The paradox of transparency

A friend of mine has been busy for the past few years, converting his practice to a fee-based model. He charges his clients an annual fee, billed monthly and based on a percentage of the assets he manages for them.

He receives no compensation from any products he uses in his model portfolios. ETFs, F-Class mutual funds and direct holdings of equity and fixed income securities are his preferred investment solutions. A reasonable number of annual transactions are included in his fee.

His motto is that clients pay him for advice, not to move money around.

This is precisely the kind of transparent, advice-based practice most of us aspire to offer. It can remove conflicts of interest, allow clients to properly assess an advisor’s value and align the advisor’s compensation with service and portfolio returns. Many have said, in these pages and elsewhere, that a fee-based practice is the way of the future and the road to true professionalism.

But if that’s the case, why after moving to implement this model in his practice is my friend reconsidering? Why is he wondering how to dismantle what he has just built? Well, the reality is cracks are appearing in the model, and he’s questioning its durability. He asked me recently, “Did I make a mistake?”

His concerns stem from his decisions around holding cash in his portfolios during the recent bear market. He was quick to take action as bad news began rolling in and advised clients to go heavily to cash and short-term fixed income in mid-2008. He felt this was prudent advice, as his clients have a conservative risk tolerance.

He also deemed it appropriate since his clients were paying for his advice, not for his asset allocation. In other words, he applied his normal fee as he was still managing the account. His belief was that he should be agnostic with respect to products or securities. And in that context, his fee was applied based on his advice, not on whether the client was holding a stock, a bond, a T-bill, whatever. To charge otherwise, based on asset class, and to apply a different fee to equities, fixed income and cash, would introduce a potential conflict of interest. So, by advising clients to go to cash in a time of severe market turbulence, he was giving advice based on the client’s interest – not his own production concerns.

And he was right. His clients protected their capital and were well served by his advice.

Biting the hand

But now, many of those same clients are unhappy with how his fees were applied during that time. Several complained they were paying fees when they were sitting in cash. Some questioned why they were paying his full investment management fee when, as one client put it, “You weren’t doing anything.” The clients may have been happy with the results, but in retrospect they feel they shouldn’t have been billed for sitting on the sidelines.

My friend made the point that going to cash was an active management decision, and he should be paid for that decision. Further, he suggested if he wasn’t going to be compensated for advising clients to go to cash, then clients shouldn’t expect to receive such advice.

After much thought, he concluded the issue was never about moving the clients to cash. The clients were happy with that decision, and they also understand the advisor must run a profitable practice. It’s a business, not a charity.

The issue, ultimately, is that the clients resented seeing the cost of the advice displayed on the bill. It was the visibility of the fee that caused the problem, not the fee itself. Had the fee been embedded into a product, the client would not have complained about paying it, even though they know the fee is there.

Cost of advice in question

I can’t fault him for his feelings, since I went through a similar experience in my own practice. One of my best clients also went to cash, based on my advice, in early 2008 and we’ve remained heavily in cash ever since. And I continue to charge my regular fee, as we’ve continued to work on other elements of his financial plan.

Our decision to remain out of the equity markets is a tactical one, and it’s revisited monthly. Yet, he sent me an e-mail in March, questioning my fees for the past two years. Like my friend’s clients, he was unhappy that he was paying full fees while we were sitting in cash. I pointed out that his net returns were better than they would have been, had we invested, despite the recent rally (as we did not lose any money in the first place), and added that my service to him had not declined. Indeed, we met and talked more in the past two years than we had in the previous three. Should I not be compensated for that? I then suggested we implement a program for legging back into the market. After a brief pause, he asked if I really felt he should go back into equities, or was I recommending this because he didn’t want to pay any fees for being in cash? I asked him: Can he now tell the difference? Sadly, his desire to avoid paying fees on cash has muddied the waters of our relationship. He has created a situation where my objectivity is now in question.

Finding fee fairness

This is the paradox of fee transparency. While it is in the client’s best interest to see all the fees, they, in fact, really don’t want to see them.

This is also true for larger accounts, where a fee that sounds small in percentage terms seems large in dollar terms. If you’re running a $1 million account and charging 0.75%, that’s $7,500. Clients may have a tough time equating a few meetings a year as being worth $7,500 – particularly if they’re sitting in cash for any length of time. Whether it’s a tax-deductible expense or not, it can still be sticker shock for many.

Some will argue that highlighting how and when our fees are applied at the beginning of the engagement process will eliminate this problem. I disagree. Every one of my clients, and my friend’s clients, has signed an agreement clearly spelling out our fees and how they are calculated. This was discussed and agreed upon when the accounts were opened. The clients knew the fees. But in hindsight, some didn’t think it was fair for the fee to be applied on cash.

Had the fee been embedded in the investment portfolio – say buried in a fund’s MER – they would not have complained. Indeed, my friend had some clients who ignored his advice, remained invested, and have never disputed his fee. Complaints are only coming from clients who went to cash and protected their portfolios. They should be his most satisfied clients, not his unhappiest.

I’m not sure how we can resolve this issue. Yes, we should always be demonstrating the value we provide for our fees. Our services must stand up to the client’s scrutiny. But there can be times where our perception of the value we provide is drastically different from what the client is willing to pay.

I’m not advocating we go backwards to a time when fees were hidden. I believe the best advisors are happy to prove their value and have no problem earning the fees they charge. But there is a part of our clients’ human nature that we must be aware of, and be willing to accommodate.

So, I’ll pass along the advice I gave my friend: develop an alternative fee arrangement for those clients who do not want to see a fee. He’s now building an alternate set of model portfolios, offering A-class mutual funds and Advisor-series ETFs to clients who have opted out of the transparent fee model. More importantly, he’s now trying to screen new clients for what he calls “fee sensitivity.”

Does this approach make us less professional? Does it take away from the objective of transparency many have called for? I don’t know. But I suspect it’s a more realistic business model and more suitable for those of us down in the trenches who are trying our best to help our clients – whether or not they elect to see our bill.

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Harper Fraze is a pseudonym. He is an investment advisor with a large Canadian-based financial services firm he cannot name.

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Harper Fraze