate than the loaded mutual fund. The fee-only type of compensation provides investors with the opportunity to get more service out of the money they spend on professional advice and stock-picking expertise.
Compensation and Objectivity
Because of the way they are compensated, fee-only advisors can be expected to practice a greater degree of objectivity – at least, in theory. These professionals are better able to look at the entire universe of stocks, bonds, mutual funds and guaranteed investment certificates without being swayed by any personal benefits that may come with giving certain recommendations.
Because it's based on an hourly rate, fee-only investment advice is not motivated by the frequency of your trades and is therefore more likely to encourage you to make trades when it's right for you. However, although fee-only professionals help investors avoid the problems of churning, there should be no misunderstanding that brokerage commissions are eliminated entirely. Fee-only advisors may charge by the hour for services, but investors still need to pay a brokerage to make trades. Commissions remain the primary means by which investment firms make money, and it'll likely stay that way for the foreseeable future.
In the great bull market of the 1990s, there was a rise in do-it-yourself investing, made easy by technology that allowed average investors to access most of the services previously available only through an advisor or broker. First, some investment firms began offering telephone trading systems, whereby clients could enter a trade solely by punching buttons on the phone to select their trades and amounts. As systems became more computerized, stocks and other investment vehicles could be bought and sold directly with the click of a mouse, and the cheaper online broker (a variation of the discount broker) came on the scene. This kind of trading offered lower commissions but did not come with the advice and guidance of the full-service brokers – giving many investors good reason and motivation to start taking charge of their own finances.
The real appeal of web-based investing was not the trading systems, but the universe of investment advice and information that became available over the internet. Individual investors no longer had to rely exclusively on their human advisors for access to analyst research, opinions on certain investment products and specific advice on the timing of buying and selling. Better still, much of this advice was available for free and wasn't based on commissions.
Individual investors jumped all over the information, gobbling it up and treating it as if it were the gospel truth. Unfortunately, much of the information consisted of unfounded rumors, rampant speculation and, at its worst, outright lies. Investors often lost a bundle as a result of being caught up in the more nefarious practices on the wild wild web.
It's because of the risks of do-it-yourself investing that the investment professional is still relevant. Very few average investors have the time, education, experience and inclination to achieve the same level of expertise offered by many professionals. At their best, investment advisors are disciplined, committed, intelligent individuals who genuinely aim to help their clients achieve their investment objectives. So if you don't have the time or expertise to do proper research, it may be wise to seek the services of a professional.
The Bottom Line
Commissioned services may very well be the most suitable for some investors, particularly in the case of a smaller portfolio where less active management is required; paying the occasional commission is probably not going to be the downfall of the portfolio's returns over the long-term. Yet for anybody who has a very large portfolio to manage, whose investment objectives necessitate frequent trades and active asset allocation, the rise of the fee-only investment advisor is akin to portfolio nirvana. It allows investment professionals to do well for themselves while taking their clients' best interests to heart.