10 Things Form ADV2 Reveals and How it Can Save You Millions
[Editor’s Note: This post came out of an email discussion with a local financial advisor, Ryan Kelly, President of RFK Capital Management. He had done some pretty detailed digging into the required disclosures among financial advisors in Utah. Then he compiled the data. Long term readers won’t be too surprised by what it shows, but the average price people are paying for financial help was even higher than I expected. The craziest thing is that the average figure is just that- an average. Half of firms charge (and half of clients pay) more! The author and I have no financial relationship.]
Last November, I read the public disclosure documents for the 53 largest investment advisory firms based in Utah. It took a long time to complete this exercise. My wife called it the ultimate snoozefest, but to me it was fascinating.
In my reading, I focused on the following two sections of each document: section five on fees and compensation, and section eight on investment strategies, methods of analysis, and risk of loss.
Having just launched my own firm, this was particularly useful to help me craft my firm’s business strategy and investment strategy. There are ten things I discovered about the industry that may be helpful for you to know. You must understand this industry to get a fair deal if you seek professional financial and investment advice.
What is Form ADV 2?
First, what is this public disclosure document? It is called the ADV 2. The SEC website says form ADV 2 is the primary disclosure document investment advisers provide to their clients. The document is filed with the SEC and made available to the public on the SEC’s Investment Adviser Public Disclosure (IAPD) page. The document is prepared in a narrative format, written in plain English, and contains a wealth of information about the firm including the types of services offered, the adviser’s fee schedule, investment strategies, and other important information.
How I Chose 53 SEC Registered Investment Advisory Firms to Analyze
My first step was to generate a list of Utah based firms because this is my future business market. To put a limit on the time involved, I decided to only focus on SEC registered firms. Firms with over $100 million in assets under management (AUM) are required to register federally with the SEC, whereas firms with less than $100 million in AUM are required to register with their state securities division.
I went to the IAPD website (adviserinfo.sec.gov) and on the left side of the main page clicked on “Investment Adviser Data” and then clicked on the url link below “SEC Investment Adviser Report.” I then scrolled down to the “data downloads” section and clicked on the file named “Registered Investment Advisers–November 2018.”
Remaining were 53 Utah based firms with AUM above $100 million. I began reading each firm’s ADV 2 and focused on section five (fees and compensation) and section eight (investment strategies, methods of analysis, and risk of loss). I created my own spreadsheet and began inputting the information I found for each firm.
10 Things I Discovered About the (Utah) Investment Advisory Industry
#1 – Average Total Fee is about 2.3% per year
I wanted to estimate the average total annual fee for investment management services. For each firm, I looked at the three fee layers: advisory fee, underlying mutual fund or sub-advisor fees, and trading commissions.
The first fee layer was easy to calculate because firms clearly disclose it. Since the advisory fee rate typically drops slightly as assets increase, I had to settle on a specific amount to compare apples to apples. For a $500,000 investment, my data suggests the average annual advisory fee charged by Utah based advisors is 1.4%.
The second fee layer, the mutual fund or sub-advisor fee, was more difficult to calculate. Most firms provide guidance in the ADV 2 on the types of mutual funds they use to build client portfolios, and so I felt I could make an educated guess on this second fee layer.
Based on this guidance, my estimate is that the average second fee layer is 0.8%. If you would like to learn more about the approach I took to estimate this, please visit my fee study article on my website: www.rfkcapitalmanagement.com/fee-study
To calculate the third fee layer (trading commissions) I took a simple approach and just assumed a 0.1% fee for each firm. This is probably too high for some firms and too low for others based on the degree of turnover for the firm’s underlying investments. Every firm indicates that clients cover the cost of trading commissions and all other brokerage fees.
Thus, my estimate is that the average total annual fee is 2.3%.
#2 – Americans Need a Fee Transparency Law
This 2.3% annual fee amount was higher than I thought it would be. It proved to me that Americans are “investment fee illiterate” and need a fee transparency law. We have fee disclosure, but not fee transparency.
Webster’s dictionary defines transparent as “readily understood” or “free from pretense or deceit.” Transparency comes when advisors proactively help investors understand the impact of all fees on long term investment returns.
Here’s a chart that shows the impact of high fees over 30 years.
Over 30 years, a 2.3% total annual fee on a $500,000 initial investment results in a total fee accumulation of $613,587 over 30 years. This assumes a 6% gross annual return.
Alternatively, a Vanguard Do-It-Yourself (DIY) investor can invest in three Vanguard funds (total U.S. stock, total international stock, and total U.S. bond) and pay a 0.06% total annual fee. Over 30 years, a 0.06% total annual fee on a $500,000 initial investment results in a total fee accumulation of $23,468 over 30 years. This also assumes a 6% gross annual return.
Fees have a compounding effect. If the 2.3% high-cost portfolio returns 6% gross and 3.7% net annually, then the investment will grow to $1,487,074 over 30 years. If the 0.06% low-cost Vanguard portfolio returns 6% gross and 5.94% net annually, then the investment will grow to $2,823,378. The difference of $1,336,304 in ending account balances is staggering and solely comes from the difference in fees.
A fee transparency law would require investment advisors to project total fees in dollars over an extended period of at least ten years. Advisors can easily make this calculation. For example, if an investor hires an advisor to manage a $500,000 portfolio, and the total annual fee (advisory fee, mutual fund fees, and trading commissions) is 2.3%, then the advisor would be required to produce and share with the client an illustrative table showing that total fees over 10 years will be $136,165 assuming a 6% gross annual return and 3.7% net annual return. Mutual funds must provide this information and advisors should too.
#3 –50% of Utah Based Investment Advisors use High-Cost Mutual Funds or High-Cost Sub Advisor Firms
My research suggests that 30% of Utah based investment advisors use high-cost mutual funds that pay a commission (known as a 12b-1 fee) to the advisor. These are among the highest cost mutual funds available.
It also seems that about 20% of Utah based investment advisors use high-cost sub-advisors for investment management. This is essentially where the investment advisor hires another firm to do the investing. Typically, the sub-advisor charges a high fee of between 2.0% to 2.5% per year and then gives a cut of that to the advisor.
#4 -Average Total Fee is Similar Amount for National Investment Advisors, Savings Accounts, Variable Annuities, and High-Cost 401Ks
My 2.3% total annual fee estimate is in line with the total annual fee charged by large, national investment advisory firms like Morgan Stanley, Merrill Lynch, Edward Jones, Wells Fargo, and Ameriprise. This is according to a total fee study by Personal Capital.
[Editor’s Note: Is your advisor on that list above? If so, it might be worth taking a very close look at what you’re actually paying and what you’re actually getting and comparing it to my list of recommended advisors.]
A 2.3% fee per year is also the amount currently being levied on low yielding savings accounts. The interest paid on savings accounts at large banks is stuck at about 0.1% despite the fact U.S. treasury bills are yielding 2.4%. Banks can earn an easy 2.3% spread by paying 0.1% on customer savings and then investing those funds in U.S. treasury bills.
The industry average expense ratio for a variable annuity is 2.26% according to Vanguard. Also, there are many small company 401K plans that have total fees of between 2.0% to 2.5%. Across the board, the pound of flesh Wall Street takes in the form of fees is currently pegged at 2.3% per year.
#5 – Many Firms Believe Their Fees are “Reasonable”
Many firms with high fees defend their fee structures. They often state that their fees are reasonable. A common phrase you will find in an ADV2 is “We believe our fees for advisory services are reasonable with respect to the services provided and the fees charged by other investment advisors offering similar services.” I found this type of statement was most common for firms whose total annual fee is above the industry average of 2.3%. The lowest total fee firms don’t seem to make this statement.
#6 – Advisory Fees Are Negotiable (Usually)
Advisory fees in the great majority of cases are negotiable. A very common phrase in ADV2 documents is “fees are negotiable depending on the complexity of the engagement.” This means that if a client’s finances are complex in nature, then the advisor will charge more.
If you like your high fee advisor and want to remain a client, then tell your advisor you want to move towards simplicity and then ask for a lower advisory fee. Your advisor will likely agree to do so. You can likely lower your fee even if you don’t ask for a shift towards simplicity.
Two months ago, I was walking in a local park and overheard two older women talking about investment advisory fees. One commented “I don’t see why my advisor charges me 1% of my assets.” I chimed in and asked “Have you asked for a lower fee?” She had recently seen the PBS Frontline special called The Retirement Gamble and that convinced her that fees in the industry are too high. To make a long story short, this woman kept her trusted advisor (who is very skilled with financial planning) and lowered her advisory fee 33%.
#7 – Fee-Only Investment Advisors Are Not Satisfied With Market Returnsactively managed (no load, no 12b-1 fee) mutual funds, DFA funds, sector ETFs (rather than broad ETFs like the Vanguard 500 ETF) and individual stocks.
I could not find a single firm among the 53 that only uses low-cost, broadly diversified index funds to build client portfolios. Maybe a few do, but they don’t offer any indication of it in their ADV2 or on their firm’s website.
The only reason you buy an actively managed mutual fund is that you think it will do better than its corresponding market index. And yet, only 7% of actively managed funds have outperformed its comparative index over the last 15 years (according to a study by S&P Dow Jones).
John Bogle, the founder of Vanguard, conducted extensive research and found strong evidence that there is a “reversion to the mean” phenomenon with hot performing actively managed mutual funds that’s been happening for many decades. Mutual funds that have historically done well are likely to lag the market going forward. He calls this “Sir Isaac Newton’s revenge on Wall Street.”
DFA stands for Dimensional Fund Advisors. DFA is a wonderful firm with a practitioner mentality, but investors must realize their entire business is based on a belief that they can do a little better than indexing, and they charge a lot for that. DFA funds are three to six times more expensive than low-cost Vanguard index funds. Their founder, David Booth, says on their website that if they can’t do better than indexing then they don’t have a business. Historically, they have in fact done a little better than indexing but there is no guarantee they will continue to do so in the future.
If you are an investor and your advisor uses DFA funds, it is essential that your advisor can articulate clearly the reason why he or she prefers DFA funds over low-cost index funds.
An advisor who uses sector ETFs is also trying to do better than stock and bond market returns. John Bogle did not like sector ETFs and preferred broadly diversified ETFs or TIFs (traditional index funds).
#8 – Many Firms Try to Time the Market
I was surprised to discover how many firms have a market timing strategy. Section eight of the ADV2 involves investment strategies and methods of analysis. There are many firms that indicate in section eight that they move in and out of the stock market.
I had an experience last month that confirmed this finding. My wife’s friend asked me to review her Roth IRA that is managed by a Utah based investment advisor. She is 30 years old and her Roth IRA has a 60 year investment time horizon. Using her iPhone, she pulled up her account statement and I was shocked when we discovered that 100% of her Roth IRA was invested in a high-cost bond ETF. I advised her to ask her advisor why she is 100% invested in a bond ETF when she doesn’t plan to touch the money for at least 30 more years. Her advisor said the firm uses an investment consulting firm to make calls on when to get in and out of the stock market. In October, the firm suggested getting out of the market which is why her Roth IRA moved out of a stock ETF and 100% into the bond ETF. As of January 31, her account was still 100% invested in the bond ETF. The firm got out of the market at a good time in October, but did not get back into the market at the right time and has missed the recent market rally. I assume they will continue to play this game for the next 60 years of her investment lifetime.
Regarding fees, the bond ETF has a 0.5% expense ratio and she is being charged a 1.9% advisory fee for a total annual fee of 2.4%.
I showed this friend several YouTube clips of John Bogle talking about the principles of long-term investing success. We talked about the wisdom of not trying to time the market which is just short-term speculation, and the need to keep costs low. She quickly agreed. I helped her open a Roth IRA at Vanguard and she is now a DIY long-term investor and is invested in three simple index funds (50% in Total U.S. Stock, 30% in Total International Stock, and 20% in Total U.S. Bond).
I have shown her YouTube clips of John Bogle encouraging investors to “stay the course” and advised her to do the same. Her total fees are less than 0.06% per year. The fee savings over the next 60 years will be in the several hundreds of thousands of dollars and she will earn her fair share of global stock and bond market returns.
#9 – Many in the Industry Have Vast Experience with Financial Planningskilled and experienced at giving financial planning advice. Many advisors in Utah have significant financial planning credentials and years of experience. Also, their websites indicate a focus and commitment to the financial planning discipline. They understand that financial planning is an important component of the relationship. This is a bright spot and shows the potential for the industry to add value.
#10 – The “No Man Can Serve Two Masters Problem” Means We Need Flat Fee Investment Advisors and Advice Only Financial Planners
In this industry, it is not the financial planning side that is broken. Rather, it is the investment management side that is broken.
I recently read the book “John Bogle and the Vanguard Experiment” by Robert Slater. It is an out of print book that tells the amazing story of the founding of the Vanguard Group. The short version of the story is that Bogle realized there is a “no man can serve two masters” problem in the mutual fund business. Basically, what is good for the mutual fund investor is usually not what’s good for the management company’s shareholders. High profits for the management company’s shareholders mean low profits for the mutual fund investor, and vice versa.
Bogle found a structural solution to the “no man can serve two masters” problem. In the case of Vanguard, he formed an investor-owned mutual fund company where any profits would go to lowering the expense ratios of the Vanguard mutual funds. There would be no outside shareholders. Vanguard’s unique structure is why the mutual fund industry is continuing a fee war that is driving down the cost of mutual funds, and why Vanguard is bulldozing over “for profit” mutual fund companies and will likely continue to do so.
John Bogle solved the conflict of interest problem from the top at the mutual fund level. We now need investment advisors to solve the conflict of interest problem from the ground level. Just like with Vanguard, there are structural solutions. How can an investment advisor solve the “no man can serve to masters problem” at the investment advisor level? The two structural models that seem to solve the problem (or greatly minimize it) are flat fee investment advisors and “advice only” financial planners like Sarah Catherine Gutierrez at Aptus Financial.
I believe Sarah’s advice only model has tremendous disruptive power to lower costs and increase efficiency in the investment advisory industry. With this model, the advisor provides the client with the tools needed to be his or her own investment manager. This can include:
- Educating the client on timeless investment principles
- Writing a specific financial plan for the client,
- Helping the client open the necessary accounts
- Execute the index fund trades
- Providing behavioral coaching along the way.
I predict that in 20 to 30 years Sarah’s impact on the entire investment advisory industry may even approach John Bogle’s impact. I recognize this is quite the statement to make. The reason I believe it is that her model has the potential to lower excessive fees in our financial system to the tune of hundreds of billions of dollars every year. It also has the potential to make millions of Americans more effective DIY investors who invest based on the timeless investing principles of broad diversification, low costs, tax efficiency, and long term discipline.
My firm is currently beta testing a DIY investing service. During the beta test phase, our clients get a personalized financial plan (written in a narrative format), an investment plan, and assistance in becoming an effective DIY investor for a $800 flat fee.
This model minimizes conflicts of interest. Conflicts of interest in this industry can never be eliminated, but they can be minimized. It is a “fee for service” model rather than a “money on money” model. It empowers the advisor to become a true fiduciary and offer unbiased, unconflicted advice. It saves the client/investor an enormous amount of money over an investment lifetime because fees are only paid when financial planning and investment advice is given.
It does not mean the advisor makes very little money. Low-cost index funds and advisors can co-exist. The advisor can still make good, reasonable compensation. However, it demands that the advisor manage his or her firm more efficiently and become a true practitioner with both financial planning and investment advice to build his or her value proposition.
Lowering the total fees draining from our financial system will result in better retirement outcomes and a more efficient financial system. The spread between gross return and net return for investors will narrow. It’s high time for all American investors to get their fair share of future stock and bond market returns. Firms that focus on “structure” and minimizing the “no man can serve two masters problem” will lead the way in this revolution.
What do you think? Have you ever read an ADV2 form? What do you think about the future of the investment advising industry? Comment below!