Saturday, October 17, 2015

Conflicts of Interest: A Look at Advisors vs Clients Paying Ticket Charges

More and more Financial Advisors have moved from a commission based compensation arrangement to a Fee-Based arrangement based on a percentage of Assets Under Management (AUM). For example, in a very common setup the advisor will charge 1% per year on the assets of their client. This trend will only continue to grow as the Department of Labor finalizes their "fiduciary rule" and commission based products get pushed to the wayside.

AUM based pricing theoretically puts both the client and the advisor on the same side of the table. If the clients account goes down 10% then so will the advisors compensation. However, what is often overlooked in the discussion is that there is more then one way in which fee-based AUM pricing is done and what is included.

For example, Some advisors may charge 1% of AUM and the client will be responsible for the ticket charges incurred for buying or selling funds. Meanwhile, other advisors may absorb the ticket charges and pay for them out of the fee they are charging the client. On the face of things, as a client, you may like the simplicity of the ticket charges being included in the fee. However, what you may not have noticed is the massive conflict-of-interest which that arrangement has introduced into the relationship when it comes to making changes in the portfolio.

To illustrate, let's assume that each buy or sell of a mutual fund or ETF costs $10 (in reality some funds avoid transaction fees and some cost much more $25+ depending on where they are executed). Now, let's assume the advisor is contemplating replacing Fund A with Fund B. In a normal environment where the client is going to pay the transaction cost, this would be a sort of cost-benefit look at the transaction

Cost to Sell Fund A = $10
Cost to Buy Fund B = $10

Total Transaction Costs = $20

Amount currently in Fund A = $40,000

Amount Fund A would need to outperform Fund B to make up for transaction costs?
$20/$40,000 = 0.05%


However, what about a situation where the Advisor is going to pay for the transaction costs? Remember, the advisor gets paid a percentage of assets under management. To properly understand the situation you must also understand what it takes the advisor to MAKE that $20. For an advisor to make back that $20, they must get $2,000 more under management (1% of $2,000 = $20). Therefore, the cost benefit analysis from the advisors perspective can start to conflict with the clients. The client only needed Fund A to outperform Fund B by $20 (or 0.05%) for the transaction to pay for itself since the client essentially gets all the profit (less 1%). For the Advisor, he needs to manage $2,000 more to fund that $20 transaction.  Therefore his cost benefit is different.....

Cost to Sell Fund A = $10
Cost to Buy Fund B = $10

Total Transaction Costs = $20

Amount of additional AUM advisor needs to pay transaction cost = $2,000 (1% of $2,000 = $20)

Amount currently in Fund A = $40,000

Amount Fund A would need to outperform Fund B to make up for transaction costs?
$2,000/$40,000 = 5.0%


Yes, from a cost-benefit perspective of the advisor Fund A needs to outperform by 5%! Just imagine if the dollar amount in the Fund was less? If the position size was $20,000 instead of $40,000, then Fund A would need to outperform by 10% from the advisors perspective! Meanwhile, it would only need to outperform by 0.1% from the clients perspective in a normal situation which they pay the transaction cost.

Clearly the conflict of interest that is introduced is the fact that the Advisor has MUCH less incentive to make moves in the account if they are paying the transaction costs. This is because there is a MUCH higher hurdle to get over before the transaction benefits them.

To grasp this fact a little more let's look at this from a hypothetical firm perspective. If the Firm has 500 clients in Fund A, this is what a switch to Fund B would cost them....

Cost to Sell Fund A = $10 x 500 clients = $5,000
Cost to Buy Fund B = 
$10 x 500 clients = $5,000
Total Transaction Costs = $10,000

Additional AUM Firm needs to pay transaction costs = $1,000,000 (1% of $1,000,000 = $10,000)

Yes, for switching from Fund A to Fund B the firm must either have Fund A outperform Fund B by 5% (assuming average position size of $40,000) OR the firm must bring on a new account worth $1,000,000.

Now this is just 1 fund switch, this also applies on a larger scale to something like a complete rebalancing. Now Advisors may say that because they are absorbing the transaction costs they raised their fee slightly to compensate for this....however, if you think that solves the conflict of interest problem you are kidding yourself. The reality is they are charging that rate INDEPENDENT of the number of trades they ultimately make. Reducing those even slightly makes a quick addition to the bottom line.

This conflict of interest only gets nastier if the market were to tank. Lets say a firms portfolios are down 20%+, therefore their revenue is down 20%+. Do you honestly think that firm is not going to be tempted to make less trades then they otherwise would?

To stay on the same side of the table, I think firms should pass on ticket charges. Then they are more likely to look at the same cost-benefit analysis as the client when they consider transactions.

31 comments:

  1. The best place to safe your money after banks is investing in some reliable company on Stock Market Tips , refer to some stock and foreign exchange forecasts services.

    ReplyDelete
  2. Most likely it won't do anything, but everyone is different, so ask your physician for advice

    ReplyDelete
  3. Yes I agree, Thanks for sharing, i am working for buy generic viagra just take a look at it.

    ReplyDelete
  4. Pretty good stuff. I just came across your site and wanted to say that I’ve really enjoyed reading this article. - movers and packers in marathahalli packers and movers Hyderabad madhapur

    ReplyDelete
  5. Stock Advisory Company Miss Call This No 7879881122 Good post! I just forwarded this onto a coworker who has been conducting a little research on this.

    ReplyDelete
  6. Packers and movers in thane@
    http://www.transmoving.in/packers-movers-thane.html
    Packers and movers in varanasi@
    http://www.transmoving.in/packers-movers-varanasi.html
    Packers and movers in surat@
    http://www.transmoving.in/packers-movers-surat.html
    Packers and movers in lucknow@
    http://www.transmoving.in/packers-movers-lucknow.html

    ReplyDelete
  7. Packers and Movers Gurgaon to Ahemadabad@
    http://www.ncrpackersandmovers.com/packersandmoversgurgaontoahemadabad.html
    Packers and Movers Gurgaon to Ankleshwar@
    http://www.ncrpackersandmovers.com/packersandmoversgurgaontoankleshwar.html
    Packers and Movers Gurgaon to Aurangabad @
    http://www.ncrpackersandmovers.com/packersandmoversgurgaontoaurangabad.html
    Packers and Movers Gurgaon to Bangalore @
    http://www.ncrpackersandmovers.com/packersandmoversgurgaontobangalore.html

    ReplyDelete
  8. I am really impressed by this blog, I must say this blog is educative as well as amusing, and let me tell you, you have hit the nail on the head.. mcx tips

    ReplyDelete
  9. Basically applying your current tender, You are investing in buy this fact products from the owner if you're hitting prospective buyer. You read and agree with the world delivery overseas regimen stipulations starts in model new windowpane or simply loss. Scan rate former offered are usually be more responsive to change really should increment you high quote many..

    While filing any tender, You are investing in buy this Maglie Calcio Poco Prezzo skill method from owner if you are the dfb trikot müller back again prospective Maglie Da Calcio a Poco Prezzo buyer. You read maillot de foot pas cher and conform to the world maillot foot 2018 delivery overseas maillot de foot personnalise company t's and c's goes into business in the right pickup's wind shield in addition camisetas de futbol baratas to case. Signific payments in the offered generally cause to undergo change any time you expansion you limit buy quantity.. equipement foot

    Until this company offers useful practices responsibilities, Taxation's, Brokerage firm besides other penalty dues. Regarding deal is be more responsive to change and soon you make installment revenue. The local surf forecast in an european union new participant point out more resultados de futbol to the point english, Significance tax with this manuel neuer trikot rot pay out certainly not recoverable.

    ReplyDelete
  10. Siempre habrá una razón por la cual podrán comprar Bolsas Michael Kors Precios de los minoristas en línea. Los compradores de hoy que estén interesados en comprar Michael Kors Rebajas podrán descubrir cómo pueden obtener los mejores resultados que siempre quisieron simplemente haciendo ruido con lo mejor de Bolsos Michael Kors Outlet que ofrecen más allá de precios asequibles.

    Dessutom med så många alternativ att välja mellan, har det blivit praktiskt taget omöjligt för köpare att ta reda på hur de kan köpa Designer Michael Kors Väska Rea online utan att behöva investera för mycket pengar eller tid i scouting den lokala marknaden som annars skulle tyckas omöjligt att göra först . En riktig äkta Michael Kors Rea skulle kunna ge dig tillbaka tusentals dollar och det är något som de flesta inte har råd med. Du kan faktiskt köpa Michael Kors Plånbok online.

    Maintenant, la question se pose de savoir si vous pouvez réellement trouver en ligne authentique Longchamp Soldes bon marché qui sont vraiment authentiques et la réponse est oui, vous pouvez! Un des sites les mieux notés et les plus populaires pour localiser le Sac A Main Longchamp en ligne parfait pour votre collection personnelle est eBay. Rappelez-vous, juste parce que vous êtes en mesure de magasiner en ligne Sac À Main Longchamp sur eBay à des prix incroyablement bas ne signifie pas qu'ils sont faux ou de qualité bon marché.

    ReplyDelete
  11. I'm glad I found this blog. It really offers value and knowledge to the readers. Thanks for the insights you share. Please keep it up and more power to your writings. Lawrence Todd Maxwell

    ReplyDelete
  12. Very impressed post..I would like to share it to my friends..Such a very useful article. Very interesting to read this article.I would like to thank you for the efforts you had made for writing this awesome article.I really appreciate your efforts and I am waiting for your next write ups thank you once again.
    JSC Result 2018 by sms
    JSC Result 2018 Online

    ReplyDelete
  13. Loading and unloading comes as a part and parcel of our moving services. In case you are particular about use of machinery for loading and unloading, you can get your option through one of our providers. For very professional and fully managed relocations, opt for our VManage Premium package.
    Packers and Movers in Bangalore
    Packers and Movers in Pune
    Packers and Movers in Mumbai
    Packers and Movers in Hyderabad
    Packers and Movers in Delhi
    packers and movers in panchkula
    Packers and Movers in Kolkata
    Packers and Movers in Chennai

    ReplyDelete
  14. For those who may not know about this might find it hard to imagine that international shipment of household goods is a very standard practice by now. We have truly become global citizens. There are statutory provisions in import and export regulations to deal with international relocations. You just need to opt for international relocation while filling out forms or while searching and you will be redirected only to relevant providers.
    packers and movers thrissur
    packers and movers in belgaum
    packers and movers kharagpur
    packers & movers in nagpur
    packers and movers btm layout

    ReplyDelete
  15. Anyone reading this text must have come across the need for a home relocation. This requirement is typical of the city life andcareer-moves. Moving India provides comprehensive home relocation covering not only the furniture, fixtures and utensils but also your vehicle and pets.
    packers and movers satna
    packers and movers bhilai
    packers and movers in cuttack
    packers and movers in durgapur
    packers and movers in meerut
    packers and movers rajahmundry
    packers movers jodhpur
    packers and movers kakinada
    packers and movers korba
    packers and movers dhanbad

    ReplyDelete
  16. It is very important to get your goods insurance while you are relocating. While several vendors provide insurance services as part of their services, some of them don’t. In due course, you will be able to contact us for your goods insurance requirements.
    packers and movers coimbatore
    packers and movers in nashik
    packers and movers in panchkula
    packers and movers in zirakpur
    packers and movers allahabad
    packers and movers in amritsar
    packers and movers mangalore
    packers and movers bilaspur
    packers and movers in ajmer
    packers and movers pondicherry

    ReplyDelete