As ETFs and indexing makes the raw cost of “owning the market” cheaper and cheaper, the question arises of whether, or how, advisors can continue to justify an ongoing AUM fee for an investment portfolio. For some, the cost is justified by the alpha or portfolio-related “advisor gamma” value-adds that are provided; for others, the benefit is the inclusion of financial planning services. For the rest, the benefit may just be to help protect clients from themselves and their self-imposed “behavior gap” on returns.
Yet AUM fees are far more relevant for some of these services—like portfolio-related alpha—than others. In other cases, while some AUM fee is justified there is significant pricing pressure (e.g., providing portfolio-related gamma like automated rebalancing, tax-loss harvesting, and asset location). In some cases, the advisor provides so little actual portfolio-related value that the financial planning fee may become unbundled altogether.
Notwithstanding the potential pressure to unbundle, though, a look at the landscape of the financial services industry suggests that, if anything, the trend remains toward, not away from, AUM fees. The shift towards fee-based revenue has been increasingly adopted by even the largest firms, from wirehouses to Schwab Private Client to Vanguard Personal Advisor Services, often bundled together with comprehensive financial planning services that are either very low cost or entirely free because their impact on retention rates and increased lifetime client value alone justifies their cost to deliver.
All of this suggests that even the declining cost of beta may not be enough to end the AUM fee, though the fact that a huge swath of Americans cannot be served by AUM fees, because they don’t have the assets in the first place, means a wider range of financial-planning-fee-for-service models may be inevitable anyway.
Creating Value When Beta Is (Nearly) Free
Notwithstanding the fact that the cost of indexing and simply “buying beta” is getting cheaper and cheaper with the ongoing rise of Vanguard index funds and various ETFs, advisors have been increasingly adopting an assets-under-management (AUM) style business model that layers the advisor’s investment management fee on top of the portfolio. That raises this fundamental question: what value, exactly, is that advisory fee supposed to be paying for, as the cost of buying “the market” beta moves inexorably towards zero?
For some advisors, the primary purpose of the investment management fee is an attempt to deliver alpha: adding value to the portfolio above and beyond its core beta exposure, and being paid accordingly. In this context, alpha might be in the form of picking individual securities, selecting third-party managers that add value or simply trying to better manage risk (which can improve risk-adjusted returns without increasing the raw return itself).
For others, the goal is actually to add advisor “gamma,” value-added advice that enhances the overall (portfolio or other) results, outside of trying to improve the raw investment performance itself. For instance, this might include tax-management strategies like automated rebalancing, tax-loss harvesting (where appropriate) and asset location. For retired clients it might include the tax-strategic sourcing of withdrawals across various types of retirement accounts and establishing dynamic withdrawal strategies.
The more wealth there is in the first place, the more value these gamma strategies can add. For other advisors, their gamma value-add may be financial planning advice that goes far beyond the portfolio, to all the other areas in which clients may need (financial) help, or towards a particular type of niche clientele.
A third, more nuanced category of advisor value-add, might be determining which beta to own and when to dynamically adjust it, in a world where it’s not entirely clear how to allocate among “the markets” of various asset classes.
For instance, an investor can own the Vanguard Total Market Fund and the Vanguard Total Bond Fund, but how much should be allocated to each? Should the entire stock and bond market allocations be determined by their weightings in global market capitalization? How can that be done for asset classes that don’t really have an effective means to measure market cap (e.g., commodities futures)? And with herding behavior, groupthink and limitations of leverage and shorting, it’s also not clear if asset classes as a whole are necessarily as efficient as their underlying securities, raising the question of whether tactical asset allocation among asset classes may have opportunity (though to some extent this may simply be a sub-category of alpha).
In the end, for some advisors the primary portfolio-related value proposition is not to beat the market, enhance returns or otherwise add to wealth, but simply to help prevent clients from reducing their own wealth due to their own bad behavior, i.e., aiming to reduce clients’ self-imposed “behavior gap” in returns. While the exact magnitude of the behavior gap is still widely debated, clearly there is at least a subset of investors for whom the behavior gap is a significant negative, and merely closing that gap may actually contribute more “advisor gamma” than anything else to enhance the client’s actual long-term wealth and their ability to achieve their goals!
Broadly speaking, then, the ongoing commoditization of beta through indexing and technology essentially puts advisors at a crossroads regarding their value proposition: to provide alpha (in the form of security or asset class selection), or gamma (in the form of tax and other portfolio/wealth value-adds, or helping clients behaviorally), because there’s no longer any money in getting paid for beta itself.
The Relevance of AUM Fees to the Value of Advice
Given the crossroads that advisors face in being forced to choose whether they will provide alpha or gamma (or both) to clients, the secondary question arises: is an AUM fee still the appropriate mechanism to charge client for these value propositions? Will the declining cost of beta put pressure on advisory fees overall?
Ultimately, the impact of the declining cost of beta on advisory fees will likely depend on exactly what value propositions the advisor provides in the first place, as some are more or less conducive to AUM pricing, and are more or less exposed to pricing pressure.
In the context of adding alpha, AUM fees are still arguably a very appropriate mechanism for charging clients; the AUM structure helps to align advisor and client interests without some of the perverse incentives that arise with performance fees, and still allows for the advisory firm to effectively grow and scale resources. The more the advisory firm manages for the client, the more real-dollar-value that is added to the client if/when the alpha is delivered, so the AUM fee remains a reasonable way to charge for the service.
On the other hand, there is clearly some pricing pressure on alpha, especially since today’s technology tools make it easier to evaluate investment managers and determine whether they’re really living up to their expected alpha or not. This is especially true for investment managers in the business of security selection, where performance can be clearly and easily measured against a relevant benchmark. Ironically, pricing pressure may be somewhat less on firms that manage tactically across asset classes, if only because it is significantly more difficult to determine the appropriate benchmark to evaluate such “unconstrained” managers in the first place.
On the gamma side, the relevance of an AUM fee varies significantly depending on the type of service being performed. For gamma value-adds that tie directly to the portfolio itself, where the value is implicitly tied to the amount of assets being managed, the AUM fee remains relevant, with the caveat that, because many of these services can and are implemented by technology (whether from rebalancing software or “robo-advisors”), the downward pricing pressure on that AUM fee is very significant.