One of the perennial questions amongst providers of financial advice and research is why investors are so reluctant to pay for it. Here is an example from Vance Barse:
Of course, the fact that investors are reluctant to pay for independent advice and/or research makes it difficult for companies to generate revenues to cover the costs of their advisers and analysts. In my view there are several mistakes that the financial services industry has made in the past, that now come back to haunt it.
Giving free advice was a big mistake
Probably the biggest mistake the financial industry ever made was to give advice for free in the first place. It was much easier taking a share of the fees from selling product or executing trades than to ask clients to pay for advice straight away. This had several adverse effects. First, it provided the wrong incentives to asset managers, brokers and wealth mangers. Instead of providing advice that was in the best interest of the client, they were more concerned about selling expensive products (most of which never performed, mostly because of their high fees). It was only a matter of time until that business model would fail because of mis-sold products or disruption from low-cost providers. The only thing that surprises me is that it took so long.
Once investors flocked towards low cost products like index funds and ETFs, the industry had two options. Either come up with new products that can charge high fees (e.g. hedge funds, private equity, actively managed ESG funds, etc.) or start charging for advice and research separately.
The problem with charging for research and advice separately, though, is that investors are anchored on a price for that already. For decades, they have received that for free and so their anchor is a price of zero. No matter how low the price for advice you try to charge, it will always feel like a fee increase to the investor.
Nowhere is this more visible than with the introduction of MiFID II in Europe. With it, sell side research had to be unbundled from commission fees and charged separately to customers. A survey by the CFA Institute in 2019 asked buy side and sell side respondents whether they think the cost of research has increased or decreased. A plurality of respondents said it had increased. Meanwhile, the same survey showed that research budgets of buy side firms had shrunk by 8.1% in the European Union and 6.8% in the UK after the introduction of MiFID II. Investors think research has become more expensive, yet spend less on it than before.
Perceived change in cost of research after the introduction of MiFID II
Source: CFA Institute (2019).
The result is that sell-side firms have to cut costs and reduce coverage. There is a consensus amongst the buy side and the sell side that the introduction of MiFID II has led to reduced coverage, a potentially negative side effect, because there is also evidence that with the reduced coverage comes lower liquidity, particularly for small- and mid-cap stocks. Of course, now it is too late to rectify the situation. The financial industry pays the price for anchoring their clients on free advice in the past.
Perceived change in coverage of research after the introduction of MiFID II
Source: CFA Institute (2019).
Financial advice is not easy to judge
Another challenge for the financial industry is that financial advice and research are both hard to judge. The services of a doctor can be judged by the outcome. If the patient dies, it wasn’t great (but then again, the patient can’t complain about it anymore either). If the patient recovers, it was good advice (and in most cases, the patient is willing to pay for it). Similarly, if an architect provides plans for your house, it becomes evident relatively quickly if the plans are worth their money or not. If the house falls down, they weren’t.
The problem with financial advice is that it is hard to judge. First, it typically takes years before the desired goal or outcome is achieved. Most of my investments are for my retirement, which is still more than 20 years away. I can judge the result only then. Also, what is a good or bad outcome is far more subjective in finance than it is with your health or with architecture. Clearly, you can argue if a house is an eyesore or a work of art, but its functionality is evident. Similarly, an operation might lead to some side effects or require you to take medication for the rest of your life (e.g. to keep blood pressure low), but it is evident if the operation improved your overall health or not.
With financial advice it is not that clear. Because there is a trade-off between risk and return, what may be good for you in the long run can fell very bad in the short run. My retirement savings are predominantly invested in equities because I have such a long time horizon. Yet, in every bear market the losses hurt, and badly so. To stay with the analogy of medicine, financial advice dispenses medicine that makes you vomit once a month for the next twenty years for the promise that you will have a better quality of life at old age. I am not sure if I would take such a medicine if my doctor prescribed it.
Unfortunately, this is not an obstacle that we can overcome, so financial advisers are not like doctors in that respect. Instead, they are more like dietitians. They force you to give up on all the nice things in life for the promise of being healthier once you get older. How many people are willing to hire a dietitian? And how much money are dietitians paid compared to doctors? Food for thought for financial advisers and financial services companies (pun intended).
There are no laws in financial markets
Finally, financial markets are not subject to immutable laws. The laws of physics dictate if a house will be stable and fit for purpose and architects can rely on these laws to remain the same over time and everywhere in the world. Similarly, despite the vast differences from person to person, the laws of chemistry and biological processes dictate how our body works. As a result, much of medicine can be applied knowing that if it worked in clinical trials, it will work with the general audience as well.
These immutable laws also mean that architects and doctors can learn from past mistakes. Because the laws don’t change, you can look at past mistakes, correct them and avoid them in the future. Over time, both medicine and architecture will get better.
Financial markets don’t work that way. There is no immutable law that states that value has to outperform growth and that a variable has to revert to the mean over a given period. Value can underperform growth for a very long time and undervalued stocks can stay undervalued for many years and potentially decades. The result is that financial advice that is sound can still fail in practice because markets don’t always behave like they have done in the past. Sometimes, this time is different and that’s when even the best financial advice will go wrong.
Of course, once an investor has taken advice and it went all haywire, she is less likely to accept advice from the same person again, let alone pay for it. Hence, the sad state of affairs is that even the best advisers will lose clients during their career and have a hard time charging for their advice like doctors or architects do.
How to overcome these obstacles?
To be honest, I have no idea how to overcome these obstacles and successfully charge for advice. If I did, I would become the next Jack Bogle. My best guess is that it comes down to earning clients’ trust. I have written about how to build trust here and shown that being honest and transparent with your clients earns you the trust of your clients. Building a trusting relationship with your clients is a necessary condition for advisers but by no means sufficient. As I once was told by a wise man, if you are honest and transparent with your clients that can buy you one to three extra years, but if you are still wrong after that period, clients will abandon you. I am still working on figuring out how to make trust last longer in the face of adversity. If you have any ideas, please let me know.