What Is a Fee-Based Investment?
The term fee-based investment refers to a product offered by an investment company, bank, or other institution where the financial professional is compensated through a fee as well as a commission for selling the investment vehicle. The investor covers the fee, which covers things like advice, account access, and any other service related to the investment itself, while the commission comes from the investment provider. Financial professionals who sell fee-based investments are called fee-based advisors.
- A fee-based investment is a product where the financial professional is compensated through fees and commissions.
- Fees are paid for by investors, while commissions are earned from companies that provide certain investment vehicles such as mutual funds.
- Because of how they're paid, fee-based advisors may have a greater incentive to offer fee-based investments, even if they don't serve the client's best interests.
- Fee-based investments are different from fee-only investments—advisors who sell the latter are only paid a fee.
How Fee-Based Investments Work
The term fee-based is often used to describe a hybrid advisor or a dually registered advisor. This is a professional who charges fees to certain clients and earns commissions by selling products to others. So, the investor is charged one or more fees for the services provided by a financial planner or advisor, while commissions are paid by companies that provide the investment. Fee-based investments vary depending on the planner who sells them. Like the products other advisors offer, they can range from retirement and estate accounts to regular investment accounts. Fee-based advisors may sell mutual funds, stocks, bonds, and other securities.
Fees may be a fixed amount or a certain percentage of the assets under management (AUM). In many cases, the commissions a fee-based advisor earns are fixed into the investment product itself, like the management expense ratio (MER) of a mutual fund.
The appeal of offering fee-based investments has to do with the flexibility they offer financial advisors as well as the potential creation of sustainable revenue via recurring fees. These types of investments allow advisors to continue serving clients who prefer to stick with the commission model—which often accounts for a significant share of an advisor's revenue—while continuing to use familiar, tried-and-true products. This is especially true for advisors who want to drop their broker-dealer status to move to a standalone registered investment advisor (RIA) model. In such a case they stand to miss out on significant trailing commissions. This consideration is particularly salient, as the ranks of hybrid advisors continue to grow.
Fee-based investments and advisors may have a greater incentive to sell a product that offers them the best commission rather than what is best for the client because they need only to meet the less stringent suitability standard. This means there may be a conflict of interest with fee-based advisors, as they may not have their clients' best interests in mind. Although fee-based advisors must disclose how they are compensated because of the inherent moral hazard of the commission-based model, not all of them do.
This is why it's important for financial professionals to disclose all the fees associated with their service and investment products, including fee-based investments. This allows individuals to make fully informed decisions about how much they'll be required to pay. But not all advisors are so transparent. As such, prospective fee-based investors would be well-served by asking financial professionals the following questions to be sure of exactly what to expect from a fee-based advisor:
- What are your professional qualifications and what is your educational background as it relates to dispensing financial advice?
- What is your expertise?
- How are you paid—fees, commissions, or a combination of both?
- Do you adhere to a fiduciary standard?
- Why are you recommending this product to me? Why is it suitable for me?
Be sure to ask your financial professional how they're compensated and why they recommend specific investment products.
This doesn't mean investors should avoid fee-based advisors. In fact, they may be better for some—usually less-wealthy—clients who may otherwise not be able to afford a fee-only advisor.
Fee-Based Investments vs. Fee-Only Investments
It may seem confusing, but there are differences between fee-based and fee-only investments. While fee-based advisors collect both fees and commissions from fee-based investments, fee-only advisors are only compensated for the services they provide to their clients through a series of fees.
As mentioned above, fee-based advisors aren't required to disclose all their fees to their clients. Fee-only advisors, on the other hand, have a fiduciary responsibility toward their clients and must act in their best interests. They should only sell investments that serve their clients' financial needs. As such, fee-only investment arrangements are widely considered to be better for the client as there is no threat of a conflict of interest.
Example of a Fee-Based Investment
Here's a hypothetical example to show how fee-based investments work. Let's say Mr. Sharma wants to set up a retirement account and meets Ms. Jones, a fee-based financial advisor. She suggests that he set up an investment account. Ms. Jones makes an assessment of Mr. Sharma's current financial situation as well as his goals for the future. After drawing up a plan, Ms. Jones suggests that Mr. Sharma put his money in a series of stocks, bonds, mutual funds, exchange-traded funds (ETFs), and other investment vehicles. As part of her compensation, Ms. Sharma pays her a 1% fee for her advisory services. She may also receive a commission from some of the investments she sells.