Vale ad valorem

Whoever decided that ad valorem was the best way to charge people for managing their money knew what they were doing.

By levying charges as a proportion of assets under management, all the different intermediaries involved have been able, over time, to extract vast sums from customers, who not only barely notice, but also assume, because the percentage figures seem so tiny, that they’re getting a good deal.

The problem is, those little numbers add up to a very big one, and to add insult to injury, the industry insists on a level of opacity that makes it all but impossible to work out what that total is. Recent research by Grant Thornton suggests the total cost of retail investing in the UK is 2.56%; Dr Chris Sier from Newcastle University puts the figure at 3.1%.

Either way, that’s a huge chunk out of anyone’s returns, especially when you consider that the average annual return on UK equities in the 20th century was around 4.5%. Factor in the hugely corrosive impact of compounding over decades of investing, and this whole asset management business starts to look like an industrial-scale scam.

Here in the UK, ad valorem is also the fee model favoured by around 90% of financial advisers. There is, however, a rather heated debate taking place as to whether a fee-based (or indeed fee-only) model would be more appropriate. You’ll see from the comments at the foot of this article in New Model Adviser that feelings on this subject are running high.

To be honest, I can see both sides of the argument. Those in favour of fees say, for example, that fees are fairer, particularly to clients with very large portfolios, and that they minimise conflicts of interest. Those who prefer ad valorem say, among other things, that it’s simple to calculate and to understand, and it means that clients can feel free to pick up the phone or arrange a meeting if they have any concerns, without the adviser having to send them a bill.

Ultimately, of course, it’s up to advisers how they charge for their services, and I certainly wouldn’t want to tell them how to run their businesses. What I would say, though, is that I’m convinced that fee-based models will become more popular, and eventually the norm.

Although I’m based in Europe, most of my work in the advice sector is in the United States, where fee-based and fee-only charging models are far more common than it is in the UK. One of the main reason for that is the distinction between advisers and brokerage firms. Whereas most brokers will recommend high-fee, actively managed funds (mostly those, one suspects, that pay the biggest commissions); fee-based and fee-only advisers on the other hand are far more likely to advocate the use of low-cost index funds.

I don’t want to get into the active versus passive issue here. Suffice it to say that the performance of actively managed funds over the last 30 years — and especially since the global financial crisis — has been dismal. Awareness of that fact is growing all the time, not just in the US but also in the UK and elsewhere.

Another important development is the willingness of regulators, including the Financial Conduct Authority, to crack down on firms that don’t make their fees and charges transparent. MiFID II, the European directive due to be introduced next year, will force companies to itemise each and every cost that the customer bears. Indeed, as I understand it, under MiFID II, advisers who maintain a percentage charging model will be forced to disclose it as a conflict of interest.

Over the next few years, the watchword will be transparency, as regulators and (I hope) the media shine a light on exactly how much we pay to invest. Ad valorem will increasingly be seen, as is already happening in the States, as part of the old order and a throwback to the days of commission — forever associated with overpriced and heavily marketed funds that promised much and deliver little, except of course to those who sold them.

Undoubtedly many firms will continue to charge percentage fees, though I suspect rather smaller than the 1% that in many countries has become the norm. But my view is that the firms which see the most growth over the next 20 years or so will be those which charge fees, and perhaps a small retainer for on-going coaching and rebalancing.

Ad valorem was good while it lasted, at least for intermediaries. A new and savvier generation of consumers will demand something better, fairer and more transparent. We’ve entered the era of fee-based advice.