PMU,
Thank you for your reply. You seem to be advocating a charging structure based on outperformance against a benchmark which would be similar to the performance fee applied by Hedge Funds.
My view on this form of pricing is simple:
In 2004 hedge fund fees totalled $70 billion on assets estimated to be $1 trillion, which works out to an average fee of 7%. In that same year, Alpha magazine reported that the average take-home pay of the top 25 hedge fund managers was a whopping $251 million.
Therefore it is reasonable to conclude that under this pricing structure, it is the fund manager who actually benefits most whereas I am proposing a fee of 1%pa which declines for larger portfolios.
One of the biggest mistakes I think investors can make is in failing to understand where investment returns come from which I believe sets up a dynamic between a client and an adviser that often leads to failure.
In effect, clients place responsibility for the investment returns on someone else (such as an adviser or fund manager) who in reality is not responsible for the returns. The market and the positions of risk an investor takes are responsible for the return.
See an excellent video here which explains the difficulty in attempting to identify a winning fund manager
My approach is based on the premise that risk and return are related. The role of a financial planner is therefore to assess the risk capacity of an investor and to recommend the correct asset allocation mix of cash, property, bonds and equities.
Advisers should not be paid for selling products, attempting to pick skilled managers or attempting to time the market.
In my earlier post I covered the potential benefits from strategic asset allocation.
The other side of the coin is ongoing asset management. In my view this relates to managing the costs of executing the asset allocation strategy and ongoing portfolio review. No value is added from "actively managing" a portfolio in the traditional sense. The more you trade, the higher your costs.
Again the role of the financial planner is to review the portfolio but in a way that keeps down costs and taxes.
By using mostly institutional class index funds with low portfolio turnover, on average, our studies indicate that this adds a further 1.5%pa to a client’s portfolio compared to a typical managed fund. P
ortfolio turnover is discussed extensively here
Since a fee-based adviser will earn no commissions or fees on the products, investments and recommendations that they make to their clients and receive no referral fees. I believe it is logical to charge a percentage fee based upon of assets under management
An annual fee can be considered a casualty insurance premium with the role of the adviser being to protect investors and their capital from themselves. As Benjamin Graham (1894-1976), the legendary American investor, Warren Buffet mentor, and co-author of the 1934 classic, Security Analysis, stated,
"The investor’s chief problem - and even his worst enemy - is likely to be himself." According to behavioural finance author and professor, Mier Statman, "When the market drops, our instinctive fear to flight is so strong,
even the most rational investors find themselves caving in to their own demise." A good financial planner takes the emotions out of the decision making process.
A US study by Dalbar inc in 2006 indicated that during the 20 years from 1986 to 2005, the average stock fund investor earned returns of only 3.9% per year, while the S&P 500 returned 11.93%.
The Dalbar studies seem to confirm that the behaviour of average fund investors is an obstacle to reaching the published performance of the financial markets in which they are invested.
Many investment advisors charge an investment management fee based upon the amount of money managed on behalf of a client. The theory is that with such a remuneration package the advisor is paid more the larger the account therefore there is an incentive to make the account grow through good investment performance.
In the USA the National Association of Personal Financial Advisors (NAPFA), the nation's premier group of fee-only planners, has a simple but effective definition of what it means to be fee-only: An advisor must be compensated
only by his or her client--not by third-party money such as commissions, kickbacks, and rebates. What this means is that fee-only planners can be NAPFA members while employing a variety of fee structures. Hourly fees, retainer fees, and asset-under-management (AUM) fees, for example, all qualify
as long as the client pays the fees.
This system has worked well for years, and it curbs many potential abuses.
When using an AUM fee structure, I believe that there should be a separate amount charged for equities versus bonds. If not, there is a built-in conflict of interest. Most advisors charge a flat percent for both bonds and equities, which I feel doesn't make sense.
Finally, the annual fee should also reduce as the size of the portfolio increases.