The business difference between financial product and advice

Fees are important to investors. In most cases, lower fees increase the likelihood of a positive long-term investment outcome. Index funds globally have seen enormous growth in the past decade. That growth (and the competition to capture it) have resulted in fees literally going to zero on some index funds. Even if most index funds are not yet at zero, they might as well be with fees typically around 0.10%. Index funds embody the idea that fund management cannot add value; if that is true, then the most obvious way to compete is to lower costs. In general, this is beneficial to investors. It isn’t bad business for fund companies either.

Fund management is the ultimate scalable business. The marginal cost for Vanguard to manage an additional billion dollars is negligible, but they are taking in $1,000,000 at 0.10%. That is good business, and that is why we have seen a price war. Securities lending revenue makes the price war even more interesting – fund companies are still taking in revenue even if they are not charging any fees to their fund unitholders.

The increased awareness and disclosure of fees in Canada has resulted in new business models. Robo advisors, online firms that depend on technology to offer low-cost portfolio management and financial advice to investors of any size, have seen significant growth since they entered the market. In the United States, massive companies like Vanguard have also created low-cost advice services. The CEO of Vanguard has apparently stated that one of his big initiatives is to drive adviser fees to index fund levels.

This might be a good soundbite, but financial advice does not fit the same scalability model as fund management. Financial advice requires people, and not just any people. It requires people with expertise, experience, and soft skills to make their clients comfortable with their financial decisions. The last point, the ability to make clients comfortable, may be the most important. Behaviour management is arguably the most valuable component of financial advice. Of course, good behaviour is contingent on having received sensible advice, which requires expertise and experience. None of these attributes is sufficient alone. This poses a problem for scaling an advice service while also minimizing costs. Each adviser has a limited number of clients that they can advise. That limit is increased by technology, but only to a point. Time is the ultimate constraint regardless of technology. I don’t know what the upper limit is for clients per adviser. I once spoke to the CEO of a robo firm who explained that their target was 5,000 clients per adviser. Last I checked, Wealthsimple had more than that. Let’s say it’s 5,000.

I don’t know what the price ticket for a good adviser with the right credentials is, but let’s go low and say it’s $60,000. At a 0.10% (index fund level) fee, each adviser would need to oversee $60M just to cover their costs. That is not unmanageable with an asset minimum of $500,000, which is what Vanguard requires to access a dedicated adviser through their Personal Advisor Service. The trouble is that the adviser has a lot of other options. If they truly have the right combination of skills, credentials, and experience to win and maintain the trust of clients, then they are also attractive to traditional wealth management firms who might be willing to pay them more. A great adviser also has the option of starting their own firm. The inherent result is that the best advisers might not want to go to work for the lowest cost operator.

This would be fine if financial advice were the exact same for everyone. Everything could be systematized. That is not reality. Things like risk tolerance, how much you should be saving, and what funds you should own are very easy to determine. If those are the only decisions that you’re making, you probably don’t need to pay even 10 basis points for advice. People pay for financial advice when they have complex or niche situations, and to have someone that they know and trust keep them from making bad decisions. This is where scaling advice at index fund-level fees starts to fall apart.

I am not criticizing low-cost generalized financial advice; it is much better than the product distribution commission sales model that financial advice has followed for decades. I do believe that firms on a fiduciary fee-based model that specialize in a niche and offer highly personalized services are unlikely to feel much pain from these low-cost competitors. This story has already played out in other professional services industries; there are plenty of CPA firms with lots of great clients willing to pay their relatively high fees, even though H&R Block is cheaper.

Vanguard has a bit of a business advantage, they not only get fee revenue on the advice, but their advisers only recommend Vanguard products. Even if they break even or lose a bit on the advice, they are keeping assets in their funds. This is an advantage to Vanguard, but it poses a problem for their clients. Is it possible to receive objective advice from an adviser who is only able to recommend one product provider? Leaving asset class funds from companies like Dimensional Fund Advisors out of the conversation could be detrimental even after advice fees at index fund levels.