Many investors are told that the interests of fee-only financial advisors’ align better with their interests. This assertion highlights the importance of positive returns and the potential conflicts of interest that may occur between commission-only advisors and their clients.
This claim is usually made on the websites of financial advisors in the hope investors will trust them based on the way they are compensated. And, this trust will be enough to cause investors to give up their anonymity and contact them.
One of the most sensitive types of information, that may or may not be disclosed on websites, is the compensation methods of financial advisors. Is it a fee? Is it a commission? Is it both? And let’s not forget other important categories of information - for example, how much they are being paid and by whom.
But, the topic for this article goes much deeper than how financial advisors are compensated for their knowledge, time, advice, and other services. On the surface, both investors and financial advisors benefit during rising markets—investors see their portfolios grow, and advisory firms and professionals earn higher fees based on the increased valuations.
At the same time, financial advisors do worse when their clients do worse. So doing better is a positive phenomenon that only applies to rising markets. Doing worse applies to investors and their fee-only financial advisors in falling markets.
In this article, we will address online transparency and trust that is based on what financial advisors are willing to disclose about their compensation on their websites. All too often financial advisors want investors to trust the information, but they withhold all or part of it from them. They may believe investors will not know this information is being withheld. This is a big mistake when more investors are using the Internet to compare advisors.
If financial advisors genuinely want to build more trust with investors on their websites, then transparency about their fees and compensation models is increasingly important. Plus, the more openly advisors are willing to discuss these topics on their websites, the more trustworthy they will appear to be when investors are using the Internet to compare financial advisors.
What does transparency look like in actual practice, and how can it impact investors’ decisions to engage with particular advisors on the Internet?
In this article we will address “doing better” in a digital world, how this alignment is disclosed to potential investors on financial advisor websites, and ways to use online transparency to build trust.
A few years ago, investors’ primary source of information was the financial advisor (professional). Very few investors read ADVs or visited the FINRA or SEC websites. After all, their documentation was not very user-friendly, creating more questions than answers.
The Internet has changed all of that. Investors can visit websites (82%) and Google search names (64%) before giving up their anonymity and contacting financial advisors. They know a lot more about the advisors than the advisors know about them.
However, this online access to information is not the principal impact of the Internet. The real game changer is investors’ ability to compare financial advisors online without contacting them. This enables investors to determine who is being transparent and withholding information from them, which has a major impact on who they contact to discuss their financial futures.
Who is going to contact financial advisors they don’t trust?
Fee-only financial advisors often promote the idea that their asset-based fee model aligns their interests with their clients. The logic is simple: the investor and the advisor benefit as portfolio values rise. However, the dynamics shift during market downturns.
Even though advisors earn less when portfolio values decline, they are still being paid fees for declining market values. This can lead some investors to question whether their advisors are adding any value during tough times versus prosperous periods when just about everyone is earning positive returns.
Understanding this nuance is critical for investors. While the fee-only model reduces some conflicts of interest, it does not eliminate all of them.
One of the most significant decisions investors face is choosing between a fee-only advisor and one who works on a commission basis. Fee-only advisors typically charge a percentage of assets under management (AUM), theoretically aligning their income with the client’s portfolio performance.
On the other hand, commission-based advisors earn money through sales and transactions, which can create an incentive to recommend products that generate higher commissions, potentially misaligning their interests with their clients.
Educating investors about these differences is crucial. While fee-only advisors might seem to have fewer conflicts of interest, it's essential to understand that no compensation model is entirely conflict-free.
Is there such a thing as a truly conflict-free compensation model in the financial service industry? Not when you are dealing with other people’s money.
A common misconception is that fee-only advisors are inherently more objective than their commission-based counterparts. This belief stems from the idea that they are more likely to offer unbiased advice because they are not earning commissions. However, fee-only advisors face pressures, such as selling their companies’ proprietary products, which may influence some of their recommendations. Everyone makes more money except the investor.
Or, an advisor might hesitate to recommend a drastic portfolio move to cash equivalents if it could lead to a significant decline in their management fees. Investors must know that while fee-only compensation reduces certain conflicts, it does not eliminate them.
The foundation of a strong advisor-client relationship is built on transparency and education. Investors should fully understand how their financial advisors are compensated (firms and professionals) and the incentives that come with different compensation models. Key questions include varying opportunities for transparency and building trust:
Fee transparency is essential, but it’s only part of the equation. Investors should also understand how these fees relate to the services they receive and the advisor’s overall strategy. For instance, a fee-only advisor who charges a flat fee might have different motivations than one who charges a percentage of AUM.
By asking pointed questions, investors can ensure that their advisor’s compensation aligns with their financial goals, particularly in a wide range of market conditions.
Fee-only advisors often emphasize their fiduciary duty as a key differentiator on their websites. Fiduciaries must act in their client’s best interests, theoretically ensuring their advice aligns with their clients’ current circumstances, timelines, risk tolerances, and financial goals.
However, investors should understand that fiduciary duty does not guarantee perfect alignment between their interests and advisors. Only naive clients would believe that.
Market conditions, client retention concerns, and firm-wide policies can all influence an advisor’s recommendations from Wall Street to Main Street. While fiduciary duty adds a layer of protection, it is not a cure-all for potential conflicts of interest.
Advisory fees become more noticeable in declining markets. While clients may see their portfolio values decrease, they are still responsible for paying fees, which can increase their net losses.
Fee-only advisors may note that their fees are reduced as portfolio values drop. Still, investors must understand how these fees are structured and whether they are based on average portfolio values, quarter-end values, or other metrics.
This knowledge can help investors decide whether their advisor’s fee structure aligns with their financial goals in rising and falling markets.
Ultimately, investors are responsible for ensuring that a financial advisor’s interests align with theirs. Investors must proactively ask questions, understand compensation structures, and evaluate the advice and services they will receive. They should also consider whether their advisor’s compensation model aligns with their investment philosophy and financial goals.
By taking an active role in their financial planning and being informed about how advisors are compensated, investors can ensure that their interests align with those of their advisors.
What if financial advisors believe in full transparency but do not want to be the first or the only one to disclose certain information? For example, this transparency could cost them prospects or clients for their services.
By educating investors on the nuances of different compensation models, the concept of fiduciary duty, and the importance of transparency, they can make more informed decisions about who manages their financial futures.
Transparency is not just about investors understanding how advisors are paid; it's about recognizing how these compensation structures may influence their advice. For advisors, being transparent on their websites about these matters is a powerful way to build trust and generate investor engagements.