Boiler Room Tactics for Fee-only Advisors

Illustration courtesy of IMBd.com

How do fee-only advisors justify charging high fees when potential clients balk at them? In true boiler-room fashion, a new whitepaper by State Street Global Advisors (SSgA) provides the answers.

I can’t link the SSgA whitepaper to this article because it clearly states it is FOR INVESTMENT PROFESSIONALS ONLY. NOT FOR PUBLIC USE. That being said, the contents mirror an earlier paper published by the Wharton School, University of Pennsylvania. Bridging the Trust Divide: The Financial Advisor-Client Relationship was commissioned by SSgA and is on the Wharton website. I will quote from that public paper.

The papers highlight a sizable gap between the value clients place on advisor expertise and the value that advisors themselves place on their own worth. Needless to say, advisors think very highly of themselves. A similar gap was found between how well clients think their advisors are doing and the advisors’ much higher opinion of their performance.

Wharton professors gathered information for the paper from two surveys: one included 366 financial advisors and the other included 500 individual investors. Identical lines of questioning were presented to each group. The financial advisors comprised a wide range of investment and financial service professionals, and clients represented an equally wide range of portfolio sizes.

SSgA commissioned the paper to suggest ways that financial advisors can bridge these gaps between perception and reality and thereby justifying their advisor fee. The hope for advisors is that their perception becomes reality in the eyes of investors and not the other way around.

I see this as boiler room tactics for fee-only advisors. In financial sales, the term boiler room is associated with shady stock dealings, high commissions, and undisclosed relationships among companies being promoted. A fictional “boiler room” brokerage firm was dramatized in the 2000 film Boiler Room, starring Giovanni Ribisi and Vin Diesel. Every investor should see this film before investing with a financial advisor.

I’m not suggesting that fee-only advisors are running a boiler room operation. I am suggesting that many of these advisors are overcharging their clients by over-representing what they can deliver. The SSgA whitepaper and the Wharton paper are enablers to this misconception. They provide advisors with talking points to help them win over fee objections.

The study promotes the concept that advisor oversight is critical to success and that trading is important. It highlights research listing “consequences” resulting from investors not managing their portfolios actively enough. The Wharton paper states the average 401(k) account contains only 3.5 funds out of what is on average a set of 18 available funds—and 80 percent of the sample never traded at all over a two-year period…the average turnover for a professional [advisor] is about 117 percent.

When did 117 percent turnover ever help anyone, and when did a low number of funds and low-turnover become a bad thing? Three or four well-chosen index funds work better than most high turnover strategies. For example, the Core-4 portfolio of low-cost index funds is quite popular with self-directed 401(k) participants. That should be the model, not high turnover active management.

To be fair, the Wharton study did try to differentiate good trading from bad trading, for the overwhelming majority of retirement savers, there is no evidence of portfolio rebalancing, shifts in risk tolerance with age, or tactical portfolio changes. I agree with the first two, not the last one.

Another talking point is that advisors can add value by helping clients see the mistakes they’re making, and this includes the client’s self-managed accounts. The paper suggested that this type of off-the-record advice can help an advisor legitimizing their on-the-record fee.

The problem with free advice from advisors is that investor outcomes often worsen when they hear it. In a recent article entitled Financial Advisors Encourage Bad Behavior, I highlight a study from academia that found the advisor industry reinforces bad investor behavior rather than fixing it. Advisors often promote performance chasing and costly actively-managed products, even when the client comes to them with a well-diversified, low-fee portfolio of index funds.

More advisors are shifting to a fee-only model, otherwise known as asset management fees (AUM). As advisors shift to AUM, they also shift how they manage clients’ money. Rather than picking stocks and bonds themselves, the fee-only advisors are increasingly having their clients hire other firms to do the actual securities selection. The trick for advisors is to convince clients they are skilled at picking other managers, which include mutual funds, exchange-traded funds (ETFs) and other products.

The Wharton study recommends advisors tell clients they have a “rigorous method” for choosing other managers. An implied superior method for mutual fund or ETF selection also implies superior performance in the future. In a nutshell, the study is suggesting that the investment selection process become so complicated that only an advisor can do it.

Ironically, the paper contradicts itself a few pages later by stating, in creating the perception of value, many advisors find it easier to convince clients that they are adding value by choosing good managers—though conventional wisdom indicates that the vast majority of actively-managed large cap funds underperform the index. Score one for the authors of the paper.

One suggestion I did not see in the study was a recommendation that advisors lower their fees to a point where clients see good value. Technology has allowed every industry to be more efficient, more productive, and more profitable at lower costs to consumers. That has not occurred in the financial advice business. Fees are stubbornly high. They have not come down in decades. It’s as though 25 years of technology has overlooked the advisor industry.

So, what does an advisor say when a potential client balks at the fee? The study suggests threatening the potential client with poor service. Here is a direct quote from the Wharton paper that highlights the words of one advisor who was asked to lower his fee:

Frank relays that once he even had a client ask to be given a higher fee, after he had first inquired about a fee reduction. “We can do a lower fee,” Frank told him, “but you’re probably not going to be the first call that I answer.” In response, his new client changed his mind and said he’d pay more. “You get what you pay for—and he wanted to get more, so he paid more,” Frank recalls.

That has to be the most pathetic quote I have ever read in any Wharton paper. It’s also in direct conflict with something John Bogle believes, “In the investment industry, you get what you don’t pay for.”

Another excuse is to blame the industry for high fees. The paper suggests that a lot of high-net worth investors don’t know whether a fee is high, low or indifferent. So, advisors should frame it for them. For example, if an advisor is charging 1.25 percent, tell a $1 million dollar client that the range of offerings is somewhere between 0.95 percent and 1.3 percent. That puts 1.25 percent fee “in range” with industry standards.

The SSgA whitepaper provides an inflated set of fee ranges for different account sizes. These fee ranges are much higher than what I have experienced. There is an entire industry of low-fee advisors who charge significantly less than the ranges stated in the whitepaper. These advisors appear to be excluded from the data. The assets these low-fee firms are managing are significant. Portfolio Solutions has nearly 1.1 billion in assets and charges only 0.25 percent for a $1 million portfolio. We’ve been a low-fee advisor since 1999.

Finally, the paper suggests that advisors disclose fees early in an initial conversation with a potential client so that they forget what the fee is by the end of the conversation. Studies show that clients have aversion to fees when they come up at the end of a sales meeting rather than the beginning.

To be fair, the paper does reinforce several sound investment principles. One states that the number-one source of value added is getting the client into the portfolio and keeping them invested through different market cycles. Advisors should focus on long-term goals rather than short-term performance. Unfortunately, they’re going the other way. More advisors each year think they can beat the markets. They are suffering from Alpha delusion. Maybe the paper will help convince them otherwise.

I could go on about boiler room tactics for fee-only advisors, as suggested in the Wharton and SSgA papers, but it just gets me upset. For my own sanity, I have to believe that the professors who helped write the Wharton paper bit their tongues a few times because they were being paid by SSgA to say what they said. Let’s hope that’s the case.