There is long standing dilemma among the Investment Advisers fraternity as to which fee model should an investment Adviser adopt. It is quite obvious that advisers having different business models require different type of fee model. So ‘One Size Fits All’ approach cannot be adopted for all advisory business practice. Advisers are having inherent conflict between lowering the costs for clients and manage profitable business. When there are severe market downturns like the one we are witnessing today, they not only take a bite out of client portfolios, but also put significant pressure on an adviser’s business and ability to service clients. Hence, advisers need to rationally decide the fee structure which not only put client’s interest first but also ensures viability of business.
In this article, we have tried to resolve the dilemma of fee model for advisory practice by discussing about attributes of various fee models prevailing in industry.
Current fee structure
So far, SEBI has not specified any limit on the fees to be charged to the client. It has left the decision to the Investment Adviser. SEBI just wants the Advisor to ensure that the fee is fair and reasonable. This is indicated in the Code of Conduct for Investment Adviser. However, for better understanding, we have pointed out current fee structures prevailing in the industry and its pros and cons.
1. AUM based fee
This Is the most prevailing fee model in advisory practice. most advisers charge based on a percentage of assets under management (AUM). Although specific rates and breakpoints differ by firm, fees are typically drawn based on client portfolio managed by adviser. The advantages of this methodology are numerous:
- It’s easy to calculate.
- Revenue increases as portfolio values increase
- Clients don’t “feel the pain” in their normal cash flow.
- Fees seem fair as they are based solely on the amount managed and vary according to how well the portfolio performs.
Despite the simplicity and long-term revenue growth, there are disadvantages to AUM-based model:
- There is no differentiation between high-work and low-work clients: Those with similarly sized portfolios will pay similar fees.
- Fee emphasis is on AUM with no value recognition for financial planning, coaching, and other services.
- Reduction in revenues during down markets can have a serious impact on the financial stability of the firm.
2. Fixed fee
In this model, advisers charge fix amount of the fee from the client for providing investment advisory services irrespective of AUM.
Benefits of this model are:
- Simple calculation
- Seamless cash flow irrespective of market volatility
- Ideal model for non-asset based advisory services like tax advice, financial advice, Will drafting etc.
Though this model is very simple in terms of calculation and collection of fees, it has certain drawbacks too which are:
- No benefit from increasing AUM size
- Increase in internal cost can lead to tight finances for advisers
- No automatic increase in revenue, it requires negotiation with client to rise in fee
3. Fee based on profit sharing or performance based fee
In India, handful of advisers provide advisory services for fees based on profit sharing (performance based fee) i.e. they collect certain percentage of fees on the profit generated by client from the advice provided by investment adviser. There are few advisers who provide stock tips or trading tips, adopt this fee model to collect revenue.
Although this fee model creates win-win situation for both advisers and clients, the regulator, SEBI is certainly not in favor of this model. In the 4th consultation paper issued by SEBI in January, it has proposed only two fee model which can be adopted by Investment advisers viz. AUM based fee and fix fee model.
Investment advisers are bound to provide services which are in the best interest of the client after conducting risk profile and ensure suitability of the advice to achieve their financial goals. They cannot provide performance based fee as they may advice risky financial products to earn higher profit. Investment Advisors has fiduciary duty towards clients, hence fee of an adviser cannot be conditional on meeting of threshold or performance.
Which fee model should you adopt?
SEBI in its 4th consultation paper has made it clear that advisers can adopt either AUM based fee model or fix fee model. In fix fee model you can charge maximum INR 75000 p.a. per client family (this has been revised to 1,25,000 in SEBI committee meeting) while in AUM based fee model you can charge upto 2.5% p.a of average AUM per client family. Although final guidelines are yet awaited, but we know their intent.
As I discussed outset that advisers having different business models require different type of fee structure. However, we have list out the few common parameters which one should consider While determining the fee structure for advisory services:
- Decide your minimum fee level which should be enough to recover your operational as well as administration expenses
- calculate minimum AUM (equity, debt combined) level require to cover your minimum fee level
- decide the level of the hard work, efforts and time require to provide service to client
- understand the nature of the service i.e. whether one-time advisory service or require timely follow up and management of assets
- identify the cost of other services you provide which does not cover in part of AUM.
Considering the attributes of different fee models as discussed above, you should make thorough analysis of your business practice, your operating and other expenses, nature of services you provide to your clients etc. before arriving at decision as to which fee model should you adopt.
In nutshell, for basic investment advice, tax advice or any other financial advice which are one time in nature you may consider to adopt fix fee model while for comprehensive financial planning, goal oriented advice or other investment advisory service which require timely review or managing the assets, you may adopt AUM based fee structure.
If you need any consultancy on IA business compliance or audit under the regulation, you can get in touch with me at [email protected] or 9714345677.
Disclaimer: views presented in the above article is my personal view and solely for information purposes. You should not rely on the information contained herein. In no event I shall be liable for any direct or indirect loss or damage resulting from the information contained in this article.
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