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