I confess to being appalled by January’s “Soapbox” recommending performance-based compensation for investment advisors. The author, Dave Pike, could not have gotten it more wrong. But before he retorts that I am an old-fashioned, comfortably settled into my annuity fee stream and, most importantly, afraid-of-the-competition advisor, let me explain.
Mr. Pike, not incorrectly, suggests that performance-based fees incentivize advisors to seek out the highest performing investments as part of a natural profit-maximizing drive (theirs). Pike presupposes that the goal of an investment advisor is to “maximize the portfolio performance” of a client. I don’t know what planet Mr. Pike works on but it is not the one on which I am employed. My own principal goal for clients is to seek, and hopefully secure, their long-term financial well-being. “Maximizing performance” is frequently not an appropriate strategy as this creates far more risk of loss than would be warranted.
Performance pay is the standard arrangement for hedge fund managers and there is considerable research on the practice. From the research, it is clear that performance pay creates important misalignments in the incentives between managers and investors. In order to profit-maximize, hedge fund managers (not to mention corporate CEOs) have an inherent incentive to take more risk and employ more leverage than they otherwise would. Gains are shared by both manager and investors. Losses, which are typically more irregular (or the manager would not stay in business), are disproportionately “shared” by the investors. It is a game of “Heads, we win. Tails, you lose.”
To paraphrase Nassim Taleb, gains occur on an annual basis but risk occurs only over a full cycle. Managers with performance-incentives are generally overpaid for the good years, when excess risk-taking is rewarded in the short-term. But when the cycle turns and the price of that risk-taking comes home to roost, they are not only not penalized but often are not even around, leaving the investor to assume the full cost.
Fees based on assets or a simple retainer may not perfectly align the incentives of manager and client but these arrangements are clearly superior in this regard to a performance-based fee.
Martin Weil, CFP
President, MW Investment Strategy Grp.
STILL KNOCKING FOR OPPORTUNITY
The assertion that the “industry still is not laden with opportunities” is correct (“Barring The Door,” February 2008). In my readings, there are far too many articles discussing the lack of qualified advisors, which just doesn’t agree with the anecdotal evidence.
Maybe the people bemoaning the lack of “advisors” are really searching for rainmakers, as opposed to advisors. Being a recent CFP myself, I unfortunately know too many under-employed CFP professionals, all of which are ready and able to serve in the profession.
Thanks for speaking out (and keep up the interesting writings).
Chuck Johnson, CFP
Resolute Financial, LLC
SETTING THE NUMBERS STRAIGHT
In the Mutual Fund Spotlight article on Icon International Equity Fund, the “Growth of $10,000″ chart (March 2008, p. 68) reflected incorrect data. According to Icon Advisors, the chart should read: Growth of $10,000 invested December 31, 2004 – December 31, 2007: Final Value $19,332.21; Cumulative Total Return 112.46%; Av Annual Return 21.31%. To see a corrected chart online, please go to: http://www.investmentadvisor.com/article.php?article=8557