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Rekenthaler Report

Asset-Based Fees Are Not Intrinsically Better

They exist because of customer demand, not moral superiority.

The Pitch
The money-management firm Fisher Investments is running television advertisements that plug how the firm charges its clients. “Our fees are structured so we do better when you do better.”

The rationale: Fisher charges an asset-based fee, so that if its customers’ portfolios increase in value, it collects more revenue. That math works both ways, so if those portfolios lose money, then Fisher’s revenues will shrink. Clearly, Fisher executives expect that investors will be attracted to that proposition, as it is one of four company attributes mentioned by the ad (the other three being that Fisher customizes its advice, doesn’t accept sales commissions, and is a fiduciary).

Back in the Day
The executives assume correctly. Investors have embraced asset-based fees, while jettisoning upfront commissions. The process started with the development of the mutual fund 12b-1 fee, launched in 1980, which permitted funds with sales charges to collect those proceeds over time. No longer would funds be required to demand upfront payments. Now, if they so decided, they could skip the initial tariff and instead layer an additional fee onto their management expenses.

That approach quickly became popular; within a few years, mutual fund B shares had become an industry standard. Funds with B shares continued to compensate brokers immediately for their sales, as had been the case with the traditional A shares. Only those payments were not funded directly from investors’ pockets. Instead, they were fronted by the fund company, which then recouped its costs by charging those who owned B shares the ongoing 12b-1 fee.

Over time, B shares acquired a bad reputation. Their existence came as an unpleasant surprise to many shareholders, who figured that if they had paid nothing upfront that they had purchased a “no-load” fund. Not so. What’s more, they often fared worse than if they had paid a commission. While some B shares converted over time into cheaper A shares, others did not, thereby charging their long-term owners more than the cost of the A share.

Market Forces
As B shares lost favor, the next step was obvious: Financial advisors would switch from selling funds that charged commissions of any kind to selling funds that lacked commissions, while levying asset-based fees. That change has indeed occurred. Per McKinsey’s “The state of North American retail wealth management,” more than two thirds of revenues for its surveyed financial advisors now come from asset-based fees, rather than commissions.

My point? Fisher’s advertisement suggests that its asset-based fee structure is unusual; instead, it has become commonplace. And in most cases--here I do not speak to Fisher specifically, as the company conceivably could be one of the exceptions--that structure was not created because of investment philosophies. It occurred instead because that is what investors desired.

By the Numbers
This is just as well because the math doesn’t work. Consider the asset-based investment manager that makes an annual 8% for its clients over the next 10 years, as opposed to 7% for the relevant index. (This is a heroic assumption indeed, to beat the benchmark by 100 basis points after expenses, for the average of all clients, for a full decade.) By the decade’s end, that manager’s investment success will have increased its revenue base by 9.7%, compared with its receipts had it merely matched the index.

For example:

1) Beginning assets--$100 million

2) Ending assets, after 8% appreciation for 10 years--$215.9 million

3) Ending assets, after 7% appreciation for 10 years--$196.7 million.

The second figure is 9.7% higher than the third figure.

What really matters to the organization’s revenues are two items left unsaid. One is its ability to attract assets. Whatever its investment performance, the company will receive much higher revenues when starting with $100 million than when beginning with $10 million. Customer acquisition counts for more than does investment performance. (Although certainly the latter can lead to the former.) The other is the financial markets’ performance. For revenue growth, the index’s 7% annualized return is far more important than the manager’s 1% contribution.

Same Boat, Different Stories
Note that a similar argument could have been applied to 12b-1 fees. Whereas upfront load charges provided fund companies with no performance incentive, adding a 12b-1 fee would motivate them because the higher their funds’ returns, the more money the 12b-1 fee would generate. The logic is the same as financial advisors’ asset-based fees. However, I do not recall such a defense being offered for the 12b-1 structure. It was not lauded for aligning fund-company goals with those of the investor.

(Instead, the main defense of 12b-1 fees was that, by helping fund companies gather more assets, the fee ultimately would lower shareholder costs. As funds grew, thereby enjoying the benefits of scale, they would offer volume discounts, which over time would more than offset the 12b-1 fees. That promise was almost never fulfilled, even for funds that became very large.)

The mutual fund management fee also operates in this fashion. One could argue that, because higher fund returns lead to greater fund-company revenue, fund companies “do better when you do better.” But such statements are almost never made. Quite the contrary. Critics frequently suggest that the fortunes of mutual fund companies are too loosely connected with those of their customers--a problem, they assert, that might be cured by adding a performance fee.

None of this is to discredit asset-based fees. Just as they are not intrinsically superior to upfront commissions--or any other method of compensating those who give financial advice--nor are they intrinsically worse. But neither should they be permitted to claim the moral high ground. What matters, ultimately, is the quality and price of the advice that is received, not how its charges are levied.

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.