With the rise of the robo advisor — and fintech more generally — debate has swirled around whether the traditional 1% AUM fee can endure. The issue cuts to the heart of the advisory business, as brokers seek CFP marks to better justify their value proposition and longtime advisors confront a suddenly crowded marketplace.
But the broader debate seems to miss a fundamental point. The real pressure is not on the 1% AUM fee itself, but on salespeople to shift the value proposition of the AUM fee from the distribution end to the actual, dispensed advice — the kind that investors will gladly pay for.
HOW DID THE 1% AUM FEE COME ABOUT?
For most of the past century, the assets-under-management fee has been the domain of those providing investment management services. It is, after all, a rather natural payment mechanism; the asset manager’s fees are directly related to the amount of money that he/she is responsible for, and ostensibly is adding value to.
Accordingly, mutual funds charge an expense ratio based on assets under management for their services, dating back to when MFS launched the
However, the idea of setting a charge for services based on assets under management is not exclusive to the world of discretionary investment management. Brokers also can receive an AUM fee in the form of a 12b-1 fee, so named because it is authorized
Notably, the 12b-1 fee is technically a distribution charge, i.e., a sales charge, or a commission, paid by the mutual fund company to the broker who sold it, rather than a fee paid by the client. Regardless of who pays the fee, though, the net cost to the client is substantively the same, especially given that
Still, though, the majority of the 1% 12b-1 fee is simply a levelized yearly payment of 0.75% of an upfront commission.
At the same time, another version of the 1% AUM fee comes from the brokerage world, which historically just charged transactional trading commissions, and/or sold securities from inventory and earned dealer compensation in the form of mark-ups/mark-downs or similar fees.
As the AUM fees of brokerage salespeople and advisers converge, so, too, are the regulatory standards that apply to them.
However, after the
First dubbed a wrap fee, or a fee-based brokerage account, the SEC
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The fundamental point, though, is that over the years, more and more segments of the financial services industry have been adopting the AUM model — or at least, AUM-like fees.
HOW TECH IS PUSHING DOWN COST OF DISTRIBUTION
The significance of this history of multiple types of fees, all based on an investor’s assets under management, is that functionally there are two different kinds of AUM fees: one for investment advice and/or discretionary investment management, and the other being a levelized fee that is actually a substitute for an upfront commission — whether a wrap fee for brokerage trading commissions, or the payment of an upfront commission that is being spread out over time.
In other words, one type of AUM fee is actually for advice, while the other is simply a levelized commission for a product sale or brokerage transaction. Viewed another way, the historically upfront-commission-oriented compensation of investment salespeople is converging on the AUM model traditionally used for investment management.
Notably, though, the driving force toward more levelized compensation for salespeople doesn’t appear to be solely driven by the altruistic goal of reducing churn, as highlighted by the
Instead, the shift away from the commission-based transactional model also appears to be driven by the ongoing march of technology over the past several decades.
After all, there was little need to move away from transactional brokerage business and toward the AUM model of investment advisors in the first several decades after the Investment Advisers Act of 1940. Brokerage trading fees were fixed anyway, regardless of the size of the trade, which made them highly profitable — and overly expensive for the typical individual investor. It wasn’t until
In the 20 years that followed, though, the average cost to transact a trade
And in the subsequent 20 years after that, the average sales load on mutual funds began to fall as well, driven by the emergence of online brokerage firms like E-Trade and TD Ameritrade, which made it possible for investors to buy no-load funds directly, without paying an investment salesperson a commission at all.
You can’t earn 1% just to sell an index fund.
And the trend is now accelerating, as more and more no-load and institutional-class funds become available, along with ETFs, all of which exclude 12b-1 fees from their cost structure and therefore are presented as the cheaper alternative than the competition — and often also the better performer, given the significant impact of
In other words, technology is slowly but steadily driving down the cost of distribution — at least for a subset of the best and cheapest investment solutions — which is undermining the ability of investment salespeople to be paid commissions for distribution.
The competitive forces of technology and the market pressure they apply, along with rising regulatory scrutiny on upfront commissions, is driving a great convergence, where the investment advisor’s AUM fee and the investment salesperson’s AUM-as-levelized-commissions fee are looking more and more alike.
ADVISORS VS. SALESPEOPLE
While arguably there are some positives to this great convergence of advice fees and distribution commissions — in particular, the reduced incentives for brokers to churn investment products — it has also created
To some extent, this is simply the natural outcome in any marketplace. Producers, including advisors, can compete on the costs they charge and the value they provide, and allow consumers to decide which is best. However, the situation is complicated by the fact that
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Historically, Congress attempted to establish this distinction with
In fact, the entire controversy of the proposed
Unfortunately, though, the SEC
In other words, as the AUM fees of brokerage salespeople and advisors converge, so, too, are the regulatory standards that apply to them.
CHANGING THE VALUE PROP
The significance of this great convergence of the 1% AUM fee, and the commoditizing forces of technology that are impacting it, is that while it’s increasingly popular to discuss
For instance, a detailed look at the services of most robo advisors reveals that their primary function is to help an investor select an asset-allocated portfolio that fits his/her risk tolerance and time horizon — a role that was classically filled by investment salespeople, who provided this service as a part of the sales process and in the name of determining suitability.
Accordingly, robo advisors fulfilling this function casts the robo advisor effectively as an alternative distribution channel for investment products, not a reduction in fees for advice. Viewed another way, the AUM fee for beta
In turn, this means that with an ever-declining price that investors are willing to pay for distribution costs — i.e., commissions and other sales charges — brokerage salespeople who want to defend their value and the AUM prices they charge will be compelled to deliver more advice above and beyond just recommendations relating directly to the product being sold. In other words, the broker must do more to justify the same compensation he/she earned in the past.
This trend just further accelerates the foray of brokers into advice,
Of course, this will only further accelerate the convergence of salespeople and advisors — both of whom are increasingly offering advice — lending further credence to the DoL’s decision to apply a fiduciary rule on all types of advisors and brokers who were providing recommendations to retirement investors.
Meantime, though, it’s still not entirely clear whether there’s much of any pressure directly on AUM fees for advice. While some have discussed unbundling financial planning fees from AUM fees, the most financially successful advisory firms
The fundamental point is simply that the distribution costs that investors once paid brokerage salespeople for investment products is slowly but steadily converging toward the 1% AUM fee that investment adviseos have historically charged for advice. Given that these are still different channels for regulatory purposes, though, the great convergence of the AUM model — and the increasing convergence of advice-oriented services to earn those fees —
From the perspective of advisors and especially brokers, though, the real challenge of the great convergence is figuring out to how to keep earning the same 1% AUM fee, while shifting the underlying services being rendered to the end client from just selling products to actually providing advice. In other words, the pressure on the 1% fee is not so much about whether advice is worth 1%, but whether those who were historically salespeople can provide enough value-added advice to defend that 1% fee, and whether investment advisors
So what do you think? Is there a difference between an AUM fee for advice, and a 12b-1 trail? Will technology undermine the 1% AUM fee, or just force a re-definition of its value? Please share your thoughts in the comments below.