To praise fees, not to bury them

“There ain’t no such thing as a free lunch.” That’s a phrase financial advisors are well acquainted with.

Originally, it referred to the practice in some saloons of offering a free lunch for the price of a drink, in hopes some would pay the freight in their happy hours with copious refills. Irrational exuberance, one might say.

But TANSTAAFL, as it’s called, can also be invoked in a more cautionary sense: if a security looks too good to be true, perhaps there’s a hidden risk someone may stand to profit more than Joe Sixpint.

As the income trust boom fades, for example, it becomes clear that representations of sustainable, indeed, bond-like payouts were overdone, even though the fees for transforming a corporation into a trust were undoubtedly profitable for underwriters—often external management teams and insiders intent on monetizing their stakes. At some point, some investor activist will chronicle the disparity in the profits that went to those who set these apparently effortless return vehicles in motion; as opposed to what the investments got, now that more than a few of the remaining trusts are trading below their IPO valuations.

So, Who Buys Lunch? Was this a golden goose unnecessarily mishandled? The appearance of a free lunch for all, or many, or even just for some belies the rule of arbitrage: when a profitable opportunity hits anyone’s radar, it hits everyone’s radars more or less simultaneously—including those of tax authorities. This little bit of tax-advantaged money saw its wells dry up as CRA drained the source; as it should have, if one grants credence to the theorem that won Miller and Modigliani a Nobel prize in economics. Corporations should be indifferent, under conditions of market efficiency, about the manner in which they pay out returns: as dividends, share buybacks or reinvestment in the corporation.

Does that make the income trust boom a one-off trick easy for advisors and investors to avoid? No, there’s still another aspect, in view of the unfolding crisis south of the border. Since the dotcom bust, consumers, not businesses, have spent the economy out of recession. Again, this didn’t come for free. Salaries and wages didn’t budge upwards for most people. Instead, the economy bloomed on the instalment plan. Many consumers purchased houses with teaser- rate mortgages; they took out home equity loans; they leased their cars; they maxed out their credit cards.

Ironically, the tantalizing chimera of a free lunch—of an economy that never slowed, despite a lack of capital investment and counted-on improvements in productivity that would support higher wages and lower prices—has stricken buyers and sellers alike. Consumers are losing their homes and cars. Banks and car dealers are stuck with foreclosed properties and off-lease SUVs no one wants. And this chimera has taken down some of the most sophisticated players in the business, starting with Bear Stearns and followed by the flood.

Prudence Pays Some of this financial train wreck could have been avoided. And many advisors did save clients during the tech bust by offering prudent advice. Market prices may not be entirely efficient, but a sense of perspective aids in determining when valuations are getting out of hand. So what’s good advice worth? What kind of competence and experience are clients paying for? Where’s the value?

All good questions.

Has the advisory business got the price right? It’s hard to tell, for a variety of reasons. The main one being that fees are not always transparent: the required information is often buried in prospectuses, but it’s also obscured in the simplified documents mandated by the securities commissions, the ones that estimate the cost of owning a fund but don’t disclose the components of those costs.

Yes, there’s a price to pay for participation in financial markets. Investment manufacturers and advisors deserve to be paid for their intermediation. TANSTAAFL. And advice, or rather its deconstruction, is a complex business.

It can’t be avoided, however—not if advisors want to prove their worth. There’s a perception, fostered in the mainstream media, that advisors or brokers or fund management companies are somehow making out like bandits. That perception won’t be dispelled without full disclosure of just how competitive the marketplace is, and moreover, how valuable advice really is. Advisors have to attack the notion that there is somehow a do-it-yourself free lunch. Although that doesn’t, of course, mean that things can’t be done more cheaply.

Start with the fee wars raging among brokers, exchanges and institutional investors. Trades are cheaper than ever before, with traditional stock exchanges, socked by decimal pricing and electronic alternatives, forced to compete. Then there are “dark pools” of liquidity, with big institutional investors trying to move blocks of stock without having a market impact—in effect, they become the market. Finally, there is algorithmic trading, whereby institutional investors work stocks, not through a broker but a computerized program, in order to get the best price. And the best price—or rather, the best execution of a client’s wishes—is increasingly a money-maker, as traditional marketplaces cease to be treated as quasi-utilities and the marketplace becomes more competitive.

In other words, the exchanges, and brokers whose livelihoods were built on being gatekeepers to equity trading, are seeing their lunches eaten by someone else. But that doesn’t eliminate the question: what does lunch cost?

Pay to Play Canada, some studies aver, has among the highest fund fees in the world. But are apples being compared to apples?

Management fees are broken out differently. In Canada, the management expense ratio reflects advice to clients, at least theoretically. In reality, it approximates the cost of doing business. Strip out embedded advisor compensation, and MERs melt to the 1.2% to 1.4% range. That’s easily observable from the lagging set of direct-to-investor fund shops: Saxon, at 1.86 (with a 50 bps trailer), Mawer, at 1.18% (with a 20 bps trailer), Phillips, Hager & North, at 1.12%, all managers with strong institutional businesses that are now moving more firmly into the advisor channel.

Still, those sums seem well above widely quoted U.S. numbers. But the cost of business, arguably, is greater in Canada thanks not only to a lack of scale, but a lack of interest in such things as fund supermarkets offered by outfits like Charles Schwab or Fidelity in the States.

Asset managers provide access to the markets—at a cost. So, what is a reasonable cost of fund management? There’s any number of ways to approach the question.

RBC has instituted a D-Series for its discount brokerage channel for funds it also sells through bank branches and its advisor network. Many of the funds, which were pushing up to 2% or more MERs for no-load customers, now charge roughly 1%. Transactional costs—the execution fee for recordkeeping, direct market access and the like—is 0.25%. So one can have active management at 75 basis points. That’s comparable to specialized ETFs sporting a 60 or so basis point MER.

There are other ways to gauge fund fees. Mackenzie Financial, for example, released a brochure a few years ago, which illustrated the expenses on a fund with a 2.36% MER. GST counted for 14 basis points, miscellaneous costs for 2 bps, and administrative and regulatory costs another 20 bps. The majority of fund expenses stem from advisor compensation, 100 bps, and Mackenzie’s take, another 100 bps.

Stripping out the advisor share, the management fee reduces to 100 bps, out of 136 bps to run the fund—not out of line with the no-load shops such as Mawer, PH&N or Saxon.

So what goes into the management fee, then? In its latest annual report, CI Financial notes its administration fee has dwindled to 18 bps from 46 in 1996. (The administration fee covers legal and accounting matters—comparable to the clerical costs RBC bills for discount brokerage clients at 25 bps.) That’s consistent with Mackenzie’s 20 bps for administration. But CI also reports its sales, general and administration costs—what it takes to run a company, promote its funds and service advisors—is down to 35 bps compared to 95.4 bps a decade ago. Scale clearly works.

All the same, the average MER on CI funds is 1.99%. So, if you take away the 1% advisor compensation, the funds look to be in the same league as no-load companies.

Is this enough information? No company is going to break out exactly how it makes a profit. But, it’s possible to get a feel for the universe. Now, what would institutional investors pay: namely, the ones who supply defined contribution pension plans? A survey from our sister publication Benefits Canada provides an opening.

It found the all-in cost of a DC plan ranges from a high of 131 bps to a low of 34 bps (with between about 5.6 bps to 1.2 bps going to plan member education/advice). On average, investment management fees equal 34 bps. (Keep in mind that BGI charges 17 bps for a passive investment on the TSX, and 25% for a hedged U.S. or international investment.)

So, that’s a benchmark for active investing and it’s important to know because many active fund managers are increasingly using performance fees: 2% for management and 20% of the profits above a benchmark return. And, because the fees attributed to alpha—the fund manager with acumen—may at some point crowd out the alpha earned. A recent study noted the ability of select stock-pickers to outperform the markets had declined, from 10% to 1%. One suggestion was that fees were eating up the alpha.

Pricing Advice TANSTAAFL again. Advice is not free. On average in DC-land a plan costs 104 bps to operate, with roughly 3.4 bps going to education. What does that education buy?

A number of advisors, even some who put themselves in front of a radio audience, have been attracted by the low management fees of ETFs. Some are advocates of DFA’s passive investment strategy; many also take referral fees to place clients with investment counsellors to sort through the portfolio strategy, the better to get on with the business of advice.

Advice is more than just about pushing product—as if the advisor were simply the local Buick dealer. But advice has evolved, too. One could argue investment products (including insurance) were for a long time sold with the implicit backing of the manufacturer.

In the securities business, there is of course no guarantee that past results will be carried forward into the future. What’s more, at least in the 1990s, many advisors learned, to their discomfit, that what the wholesaler pitched and how the fund performed in adverse markets were at odds. But the same was true of insurance advisors who found their clients on the wrong end of vanishing-premium policies. Results didn’t live up to the illustrations.

That’s an important part of being an advisor: seeing through the marketing bluster. Offering peace of mind to the client is a complacent, indeed dangerous, approach if the advisor hasn’t done the due diligence on how the product will perform—and how it will perform in the context of the client’s financial whole. The salespeople, like the SUV dealers, will be left behind once the screw turns. That’s why it’s imperative advisors put a price on advice and make it clear what it is they’re offering.

Competitive Pressures and Unbundling Today’s marketplace of securities is a far cry from what it was 30 years ago. Not only have the names changed, but so too have the products. Mutual funds were a tiny part of the business of selling stocks and bonds, and few had heard of hedge funds, much less commercial paper or banker’s acceptances. It was a rigid world, with fixed, bundled commissions—the higher the stock price, the higher the commissions, which included research, trade execution and registered rep compensation— as well as a 9% front-end charge to buy a mutual fund.

Imagine that 9% for a minute. Given the 1970s stock market, somewhere between two and three years of returns were discounted upfront. Of course, the business of financial advice was different then too. Brokers were clearly employees, as were insurance agents, with all the potential conflicts of interest that entailed: salespeople motivated by commissions. But, there’s another point of view: firms stood behind product, be it heavily researched stocks, or whole life insurance policies. The client walked into the Buick dealership and came out covered for life.

Much has since changed. Fees are unbundled, or could be. Brokerage, with the moral hazard shifted to the manufacturer, is being displaced by financial planning aimed at client needs, not an identikit sales pitch. “Being” is the operative word: the brokers in the former IDA channel don’t wish to tether investment recommendation to a financial plan, only to a KYC form: the endgame is to gauge whether an investment fits a certain risk profile.

Fair enough. One can’t expect brokers to provide financial plans. That’s one of the reasons U.S. investment advisors have fought hard against letting brokers give advice. Down south, investment advisors— what north of the border could be called financial planners—have fiduciary obligations to their clients.

What’s Advice Worth? Consider the Benefits Canada findings, which uncovered a wide variation of fees. The end client doesn’t see that the fiduciary responsibility is in the hand of the plan sponsor, which is offering an unadvised capital accumulation plan. To be sure, DC plan sponsors try to provide education about investment options, given that a DC plan is frequently, and quite mistakenly associated with all the benefits of a DB pension. Investment risk, leave alone longevity risk or all the other risks advisors work their best to surmount on behalf of clients, it is fair to say, is little understood by plan contributors.

So DC plan providers are reluctant to double the already significant fiduciary risks associated with hiring a financial advisor, at least one who is commissionbased. Ironically, advisors who might be engaged to service a group RRSP plan are equally fretful about having to do 50 or so KYCs, even as they serve as the agent of record for group insurance. None of the parties have done well in this arrangement.

In part, that’s a legacy left over from high front-end commission days, in part from the alternative: the deferred service charge. Both, in their time, served a purpose: getting investment products into client hands, whether to take advantage of rising capital markets, or to transfer risk. Still, there’s a fee equation at work—not least because markets are subject to competitive pressures.

While the DSC was, perhaps, the first blow to high front-end fees, the next competitive pressure was delivered by discounters offering a DSC rebate, starting in the late 1990s: a shot across the bow for salespeople who were not advisors.

All the same, it’s not just the discount channel that is paying attention to the fee equation. Now that the product lineup has become more diversified, many advisors are receptive to lowcost ETFs. Advisors, judging the performance of various active and passive approaches to money management can, thanks to various fee models, offer what they consider best for the client, without reducing their capacity to give advice or cheapening the value of their recommendations by going downmarket.

Fee for Lunch There are more than a few advisors who have given up the DSC model. It allowed them to build up their business. But can a new advisor survive without relying on the DSC?

It’s an open question among older advisors, many of whom built their businesses on this model. Fair enough. Not every advisor has a big-bank brokerage, nor is an insurance company to stand behind them as they launch their way into the profession. And there’s a good amount of anecdotal evidence that seasoned advisors are reluctant to engage newcomers—despite it being in their best interest to be able to pass on or sell a flourishing book of business. Why? Because the business of advice requires expertise and experience; getting one new advisor out of five to stay the course and develop a self-sustaining practice is a hurdle frequently mentioned.

Perhaps that hurdle would be better tackled if advisors themselves debated the true cost of client services. How much advice can a client with $50,000 reasonably expect? How much can an advisor reasonably offer? At $50,000, the advisor is likely to make somewhere around $250 a year on the account, after dealer costs. Is that two hours of advice? Four? Much as many independent advisors like to play themselves off against the banks, can they really give better service to small accounts? And what’s a small account? Years ago, Merrill Lynch pushed its $100,000-andunder accounts to its phone service. Yet $100,000 in Canada is often the threshold experienced advisors demand from new clients. Clearly, the value of advice will neither be benchmarked nor appreciated until advisors actually work out the costs—and advertise them.

Hybrid Fees Not surprisingly, then, many advisors feel the current fee model is flawed. A client who needs financial advice and who, perhaps sometime down the road, might wish to explore investment options, may come to the financial planner for advice that’s not billable: to pay down a mortgage, for example. More than one advisor has noted it’s not useful to try to expense this extremely practical advice by attaching it to the sale of a product. Yet, the advice is certainly needed, and sought.

As a consequence, many advisors are opting for a hybrid model. They charge directly for a financial plan, anywhere from $1,000 to $10,000—and, at the higher levels of complexity, they’re not acting as quarterbacks but rather as the client’s advocates, determining who can execute on the client’s behalf. They find clients appreciate knowing that a real financial plan is not free, but something that requires the time and attention of a qualified planner.

At the same time, many of these advisors charge a fee based on assets under management. In some cases, the total fee may be the same as they would have earned under the traditional commission model. But the client can decide whether the advisor is earning the fee. This is not to slight the commission model, but rather to unbundle it, so clients can value accurately the advice they get. It’s not a free lunch. Nor should it be.

When it comes to fees and prices and advice, there’s no best practice, except for this: disclosure.