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 their services, instead of being compensated by commissions on investment transactions like his commission-based counterpart.

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.

Defining Fee-Only

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.

Defining Commission-Based

In contrast, a commission-based advisor's income is earned entirely on the products they sell or the accounts they open. Products for commission-based advisors include financial instruments such as insurance packages and mutual funds. For a commission-based advisor, the more transactions they complete or the more accounts they open, the more they get 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.

Problems with 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.

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, earned through commission-based sales.

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 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. 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 a commission off the sale of investment products, the client makes the ultimate decision as to what types of investment products they want to purchase.

Hidden Costs

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.

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 them 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.

Differing Motivations

Because of the way they are compensated, fee-only advisors are, in theory, expected to practice a greater degree of objectivity. 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.

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, which is an emotional component that is high on many investors' list of absolutes.