Last night on the Alberta Primetime Money Panel, I was asked if financial advisors were profiting as a result of the extra trading that happens in bear markets. As always, I thought I would share some of my personal perspectives on this topic.
Trading is not profitable for advisors
I think the days of frequently and regularly trading by stock brokers are gone. There was a time when stock brokers made their money from buying and selling. Every time there was a buy or sell, it would trigger a fee to the client and a commission to the advisor. The more trading that happened, the more money for the broker and the financial sponsor/institution. The industry lingo for this is turnover (the frequency of trading). There was a time turnover was important to the financial industry because it was a key way to increase revenue/commission.
The problem with a high turnover portfolio was trading costs would eat up profits and investors started to question the motives of brokers. Were they promoting a trade because it was good for their client or was it just to trigger a commission for the advisor?
A shift to asset base compensation and gathering assets
When I came into the financial industry 20 years ago, there was a shift happening from transaction based compensation to asset based compensation. The popularity and growth of mutual funds played a very significant role in this shift. Mutual funds shifted the message from buy and sell to buy and hold. Selling mutual funds to clients was much easier and less work than the constant hustle of the old trading model. Now financial advisors and brokers would get paid a commission based on the total assets of the portfolio.
In industry terms, mutual funds paid (and still do) financial advisors a trailer fee on the asset base which ranged from 0.5% to 1.0% on equity products and 0.25% to 0.5% on fixed income products. Advisors get paid regardless of trading. They also get paid regardless of absolute investment performance.
Welcome to the world of relative
Mutual fund trailer fees are relative to the value of the portfolio. In other words advisors compensation is calculated as a percentage of the portfolio. If you have $100,000, the advisor would get paid $400 to $1000 that year. If the value of the portfolio grows 10%, then the advisors compensation also grows 10%. However if the value of the portfolio drops 30%, so does the advisors compensation but they still get paid. They just get paid less.
Some critics of mutual funds sold by advisors suggest that advisors should be compensated on more of an absolute basis where they only deserve to get paid if they make money and deliver positive returns. Accordingly, they should not get paid when the portfolio loses money. What do you think?
Bear markets are when advisors really earn their keep
In the world of asset based compensation, I think advisors are making less money in bear markets (not more). When portfolios drop 10% to 30% so does the advisors compensation. I also think when times are tough, advisors have to work harder. They probably get more phone calls from clients. More clients probably want to have reviews of their portfolios. There is more hand holding and they have to spend more time re-assuring clients about their investment plans and strategies. Some advisors have said to me they work harder and get paid less in bear markets.
Watch for double dipping
Unfortunately for investors, some advisors are using bear markets as an opportunity to churn and sell new products geared to alleviating the fear of clients. One example of this is where advisors recommend that their clients move to segregated funds to take advantage of some capital guarantees.
I’ve seen far too many examples where advice like this is a win for the advisors but a lose for the client. Here’s a prime example of an advisor that should lose his license for this: Be Cautious of Advisors who abuse deferred sales charges.
My two cents
Having been an advisor that sold mutual funds and other financial products I am very aware of the potential conflict of interest that presents itself when giving advice but only getting paid to sell a product. Not all advisors are created equal. I also believe that there are good advisors just like there are bad advisors and investors should never trust their advisors blindly because no body cares about your money more than you care about your own money.
In times like these when advisors are recommending changes, investors (clients) need to always ask about compensation and fees:
– Are there any penalties to sell?
– What are the fees on the new investment?
– How much does the advisor get paid to buy and sell?
How else would you know if your advisors is acting in their best interest or yours?