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Firing Up the Low-Cost Model

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Forecasting the future is quite hard, but predicting this is very easy: Low-cost portfolios will continue to gain ground, propelling advisors toward less expensive mutual funds, ETFs  and other pooled vehicles. 

There are several important factors behind this shift, but the one with the greatest potential significance is the proposed Department of Labor rule that would make anyone who advises on retirement plans an investment fiduciary, legally obliged to act in clients’ best interests.

By default, this would mean that advisors could feel compelled to recommend prudently managed, low-cost portfolios, triggering the demise of broker-sold funds with loads, revenue sharing, 12b-1 fees and other middlemen expenses.

According to a recent survey by the Financial Planning Association, low-cost ETF funds are already recommended by 81% of the advisors surveyed — the first time since 2006 that ETFs were favored by planners over mutual funds. 

Yet even if the rule doesn’t come to pass, low-cost portfolios featuring passive management and index funds may still emerge as the standard offering for retirement plans. 

“There’s more scrutiny on fees across the industry,” notes Tricia Rothschild, Morningstar’s head of global advisor solutions. “That’s been increasing in velocity.”


Translated into fund flows, this means investor dollars have been gushing into the passive fund universe, which has seen nothing but growth over the past decade. 

Nearly $8 trillion is now benchmarked to the S&P 500, according to S&P Dow Jones Indices, with ETF assets growing 24% year over year through 2014. As of May 29, there were more than 600 ETFs based on indexes, with more being introduced every month. Index funds now represent more than one-third of the assets in equity funds, according to Morningstar. 

Of course, shifts from traditional hands-on 1% per-annum managed portfolios to lower-cost, passive index- and ETF portfolios are nothing new. Rick Ferri, a CFA and founder of Portfolio Solutions, moved his clients into index fund portfolios some 15 years ago. Many independent fiduciary advisors have done the same, using funds from Vanguard, Schwab, DFA and the ETF giants BlackRock, State Street and Wisdom Tree. 

“Advisors are getting paid for advice,” Ferri says. “It shouldn’t matter if it’s passive or active. They should do what’s in the best interest of their clients.”

Robo advisors, which for the most part substitute automated online portfolio management for human guidance, are putting additional heat on the standard 1% AUM model, while hybrid offerings from such major players as Vanguard and Schwab are also fueling the move to lower costs. The new ultralow-cost AUM fees now range from zero (Schwab) to 0.25% (Wealthfront).

Millennials, with their predilections for all things digital, are adding additional fuel to the low-cost model fire. Members of Gen Y, while showing little interest in dealing with traditional broker-dealers and AUM firms, are eager to access their automated portfolios from their mobile devices and make use of new online services, such as FeeX, that help investors cut portfolio costs.

Vanguard, the index fund pioneer, which  now manages more than $3 trillion, has thrown another log on the low-cost blaze. In May, the fund manager announced changes for its Personal Advisor services that will drop its asset management fee to 0.3% from 0.7% annually. The account minimum for this most discounted rate was lowered from $500,000 to $100,000. 

Vanguard’s AUM fee is on top of the firm’s individual fund management expenses, but these are among the lowest in the industry. As of August, its Personal Advisor services held more than $17 billion in assets — far eclipsing the holdings of the robo advisors.

But will the Vanguard cum robo cum passive index low-cost movement permanently lower the bar for advisors still clinging to the 1% AUM model? 

As advisor and Financial Planning columnist Michael Kitces predicted in his advisor blog “Nerd’s Eye View” more than a year ago, the confluence of technology and big fund complexes offering cheaper services will directly challenge advisors who haven’t used technology to become more efficient, cut costs and deliver more value-added services. 

Who will be hurt the most? According to Kitces, “those who do not have deep enough expertise to really be able to deliver much more value than Vanguard can for a simple 0.3% AUM fee.”

The most vulnerable firms, adds Elliott Weissbluth, CEO of HighTower Advisors, which has more than 400 employees across the U.S, will be “wirehouses and modest-size RIAs. They won’t be able to compete; they will be too distracted.” This group, in Ferri’s view includes traditional giant mutual fund managers like American, Fidelity and PIMCO.  

Echoing Kitces, Weissbluth maintains that those advisors who will remain competitive have already implemented technology and improved efficiencies, freeing them to concentrate on “serving clients and growing their business.” 

Morningstar’s Rothschild concurs, arguing that advisors will thrive only if they offer higher levels of service than the lowest-cost firms. “Advisors are critical to financial life management,” she says. “They need to understand client goals and get away from quarterly results. They need to provide better outcomes in more cost-effective ways.”


Services that can differentiate advisors from their robo advisor competitors, Rothschild notes, include tax optimization, calculating the value of human capital and treating an entire household as an account.

Ultimately, cost may prove less important than specialized services and hand-holding as financial decisions become more complex. Tax and estate planning, for example, require more expertise than what the mutual fund houses and robos can offer. And this may create sufficient headroom for traditional advisors to maintain their businesses without slashing their AUM fees. 

Michael Dubis, a CFP based in Madison, Wis., observes:, “I just simply help clients build portfolios that make sense over time rather than letting market forces force me to change. Keeping costs down is a cornerstone to that.”

“I don’t think advisors have to lower their fees though,” Dubis adds. “If they provide good service, they should charge for that.

“Investing,” he continues, “despite what many people want it to be, is not a commoditized business; there are many commoditized products to use, and there are many firms that are simply way too big to do anything other than commoditize their offerings.” 

True investment management, Dubis says, coupled with good financial planning to craft solutions that are customized for each client “will never be commoditized.”

At the same time, it’s clear that index funds and advances in technology will not be curbed. Progress will come in one form or another — and it’s unlikely to favor higher portfolio fees.                                                              

John F. Wasik is the author of Keynes’s Way to Wealth and 13 other books. He is also a contributor to The New York Times and Morningstar.com. 

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