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When it comes to investing, there are lots of ways to go about it. You can buy stocks and mutual funds yourself or you can enlist the services of a professional investment manager.
When it comes to paying for advice and management, you can pay by the hour, pay commissions whenever you buy or sell specific securities, or pay an annual fee based on the amount in your account.
It’s the latter — paying a fee based on the value of an overall account — that’s the source of today’s question.
I have a question that has been eating at me for months. I have a managed investment account. The performance has been outstanding from the beginning. No complaints there.
My question: Every time I send additional funds to the account I am charged part of a management fee. I understand that. However, at times those funds have sat in the bank deposit program for months, even quarters, without being put to work. The interest paid on the cash sitting there is next to nothing. I’ve questioned my adviser about this and it was explained that it sits in reserve for when the time comes to put it to work and, per the portfolio model I am in, she likes to have somewhere about 10 percent in reserve.
This makes no sense to me that it is earning next to nothing and yet I am paying a management fee on it as it is part of my entire portfolio. I don’t understand why it wouldn’t also be in her best interest to put that money to work sooner rather than later, unless that is actually a requirement of the firm because THEY are making money off of that cash. Is this normal for managed accounts? Any suggestions?
Thank you in advance for taking the time to answer this situation/question. — Kathleen
Understanding “wrap” accounts
When I started as a financial adviser for E.F. Hutton back in 1981, there was only one way stockbrokers were compensated: commissions. Whenever securities were bought or sold, the broker (now more often called “financial adviser”) got a piece of the action.
The problem with this system? Your interests are typically best served by buying quality investments and holding them for long periods of time, but those of your adviser are served by frequent transactions. In fact, if you don’t trade, the commissioned broker doesn’t eat.
About 20 years ago, brokerage firms finally started addressing this elephant in the room by offering a different option. Often called “wrap” accounts, these accounts don’t charge commissions on transactions. Instead, like mutual funds, they charge an annual fee — typically 1 to 3 percent — based on the value of the account.
Wrap accounts theoretically solve several problems. First and foremost, they remove the incentive for the adviser to excessively trade or “churn” an account to generate commissions. Next, they allow advisers to create a more consistent and predictable income for themselves. Third, they limit management expenses to the client. Finally, since the adviser only makes more money as an account goes up in value, they put the client and adviser on the same side of the table.
The problems with wrap accounts
While wrap accounts have benefits, they also have drawbacks.
First, the fees can be high. Two percent is a lot to pay for management, especially considering that very few investment managers can consistently beat unmanaged, and comparatively inexpensive, index mutual funds.
In addition, like real estate agents, investment managers benefit when rising tides lift all ships. In other words, when the stock (or real estate) market rises 30 percent and your stocks (or house) increase in value by a like amount, the adviser (or real estate agent) gets 30 percent more, even though they did nothing to earn that extra money.
Then there’s the problem brought up by Kathleen above. Namely, when you’re being charged an annual fee on your entire account, paying that fee on the cash portion that’s earning nothing doesn’t seem fair.
How would you like it if you gave me $100,000 to manage, I charged you $2,000 per year to do it, then dropped it in a 0 percent interest savings account? I’d be making money, but you’d be going backward.
That’s Kathleen’s perspective. Her adviser, on the other hand, probably looks at it this way: You trusted me with $100,000 to manage and agreed to pay me 2 percent per year to do it. In my expert opinion, we should leave some of your money in savings to both reduce your risk and keep some powder dry. Now I’m supposed to reduce your annual fee for being responsible?
Who’s right? They both are. Kathleen is capable of putting money in the bank herself and doesn’t need to pay someone to do it for her. And her adviser is getting paid to manage her account holistically and prudently, which often dictates holding some of her investment dollars in cash.
Kathleen asks: “Is this normal for managed accounts? Any suggestions?”
The answer to the first question is yes, and the answer to the second is communication.
While it is typical for an investment manager to keep some assets in cash, Kathleen should voice her concerns to her adviser. I can pretty much guarantee that the adviser has heard similar concerns many times in the past and will probably respond with something similar to what I said above.
Kathleen can then offer an alternative. She can agree that keeping cash in reserve is a good idea, and offer to keep cash outside of the managed account in whatever quantity the adviser suggests, leaving the adviser free to fully invest all funds in the account.
The investment manager may or may not agree to this arrangement. If they do, problem solved. If they don’t, then Kathleen has an additional choice: Bite the bullet or find a new adviser. Here’s a video I made a few years back that explains how to go about it.
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