5 Hidden Fees of Fee-Only Advisors

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Fee-only financial advisors are often touted as the most transparent and unbiased option for investment advice. They do not earn commissions and have a fiduciary duty to act in their clients' best interests. However, even fee-only advisors have hidden costs and conflicts that can chip away at your investment returns over time.

1. The True Cost of 1% AUM Fees

A 1% assets under management (AUM) fee charged by financial advisors may seem small, but it can have a significant impact on investment returns over the long term due to the loss of compounding. Assuming an annual gross return of 6%, an investor with a $1 million portfolio paying a 1% AUM fee would pay $163,636 more in fees over 20 years compared to an investor paying a flat annual fee of $6,000 that increases by 1% each year.

However, the real cost is even greater when considering the loss of compounding. The investor paying the 1% AUM fee would have a portfolio worth $219,738 less after 20 years, despite the difference in fees paid being of only $163,636. This is because the higher fees reduce the amount of money left to compound over time.

To illustrate the impact, consider an investor who contributes $1,000 per month for 40 years. Assuming an 8% annual return, the portfolio would grow to $3.2 million. However, with a 1% AUM fee reducing the return to 7%, the portfolio would only reach less than $2.5 million, a difference of about $700,000.

While a 1% AUM fee is common in the industry, it can be costly for clients with larger portfolios. A flat fee structure may be more appropriate, as the level of service and overhead is often similar regardless of account size.

Investors should carefully consider the long-term impact of fees on their returns and seek out advisors who offer transparent and fair pricing models.

2. High-Fee Funds from Advisors

A 1% AUM is just the start. Some investment advisors place their clients in mutual funds or exchange-traded funds (ETFs) with high expense ratios, which can significantly eat into investment returns over time. Expense ratios represent the annual fees charged by funds, expressed as a percentage of assets, to cover operating costs like management, marketing, and administration.

Actively managed funds tend to have higher expense ratios than passively managed index funds because investors are paying for the fund managers' expertise in selecting investments. The average expense ratio for actively managed funds was 0.66% in 2022, compared to just 0.05% for passive funds. However, research shows most active managers fail to consistently outperform their benchmarks after accounting for fees.

My theory is that expensive AUM Advisors use complex, expensive funds in complicated portfolios to justify their fees. Some may also believe they are adding value by using specialized sector or thematic funds, even though these niche offerings often have above-average costs and poor long-term performance.

Investors can protect themselves by asking advisors to clearly disclose all fund expenses and to justify their selection of any funds with above-average expense ratios. Low-cost index funds from providers like Vanguard, Fidelity, and Schwab are often suitable core holdings for most investors' portfolios.

3. Advisors Build Overly Complex Portfolios

Many financial advisors construct complex portfolios for their clients containing a dozen or more mutual funds and ETFs. While a diversified portfolio is important, these complex portfolios are no more diverse than a simple 3-fund portfolio. The result is the advisor makes the portfolio needlessly complicated and potentially more costly.

One reason advisors may favor complex portfolios is that they believe slicing and dicing the market into numerous sub-asset classes provides better diversification and risk-adjusted returns. An advisor might build a portfolio with separate funds for U.S. large-cap, mid-cap, and small-cap stocks, international developed and emerging markets, and various bond categories like government, corporate, high-yield, and international debt. However, research suggests a simple three-fund portfolio covering U.S. stocks, international stocks, and high-quality bonds is likely to perform just as well as a more elaborate portfolio over the long run.

However, a more cynical view is that advisors use complex portfolios as a marketing tactic. Presenting a “sophisticated” portfolio to a prospective client showcases the advisor's skill and knowledge, making the client more likely to hire them and remain with the advisor long-term. Clients may be less inclined to leave an advisor if they believe their portfolio is too complex to manage on their own or transfer to another advisor.

The problem is that a large number of funds can lead to overlap, where the portfolio contains multiple funds that own the same underlying securities. This can result in a portfolio that is less diversified than it appears. Complex portfolios also tend to have higher costs and taxes.

Ultimately, a portfolio with a smaller number of broad-based, low-cost index funds is likely to be sufficient for most investors. A simple portfolio is easier to manage, more tax-efficient, and allows the investor to focus on more important factors like asset allocation, savings rate, and staying the course through market volatility.

4. Advisor Incentives to Retain Assets

Financial advisors who charge fees based on AUM have an inherent conflict of interest because their compensation increases the more money clients keep invested with them. Under an AUM fee structure, advisors typically charge an annual fee that is a percentage of the total assets they manage for a client. For example, an advisor charging a 1% AUM fee on a $1 million portfolio would earn $10,000 per year.

This arrangement incentivizes advisors to encourage clients to keep as much money as possible invested in the accounts they manage, even if it may not be in the client's best interest. An advisor might discourage a client from withdrawing funds to pay off a mortgage, make a large purchase, or invest in other assets like real estate or a business, because doing so would reduce the advisor's compensation.

AUM fees may also deter advisors from recommending strategies that would reduce the assets they manage, such as using income from the portfolio to delay claiming Social Security benefits or purchase an annuity to provide guaranteed lifetime income. While such strategies can offer significant benefits to retirees, they are not in the advisor's financial interest under an AUM model.

5. AUM Advisors May Neglect Planning

Under an AUM fee structure, advisors have a strong incentive to focus on gathering assets and managing investments, as that is how they generate revenue. This can lead to a narrower scope of services centered around portfolio management, with less emphasis on other important aspects of financial planning such as budgeting, debt management, insurance, estate planning, and tax strategy.

Advisors charging AUM fees may view financial planning as a secondary service or loss leader to attract and retain investment management clients, rather than a core offering. They may provide only cursory financial planning, using simplified templates or a superficial checklist approach, without devoting the time and resources to fully understand a client's unique circumstances and develop customized recommendations.

Moreover, because AUM advisors are essentially paid a percentage of a client's wealth, they may be less motivated to serve clients with fewer investable assets or simpler financial situations. These clients may have pressing financial planning needs but are less profitable for the advisor to serve under an AUM model.

In contrast, advisors who charge flat or hourly fees for financial planning are able to provide more objective and comprehensive advice tailored to each client's specific needs, regardless of their level of investable assets. Their compensation is directly aligned with the time and expertise they provide, rather than being tied primarily to the size of the client's portfolio.

While some AUM advisors do offer thorough financial planning as part of their service, the inherent conflict between their compensation structure and the delivery of planning advice is a concern. Clients who place a high value on receiving in-depth financial planning may be better served by fee-only advisors who charge separately for planning and investment management.

Key Takeaways for Investors

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While fee-only financial advisors are often considered the most transparent and unbiased option, they can still have conflicts of interest that may impact the advice they provide to clients. Advisors who charge based on AUM have an incentive to encourage clients to keep more money invested with them, even if it may not be in the client's best interest. This compensation structure can also lead advisors to focus primarily on investment management at the expense of comprehensive financial planning.

Investors should be aware of these potential conflicts and carefully consider the long-term impact of fees on their investment returns. Even a seemingly small 1% AUM fee can significantly reduce portfolio growth over time due to the loss of compounding. Additionally, some advisors may recommend high-cost mutual funds or construct overly complex portfolios, further eroding returns.

To mitigate these conflicts, investors can seek out advisors who charge flat or hourly fees for their services, as this aligns the advisor's compensation more directly with the quality and breadth of advice provided. Investors should also ask advisors to clearly disclose all fees and expenses, and be cautious of complex portfolios that may be unnecessarily costly and less effective than a simpler approach using low-cost index funds.

Ultimately, the key is to find an advisor who provides transparent, objective advice based on your best interests, regardless of their compensation model. By understanding the potential conflicts of interest and asking the right questions, investors can work with an advisor who helps them achieve their financial goals while keeping costs in check.

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