Friday, April 30, 2010

"Fee-Based or Fee-Only". What's the Difference?

Nathan Bachrach’s recent Cincinnati Enquirer column (“Simply Money”, April 30, 2010) sought to address the questions: “What is the difference between ‘fee-based’ and ‘fee-only’ advisors, where else do fees come from, and how is it fair that fee-based advisors get a fee on my (investment) gain?” This issue continues to cause widespread confusion among the investing public and deserves a straightforward, plain English explanation.

A fee-only advisor can only receive compensation directly from you, the client. Period. This means the advisor represents you, and only you, when giving you advice or making investment decisions on your behalf. A fee-based advisor can receive fees paid by you, as well as commissions paid to them by a brokerage firm, mutual fund company, insurance company and/or other investment partnership. These multiple revenue streams, sometimes referred to in the industry as “double dipping,” are good for the advisor but can potentially cause conflicts of interest.

Investment portfolios developed by fee-based vs. fee-only advisors are likely to look different. Fee-only advisors have a fiduciary responsibility under the law to choose investments that are in your best interest. They typically use investments that have low internal expenses, such as individual stocks and bonds, no-load mutual funds and investments with no 12(b)1 fees. Fee-based advisors may or may not be fiduciaries(See Merrill Lynch Rule Exemption) and are financially incented by commission revenue to choose higher-cost investments for your portfolio.

How is it fair that an advisor charging a percentage of assets under management gets a fee on your investment gain? In my company’s case, it’s because in our 15-year history we have never raised our prices. We charge .35-1.0% annually for active investment management depending on the size of the account. By comparison, the average actively managed mutual fund charges nearly 1.5% annually, according to mutual fund research expert ICI.

Our costs of doing business, of course, increase every year. We cover these increases by doing what our clients hired us to do -- increase the value of their portfolios through expert investment management. If we don’t do our jobs well, clients lose money, we lose money and we’re out of business in short order. The performance risk is squarely on our backs. With no commission revenue to fall back on, we have to deliver for our clients in order to survive. This is why the vast majority of advisors are fee-based or commission-based and why respected personal finance columnist, Liz Pulliam Weston wrote, “True fee-only advisors are a rare breed. The leading association for fee-only advisors, NAPFA, has fewer than 800 members.” Conversely, FINRA, the leading stock broker association, claims 665,000 representatives.

Fee-based and fee-only are not the only compensation models clients have to choose from; there are at least four others. I agree that no single approach is best for everyone, but one of those approaches is best for you depending on your particular needs. In my case, I established a fee-only investment management company for one simple reason: It’s the way I would want my own money managed.

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