Calculating advisory fees fairly for both client and advisor

Most investors who have their portfolios managed by “fee-based” investment managers should wish the second quarter of 2012 ended a day earlier.  Today, the last day of this quarter, the global equity markets are up over 3%.  Since the vast majority of fee-based investment firms calculate quarterly advisory fees off of client balances at market close on the last day of the quarter, many investors just paid their advisors 3% more simply because the last day of this quarter was exceptionally strong.

Of course, the last day of the quarter could just as easily have gone the other way and their advisors would have been paid that much less for the previous quarter’s work, and it sometimes does work out that way.  But since markets tend to go up more than they go down, this arrangement looks to favor the investment firms as far as fee calculations go and it has nothing to do with the skill of the advisor.  It is purely at the whim of the markets.

Consider another issue, client additions and withdrawals.  If all that matters for a fee calculation is the dollar value in accounts at a single point in time, investors should withdraw funds prior to that quarter-end date and only add funds after that quarter-end date to game the system properly.  Conversely, investment managers should not send client funds out of accounts until after that quarter-end date and try and convince clients to add to their accounts before the new quarter starts.  It’s silly gamesmanship that likely doesn’t amount to significant dollars for either clients or advisors, but nevertheless it’s an example of how clients and their investment managers sit on opposite sides of an issue.

But is there a better way?  Of course there is.  Firms could calculate fees based on the average daily balance in client accounts.  This way, the advisory fees charged most accurately reflect every impact of the advisor’s investment decisions as well as properly billing based on cash flows into and out of accounts.

If the advisor bills off of average daily balances it minimizes any incentive either side has to “game” the system.  Clients can then put money in or take money out based on things that actually matter rather than trying to minimize advisory fees paid.  They are likely to put money in sooner and take money out later, as it should be if one wants maximum exposure to global growth.  And advisors can focus on properly managing the assets without feeling the conflict between doing the right thing for their client versus doing the right thing for their paycheck. For more on financial advices, see here the new post about Types of Debts UK.

So ask your advisor how s/he calculates your fee: is it based on a single point in time or the average daily balance of assets over the billing period?  If it’s the former, ask them why they don’t do it the other way.  It’s easy enough to bill based on the average daily balance, so there really is no reason other than laziness or lack of desire.  In fact, clients should demand it.  It’s the right thing for advisors to do.

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