Notes from Invest Like the Best: Michael Kitces


About Michael: Leading expert on financial planning and building advisories


Financial Advisory Fee Model History

Commission Model

  • Until 1975: high commission — stock brokers making $200 in 1975 dollars for execution; fees were set by price control in aftermath of the 1920’s free for all where clients were ripped off during the bull market preceding the Great Depression1975: May 1st — ” May Day”: deregulation of stock commissions. Some brokers thought they could raise prices but Bay Area-based Charles Schwab uses computers to undercut and in the next 20 years commissions fell 90%.

Fee Model

  • 1980s to 2011: Mutual fund model rises as stockbrokers go out of business. The rise of independent broker dealers as the creation of the financial product unbundled from distribution. Financial advisors would recommend mutual funds that were not manufactured by the wirehouse they worked for creating less conflict of interest from stockbroker model. Mutual funds assets rise from 1/2 trillion to 5 trillion! Advisors lobbied for 12b-1 fees which allowed them to charge a recurring fee on assets to support their advisory business since commission dollars were now unsustainably low.

Internet Era

  • Technology platforms all funds to be distributed direct-to-consumer. Etrade: “It’s so easy a baby can do it”
  • 1998: Schwab One Source Program pioneers the no-load fund
  • Advisor model becomes the AUM model where once again the value prop to consumers improved as advisors were now constructing diversified portfolios for clients instead of jamming them into a single loaded fund. The rise of the fee-based account and RIAs. The value prop being constructing diversified portfolios tailored to the client’s goals
  • Mutual funds in decline as advisors no longer incentivized to sell them and their inferior structure to etfs. Advisors competing wanted to actually cut high fee funds from client portfolios. We are witnessing the acceleration of this process now as we are actually seeing net flows out of mutual funds in aggregate. It took 15 years to get to this point, he expects another 10-15 to finish the trend.
  • Advisors are disintermediating funds — “wholesale transfer pricing”. When there is competition up and down the value chain the owner of the relationship, in this case the advisor stands to survive.
  • Roboadvisors have competed for assets of self-directed investors much more than displacing human advisors. They were the biggest threat to Schwab and Vanguard ironically and turns out they were the first to respond with robo-advising of their own

The new model: Barbell

  1. Economies of scale and tech. From 1995 until now fees dropped yet another 90%. Commoditized funds and etfs fees going to zero. Large firms like Fidelity, Schwab, Vanguard ok with this because as fund managers they capture AUM fees on the back end.
  2. Niche advisors that add value in ways that often has nothing to do with asset management.

Understanding the New Model

  • Advisor fees average about 1%, although closer to 75bps on a weighted basis (larger accounts get discounts).
  • Robo advisors started at 25 bps which was a venture backed hypothesis price. They have been steadily raising fees and it looks to settle in around 35 bps. So the gap between a robo-advisor and a full service human advisor is about 40 bps.

Advisors recognize they need to add enough value to justify the premium.

How are they doing it?

  • Comprehensive financial planning (taxes, estate)
  • Upgrade talent. The bar is going up dramatically in terms of credentials. A basic license no longer viable qualification to compete.
  • Specialized expertise: most advisors advise about 100 clients and the top 20% are 80% of the revenue, meaning you can serve tiny niches
    • Niches:
      • Seniors
        • Social security timing (when to take it)
        • Medicare and health plan guidance
      • Narrow cohorts
        • Doctors at a certain hospital with complex hospital negotiation process
        • Competitive bass fishermen (endorsements and prize money guidance)
        • Expats from certain countries

Does the data support advisor fees declining or them fighting to add more value at constant revenue?

Instead of average fee declining, we are seeing advisor profit margins decline as they add value and costs to ‘defend the 1%’ fee. Profits are not exploding despite markets on record highs

Michael’s view on flat fee versus AUM fees

On AUM fees:

“the only business model that I’m aware of anywhere in the history of any industry or your average revenue per client automatically goes up at a real rate above inflation simply by keeping your client because your [fee] lifts with the return of the markets and return the markets is generally risk premium plus inflation so we get this natural lift in a world where every other industry that ever existed has to actually go back to their people to ask for an increase and get them to buy in”

This makes the flat fee business difficult to compete.

But why are flat fees the future?

This will be the dominant structure in 20 years because the size of the addressable market will widen.

Currently, only about 1/3 of households have over $100k in investable assets. But 1/2 of these assets are in 401k plans which cannot be advised. This leaves less than 20%.

Of that proportion,

  • 1/3 are DIYers
  • 1/3 are “validators”. They have an idea of what they want to do but need some guidance but unwilling to pay AUM fee for validation
  • 1/3 are “delegators” and thus great clients

Current AUM model only addresses about 7% of the population

So fee-for-service has an opportunity because 50% of the population need financial guidance but neither the asset level nor will to delegate to an advisor.

He says the model may shift to “1% of assets to 1% of income”

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