Q23 – What is the difference between Transaction Based Pricing & Asset Based Pricing?

Also available as podcast (Episode #23)

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What is the difference between Transaction Based Pricing & Asset Based Pricing?

There has been a movement as of late by custodians to reduce/eliminate certain transaction costs on trades performed within a client’s account.  This “move to zero” generally does not apply to ALL trade types that might occur.  For the remaining trades that do still incur a cost, “Transaction Based Pricing” & “Asset Based Pricing” are the two main ways a custodian will asses these charges.  There are pros and cons to each of these approaches that should be considered, as well as options available to the Registered Investment Advisor (“RIA”) on how they are implemented.

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Full Transcript:

What is the difference between transaction-based pricing and asset-based pricing? This is the Transition To RIA video series. It is question #23.

Welcome, everyone. I am Brad Wales with Transition To RIA where I help you understand everything there is to know about why and how to transition to the RIA model.

In today’s question, we’re going to be talking about the two main kinds of pricing mechanisms used by custodians for transactions….transaction-based pricing and asset-based pricing. On a previous video I talked about who actually pays these fees. Is it the client? Or as the RIA, there are some options. If you haven’t already seen that video, after you go through this one, I encourage you to take a look at that one as well, about who actually pays for these fees?

We’re going to talk about the difference in this video between this concept of transaction-based pricing and asset-based pricing. The key to remember with this, this is one of the ways that a custodian generates revenue. As an RIA, you will receive 100% of your advisory fee. And so, it does beg the question….“if I’m the RIA and I’m receiving 100% of the advisory fee, how is the custodian making money or generating revenue?”

One of the ways they generate revenue is these transaction or asset-based fees. I’ll do a whole separate video on how a custodian generates revenue because I think it’s important to understand it is a partnership. The RIA needs to have a way to make revenue and so does the custodian. I think it helps to understand both sides of that coin.

To be clear, on these transaction charges or asset-based charges, as the RIA, you receive none of that. You keep 100% of your advisory fee and 100% of the transaction charge or asset-based pricing is retained by the custodian. That is for your own good as well.

For reasons I’ll explain, this all is at arm’s length and it makes it possible for you to truly tell the client….”Client, the only thing I receive for my services that I provide to you is what you pay me (perhaps 1% of the account balance) which I provide services for you on. Beyond that, I don’t have any incentives or conflicts to use certain products or to trade more or less or anything like that because the only way I’m paid is based on this 1% advisory fee,” or whatever it is you charge your clients. It makes it very clean. So just to be clear, you as the RIA would not receive any portion of the transaction-based pricing or the asset-based pricing.

Let’s go through both of those here one at a time. We’ll start with transaction-based pricing. What that is referring to is – and this has changed, I did a whole video on this of how much this has changed, that a year or so ago, the pricing used to be much more prevalent in the conversation than it is now. It is, as I’ll explain, still relevant today.

Real quick, roughly a year ago, every time you did an equity trade in a client’s account or an ETF trade or a mutual fund trade in most cases, or an option trade, there was a transaction charge if you’re using this transaction-based pricing model. Every time you did a buy or a sell, there was a transaction charge.

Fast forward – I’m not going to rehash it all, as I did a separate video on it – but the custodial world has moved now to where largely most custodians no longer charge a transaction charge on equities and ETFs. That has gone to zero. That used to maybe be $6, $7, $8 a trade, and then it was lowered down a little bit and then now, it’s zero.

What a lot of people don’t realize is, when those headlines came out – “trading cost have gone to zero” again, for equities and ETFs, they’ve gone to zero. They still exist in a number of cases. With mutual funds they exist, fixed-income trades they exist, usually in options trades they exist. Transaction charges do still exist depending on what investment vehicle you perhaps are using at that time.

Nowadays, the equity/ETF world is generally now down to zero with most custodians, not all custodians though. On mutual funds, there generally would be a transaction charge unless the mutual fund you are desiring to use is on the custodian’s, as they say, No Transaction Fee list, an NTF list. I’ll do a whole separate video on what those are and what you should expect from them.

If a mutual fund is on that NTF list, you in turn don’t pay that transaction charge. If it’s not on that list, there is indeed a transaction charge for every buy or sell that you do. Usually fixed income has a transaction charge. Option trades, most custodians used to charge a flat amount upfront, and then a per contract charge. A lot of the custodians have moved to where there’s no longer that flat upfront but there’s still a per contract charge, so you could consider that a transaction charge.

The main takeaway is that transaction charges still exist. They exist a lot less than they once did because again, equities and ETFs now in most instances are at zero transaction charge. They still exist in some capacity on mutual funds and then some of these other investment vehicles.

If you were to work in that transaction-based arrangement with your client’s accounts, there will be that transaction charge assessed. I did a whole video on who pays that. Is it the client? Is it the RIA? Do you have options? I encourage you to dig into that as well. But that’s how transaction-based pricing works.

The other one is asset-based pricing, sometimes referred to as ABP. And that idea is, as a custodian, I might come to you as the RIA…. as opposed to any of these transaction charges on some mutual funds and options and then fixed income or whatever – or maybe I’m still a custodian that does charge it on equities and ETFs – as opposed to having a transaction charge that kicks off every time a buy or sell occurs, we’ll instead set a basis point.

It could be three, four, five basis points, something like that, where we will assess this asset-based pricing charge against the value of the account. In return, it’ll essentially across the board no transaction charges. There will be no issues with some mutual funds. There will be no per contract on the option trades. Instead, it will be X basis points across the board in the account.

That’s perhaps simpler to understand. It’s essentially a wrap program you’re creating with that because again, it’s all included. A lot of advisors themselves might structure it as part of their fee. The client is perhaps, at your current firm, used to not seeing any transaction charges. This is a way to essentially replicate that.

There are pros and cons to all of these. That’s one of the things I help advisors think through is just because you’re doing something one way currently doesn’t necessarily mean it will be the best way to do it in the RIA model. I have that conversation all the time with advisors to help them think these things through.

Of these two approaches, it’s certainly fair to say transaction-based pricing is much more used than asset-based pricing currently. I think that trend might at some point change. But you generally see – especially now that equities and ETFs have now gone down to zero, that’s reduced the frequency and cost of transaction-based pricing in total. That’s why it’s even…if it wasn’t already running ahead of asset-based pricing, it’s certainly more prevalent even now.

I did do a separate video on who pays that. But really quickly, usually by default whether it’s transaction-based pricing or asset-based pricing, by default, it is charged to the client. An RIA generally has the ability to elect, to absorb those instead if they would choose to. There’s a lot of nuances with that that you need to think through. So again, I encourage you to look at that video. But the quick note….by default, the client would be charged either one of those, whichever way you set up the account. And the RIA has the chance to maybe absorb it instead.

So the question is which of these two is better….transaction-based pricing or asset-based pricing? There’s never a perfect answer because every RIA is different. Every style of how you manage assets can be different. I don’t want to give some impression that….this is the way you should go versus another.

A couple of things I did want to throw out there that you’d want to consider. The first one is maybe your clients are currently in a traditional wrap arrangement where they don’t see any transaction charges. Maybe you feel they’re going to be very sensitive to any transaction charge – even if it’s a lot less than it once was – being introduced into the equation. Maybe in that case, you look at that asset-based pricing and you build it into your fee structure.

Now, I would tell you, this movement to zero for equities and ETFs is only, call it, a year old. For all in existence before that, the custodian model generally charged those transaction charges. Countless advisors made that move from a more captive, say, a wirehouse type environment, or maybe they had that kind of wrap fee arrangement with their clients, into the RIA model where they did have to explain to the client….here’s how it works, here’s how the custodian generates revenue, here’s the fee I receive. In those cases, those clients were paying those transaction charges on everything.

It shows you, it is possible to position it correctly with clients and help them understand why those fees exist. That’s an even easier conversation now because a large portion of it is now priced at zero for the transaction charge. But just know many advisors have – if you haven’t made the move yet – came before you and did it when there was full transaction charges and obviously were able to work that through with their clients.

The second takeaway, with so many trades now at this zero transaction-based pricing, maybe you don’t even need to create a wrap account. Maybe you don’t use mutual funds and you only rarely do option contracts. Maybe all you do is equities and ETFs and then that essentially solves your problem. You essentially do transaction-based pricing even though there is no transaction charges. Because again, in most of those cases, it depends on your custodian, but in most of those cases, those trades would be going off at zero.

Then the last thing is let’s say as opposed to using almost solely equities and ETFs, you use mutual funds. To the degree you can use mutual funds that are on the custodian’s No Transaction Fee list, NTF list – and again, I’ve done some videos on this – those are usually fairly expansive lists of mutual funds. It’s the bulk of mutual funds generally that the custodian makes available on those lists. It’s certainly not all, but it’s not like only 10%. The majority are on those lists.

If you are someone that makes models that you use with your clients and they’re comprised of mutual funds, if you make those models solely of mutual funds that are on the NTF list, those will all go off at zero per buy and per sell. And at that point, you are arguably better off going with transaction-based pricing because you won’t have any transactions to have it charged against because they’re all going off at this NTF list.

The main point is there is no clear winner. There’s pros and cons. Again, something I help advisors with. I’d be more than happy to think it through with you. To really look at what’s your current situation, what’s the current arrangement with the client, and then look at what are custodians currently offering? How might that look if I were to make a change? What adjustments would I need or want to make as part of that? It’s not a black-and-white answer because every advisor situation could be unique.

Something else to keep in mind, this all needs to be disclosed properly to the client. In the RIA world, disclosure is the name of the game, whether it’s conflicts of interest or anything like that. And so, there are some disclosures, that’s part of the explanation to the client….”Client, here’s how it works. I have an RIA. Here’s the custodian. Here’s the relationship,” and you just have to walk clients through that. But you also want to make sure it’s properly disclosed and that’s usually in your ADV.

The disclosures in part depend on whether you have the client pay the transaction charges or asset-based pricing, or whether you as an RIA choose to absorb those. There could be some conflicts of interest with that that specifically need to be disclosed. If that’s of interest to you, you can find my video on who pays for these fees, the transaction-based charges or the asset-based pricing. I go into the disclosure requirements, the potential conflicts of interest that I think you want to think through before you assume….”I’ll definitely absorb the fees or I’ll definitely use asset-based price or I’ll definitely use transaction-based pricing.” You want to factor all this in. And of course, you can just call me and we could quickly have that conversation as well if you’d like.

My final thought is the industry has shifted. A year ago, transaction-based pricing or transaction pricing was across the board on every product you did, unless it was on this NTF list concept. Equities, ETFs and mutual funds. Now we’re at a point where equities and ETFs are at zero. We still have pricing on these other transactions. The question is what does the future bring? I won’t claim that I know the future. I think there’s a lot of people, you go back two, three years ago didn’t necessarily assume we’d be in this situation with zero on some of these things.

It’s hard to tell what the future will bring. I would note though that a custodian does need to generate revenue and there are different ways (they do that) – this is not the only way a custodian generates revenue. Again, I’ll do a whole separate video on how a custodian generates revenue.

The challenge is, when these revenue sources are declining or go away entirely, with transaction charges on equities and ETFs, that makes it harder for the custodian to be able to provide services for you as an RIA, to invest in their platform, to make it a better platform for you to use.

It will be interesting to see where the future goes. There could come a time where asset-based pricing becomes more the norm. “We (the custodian) need to charge this asset-based pricing to cover our costs of actually doing these trades and sending out confirms and all those sorts of things.”

The world is always changing. The good news is as an RIA, it’s a very competitive marketplace out there so you have a lot of choices with different custodians and different value propositions. I’m more than happy to help you think through why one might be better for you than another. The world changes, the world will continue to change. It’s the same thing with your business that you are dealing with. We’ll see how things work out and what those changes are to come.

With that, like I said, I’m Brad Wales with Transition To RIA where I help advisors just like you understand everything there is to know about why and how to transition to the RIA model.

Talking about the topic today….”How does transaction pricing work? I’ve heard about this asset-based pricing. What are the differences? What are the pros and cons? Why might I consider one versus the other?” That is exactly what I help advisors think through.

I want to make sure you are informed ahead of time before you start getting faced with some of these questions and some of these decisions. I want you to know exactly what you should expect to hear when you ask custodians….”How does this work? What would the pricing be?” I want to make sure you’re ready to go and educated ahead of time on how that works. I’m happy to help you with any of those kinds of conversations.

If you’re not already there, head on over on TransitionToRIA.com. You can see plenty more videos I’ve posted, like I’ve mentioned some here. You can find them on the website. I’ve got whitepapers. The simplest thing is right there at the top is a contact link, click on that. You can instantly and easily schedule a specific date and time to have a conversation with me. We can talk about very granular topics like this, if you’d like, or if you want to begin that macro conversation of….”Here’s what my current practice looks like. What might that look like in the RIA model?” Everything from the economics, to the flexibility, to the control, to the responsibilities. I’m happy to have that conversation with you.

I hope you found value in today’s video, and I’ll see you on the next one.

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