Coping With Complexity: Four Pitfalls Informed Investors Can Avoid
It is an era of complex fee structures with many high-net-worth (HNW) investors unaware of just how many forms and layers of fees and costs are lurking within their portfolios.
If you speak with a HNW investor about the fees associated with their wealth management relationships, odds are, you’ll hear them assert that their “all-in” costs are something like 50 to 100 basis points per annum. Probe a bit more, though—ask whether there could be additional fees buried deeper within the relationship—and most will say absolutely not. But in truth, “unless you’re pounding on the desk demanding to see a detailed account of all your fees, direct and indirect, you’re not going to have a true accounting of the all-in costs of the relationship,” says Sean C. Kraus, senior vice president and senior portfolio manager at Whittier Trust.
Hidden fees and costs can be elusive. Four of the most frequent include:
1. Pressure to sell firm products
The industry is consolidating. More and more wealth management groups are being folded into much larger financial services conglomerates. Now, consider what can happen to any financial advisor working on behalf of clients but doing so within the auspices of such a group.
All advisors are incentivized to sell, bringing in new clients and additional assets under management. But in the largest firms, advisors are often asked to use certain managers, or in some cases, certain securities. As it turns out, the favored managers may not be the best available for clients and the securities in question might be those the firm is already holding in inventory and cannot easily sell to their institutional clients. In either case, says Kraus, “the choices may appear appropriate, but in truth, they may not be working in the best interest of their clients.”
In addition, fee arrangements with managers can dramatically affect performance. Though a firm is saying that its choice of managers is based on quality and appropriateness, in reality, the choice could be biased by fee concessions by certain managers trying to increase assets under management (AUM). “So investors may be prevented from [access to] the best of the best in terms of managers,” says Kraus.
Note that in certain cases, advisors themselves may not be focused on such realities. For example, a firm might be charging its HNW investors an overall portfolio fee but then also require its advisors to use specified managers. So, in addition to the overall 50-100 basis point management fee, investors are set up with sub-accounts in various equities and fixed income securities run by outside managers charging an additional 30-50 basis points. The advisor is conditioned to exclude the extra fees and costs from the calculation given they typically do not see these costs clearly listed on client statements.
Over time, an advisor might note that relative to other managers, certain client accounts aren’t performing quite as well and so takes a closer look. “So the advisor seeks out the group that decides which managers to bring on to the platform and asks, ‘Why aren’t we using these stronger-performing managers?'” says Kraus. And what they’re told is that the firm reviewed these new managers but they are not an option without a good reason provided. Thus, through no fault of their own, an advisor’s choice of high-quality managers often becomes very limited, which also affects performance.
2. Structured product fees
Matters can go even further south in cases of structured products. Often, a financial services firm will listen to the concerns of a client, perhaps surrounding cyclical ups and downs inherent in the markets or even an investor’s business. And so the firm will sometimes offer a customized, option-infused derivative “solution.” For example, says Kraus, “That could be a product where you are guaranteed to earn 6% on your investment over two years so long as the S&P is no lower than a certain set point.”
Strategically, the idea of limiting market risk and setting an acceptable return sounds great. “But unless you find several hours to go through the accompanying 100- to 250-page [prospectus] to find where discussions of fees have been buried, you won’t notice you’re paying 2-3% in fees to purchase these instruments and many times giving up dividend yield,” says Kraus.
Even that’s not the end of the hidden fee story. As Kraus explains, “If the reason for the structure goes away or the market turns and the investor wants out prior to maturity, then there are additional fees to sell.” In short, says Kraus, “Any time a fee structure in a relationship or a product sounds too good to be true, it most likely is. There’s likely something buried deep within.”
3. Inappropriate tax expense
One of the most deeply hidden costs of outside equity managers and mutual funds is unnecessary tax expense. As Kraus explains, “Most funds are being managed looking at absolute return for the fund itself. For the mass market, they’re not worried about whether the sale of assets within the fund could trigger a taxable event.” This is fine for investments trading within tax-advantaged accounts, but most HNW investors’ assets are of a taxable nature—that’s the nature of private individual or family portfolios. So, advisors who are steering these investors into funds without taking into account the overall tax picture are almost always generating unnecessary taxes, which also affect performance.
4. Wholly unnecessary expenses
Often, investors encounter fees and costs that should never have been on the table in the first place. Consider the case of precious metals. “If someone wants a position in gold, we steer them to a low-cost ETF,” says Kraus. But often investors instead acquire physical gold, which now in addition to a transaction commission leads to annual storage fees. Similarly, investors are enticed into paying significant fees for small positions in alternative investments “so much so that it’s nearly impossible to generate any worthwhile returns given the commensurate risks and illiquidity,” says Kraus. Advisor placement and high annual fees in general to hold small positions sometimes eliminate what would be a solid return from the underlying investments.
Fee structures have become so complex and hidden fees so common that it can be difficult for even the most sophisticated investor to understand. “I can’t think of very many who would [even] want to expend the time required to do so,” says Kraus. “Whenever we take a closer look at anyone’s existing fee structures, in most cases, there’s a vast gulf between what they believe they’re spending and the actual costs.”
What Kraus strongly recommends “is that HNW investors get together with their advisors and wealth managers and demand a detailed accounting of their fees, commissions and product costs, including managers and mutual funds.” Be certain, says Kraus, “to ask to see this performed for every aspect of the relationship: every account, every product. It should be done annually if possible as well.”
Many institutions, says Kraus, “will balk, delay or otherwise say this isn’t feasible.” But the truth, he says, is that drilling down within the account and even to the transaction level is, for these firms, a relatively easy matter. Firm systems typically allow a perusal of transactions over almost any time period.
It is a fact, says Kraus, that the overall trend in the wealth management industry “is toward greater complexity and [diminished] transparency.” Kraus maintains that the only way to avoid hidden and unnecessary fees and costs is to drill deeply into every relationship and transaction of any significance. To this end, he suggests, “speak with us, and we can forensically evaluate the various manager and broker fees and even the turnover on the fund since most aren’t being managed for taxable clients.” It is only with such details and transparency “that a HNW investor can be clear on the actual costs of the relationship.”
Written in partnership with Forbes Insights.