How Do Financial Advisors Earn Their Fee?

The following is a guest post from Marotta Wealth Management.

Most of our clients are frugal supersavers. Often they have accumulated their wealth not by earning more but by simply spending less. They are the millionaires next door living well below their means, which is why they have means.

Few investors even ask how commission-based annuity salespeople earn their fee, but with fee-only advisors the question often arises. Investment fees are generally about 1% of assets under management and drop as assets rise above $1 million. The critical question to ask is "Where do financial advisors add value that might exceed the 1% fee they charge?"

Here are five ways an investment manager might bring value to a portfolio.

1. "No, that's a bad idea."

We use eight principles to safeguard your investments. Many poor investment choices violate more than one of these safeguards. Clients ask regularly about putting their money in various investment options. The first time we say, "No, that's a bad idea," we might have just earned our fee for life. Given the greed and deceit in the world of financial services, this should not surprise you.

2. Lowered expense ratios

We build portfolios with expense ratios of about 0.38%. The average equity mutual fund charges an expense ratio closer to 1.38%. Specialty and international funds have higher averages.

Mutual fund expense ratios pay for the administration and active management talent that do not actually boost your returns. High expense ratios often include12b-1 advertising fees. These may even cover the commissions of agents who are selling those funds to you and posing as objective financial advisors. Fees matter, and the higher the fees the greater the hurdle of beating the index to justify those fees.

Even if the expense ratios of your funds are well below average, there may still be savings that can help pay the lion's share of what a fee-only advisor charges. With an investment advisor you get more than a collection of funds. You get the offer of comprehensive wealth management advice.

3. Regular rebalancing

Rebalancing your portfolio provides a rebalancing bonus. The exact amount is proportional to the lack of correlation between the asset classes and the volatility of the markets. Rebalancing can both reduce risk and boost returns. But you can't rebalance your portfolio if you don't have a target asset allocation to rebalance back to.

Crestmont Research studied the difference in returns between rebalancing every year versus every two years in varying types of markets. In secular bull markets, rebalancing less frequently had a slight 0.3% annualized advantage. But in secular bear markets, rebalancing more frequently had a more significant 1.3% advantage. Another study verified smaller gains for even more frequent quarterly and monthly rebalancing. And research on the Yale endowment attributed 1.6% of its annual portfolio returns to rebalancing.

Even an investment advisor who helps you set an appropriate target asset allocation and presses the rebalance button once a year might earn an additional 1.6% for your portfolio.

4. Staying the course

Even with a brilliant investment plan, it takes diligence to overcome our emotional biases and avoid making investing mistakes. A wise investment advisor can help clients overlook their natural loss aversion and stay the course.

Markets are always volatile. The more frequently you look at the markets, such as daily or weekly, the more discouraged you get. And even if you have a well-crafted investment strategy, you may be tempted to make changes to alleviate your suffering. Every study shows that loss aversion actually causes greater than average losses.

A Morningstar study found that investors experienced 1.5% less return than the average of the funds they were invested in, specifically because they moved out of the funds after they went down and back into them after they went up. In other words, there is a 1.5% bonus for not getting out after a drop and an additional 1.6% for rebalancing your portfolio and buying after drops.

5. Asset allocation strategy

Rebalancing assumes you have a target asset allocation in the first place, which is where an advisor's investment philosophy matters. Portfolio construction begins with the most basic allocation between investments that offers a greater chance of appreciation (stocks) and those that provide portfolio stability (bonds). Decisions at this level are the most important in determining how the behavior of your portfolio returns.

We use six different asset classes and a score of subsectors and categories. In each case we search for the optimum mix for long-term investing. Three asset classes are for stability: short money, U.S. bonds and foreign bonds. The other three asset classes are for appreciation: U.S. stocks, foreign stocks and hard asset stocks.

For U.S. stocks we set an optimum mix based on style and sector of the economy. On average, small cap outperforms large, and value outperforms growth. Returns between different styles can vary as much as 0.61% a month or 8.33% annually. Blending a portfolio allocation can make it even more efficient by either boosting returns or lowering volatility. And dynamically changing allocations based on forward-looking price-to-earning (P/E) ratios can boost returns by an additional 1.89%. There may also be times to overweight or underweight specific industries such as technology or health care.

In foreign stocks we overweight countries with economic freedom. We seek to underweight countries with high debt and deficit. These choices should outperform the MSCI EAFE index of foreign stocks, historically as high as 5.56% annually. We also include emerging market equities. We also tilt value and include small cap stocks.

The appreciating third asset class is hard asset stocks. These hard asset investments include companies that own and produce an underlying natural resource. Examples of these resources include oil, natural gas, precious metals (particularly gold and silver), base metals such as copper and nickel, and other resources such as diamonds, coal, lumber and even water.

We segment these hard asset stocks into their own asset class because they have a unique set of characteristics. First, the movement of hard asset stocks is generally less correlated with the movement of other asset classes such as bonds. Second, hard assets have a unique (and positive) reaction to inflationary pressures. And third, at certain periods in the longer term economic cycle, including hard assets helps boost returns.

Gains on specific asset classes affect only a portion of total investment returns. And in each case the possible boost in returns has to be high enough to justify the added expense of crafting a portfolio to overweight that investment choice.

None of these methods of boosting returns are secrets. I write about them every week in this column. But they do take time and effort to plan, implement and monitor. You can take the time yourself, or you can find a competent wealth manager who will act in your best interest and do what you would do if you had the time and expertise.

Investment management is at the core of wealth management. These are some of the ways in which a fee-only financial advisor might earn their fee on investment management alone. If they did, all of the other wealth management services they offer are at no additional expense.

Comments

[Mac Hildebrand]

The "No, that's a bad idea" is hard to overemphasize. I like that it came first in the list. It certainly reminds readers that they do well to consider financial advisers as assets.

Also for the investor trying to tackle his own investing, stopping to repeat this phrase to himself and consider may be extremely beneficial. There are many investors who read the ins and outs of rebalancing and managing their portfolio in hopes of returning a fraction of a percent of their investment but then cost themselves ten times that amount in a hasty emotional decision without pausing to counsel themselves.

[chynalemay]

I'm now seeing advisors charge a fee for a "plan" and then an annual renewal fee in addition, PLUS the funds often may have loads, 12-b1's etc., seems the middle class can't escape

[Old Limey]

I strongly believe that it's impossible for any 3rd. party to be able to manage my investments to my satisfaction so I have managed them myself since I retired. I spent my working life as an aerospace engineer, made my first computer run in November 1956 on an IBM 704 mainframe that used vacuum tubes and ended my career in September 1992 using what was then the fastest computer in the world, the Cray XMP4.

After retiring I subscribed to a comprehensive mutual fund and market index database that was updated every market day using a computer modem. The database also came with some very good charting and analysis software that ran under the MS-DOS operating system, it was later upgraded to Windows, and its capabilities were expanded greatly.

Using that database and software, and making my own investment decisions my annual rate of return from 12/28/1992 until 12/31/2007 was 21.29%. I used only no-load mutual funds and never used margin. At the end of 2007 4 market indicators that I was using each looked very indicative of bad times ahead. Also at that time my portfolio had grown by a factor of 18 and I decided it was a good time to move my investments entirely into the shelter of CDs, Corporate bonds, and Muni bonds which would be held to maturity, thereby reducing stress and worry and avoiding future losses. Since then my annual rate of return has been a steady 4.93% (tax free and tax deferred) regardless of stockmarket volatility. A few years ago Fidelity put my accounts under the management of a VP and branch manager and made me a member of one of their private client groups but I stll make all of my own decisions and seldom have a need to meet with him.

The other thing I like about bonds is that once you have converted your portfolio into fixed income bond investments, unlike mutual funds, there are no management fees whatsoever. Fidelity also provides a large inventory of fixed income investments that are both new issues as well as issues in the secondary market.

The 4 indicators I was watching back then were the (New Highs - New Lows), and (Up Volume - Down Volume) summation indexes for the NYSE and the NASDAQ. In particular the negative chart pattern consisted of a series of "Lower Lows" and "Lower Highs" for both indexes.

[Rick Francis]

@Old Limey wrote:

>I strongly believe that it's impossible for any 3rd. party to be able to manage my investments to my satisfaction so I have managed them myself since I retired.
Yes, but I think you are very much the exception. If you were to pass away, could your wife manage the portfolio? Even now that it is much more conservative?

I am comfortable managing my portfolio, but I think my wife would be uncomfortable managing anything other than a CD ladder. An additional advantage for her is that with a financial advisor she may be able to have a non-zero stock and bond allocation to help keep pace with inflation.

-Rick Francis

[Old Limey]

Rick:
Whenever I have met with the executive that manages the private client group I am in at Fidelity, my wife also comes along so she has got to know him. However to answer your question she is not computer literate, recently gave up driving, and knows nothing at all about investing. Our middle daughter, age 51, is well educated, computer literate and good at Math, as well as being our executor. She also has a muni bond portfolio 77% the size of ours. I plan to teach her how to manage all 14 of the family's Fidelity accounts but have been procrastinating about doing it. Since she will also be the beneficiary of our muni bond portfolio after we are gone I need to take care of things before it's too late. It doesn't take much work but every month, the interest that comes in has to be reinvested and occasionally a group of bonds mature or get redeemed which also have to be replaced. It's not a lot of work but it does require familiarity with Fidelity's website and their "Active Trader Pro" software which she doesn't currently have.

This just emphasizes the downside to doing things of this nature for family members, they never learn how to do it for themselves. I'm in the same predicament where cooking is concerned - I know nothing and have no interest in learning.