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Misconceptions Over Investment Terms Can Plague Advisors Large and Small

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The environment for financial advisors is as challenging as I’ve ever seen it—including the limited partnership implosion of 1986. Even though advisory firm revenues have been rising in tandem with the stock market (which, of course, can’t continue to go up and may have recently peaked), there are myriad social trends that aren’t so promising.

Since 2008, the public trust of financial companies has been at an all-time low; academics such as Yale University’s Ian Ayres are claiming that management fees higher than an ETF’s are excessive; advisory fees are feeling downside pressure from robo-advisors; regulators and “professional” organizations seem to be cracking down on independent advisors in an effort to appear to be “doing something” and possibly diverting attention away from Wall Street. Even sorting out all these issues is a challenge, since the media seems to be way more focused on hype than facts. 

I recently came across a case that involves a number of these issues and offers a few lessons for independent advisors. The lessons include the importance of being able to clearly articulate the nature of risk and its relationship to returns, how to assess the success of investment performance and how to determine the “fairness” of compensation.

Readers who live in Southern California will have heard about the recent controversy involving the San Diego County Employees Retirement Association (SDCERA), which manages some $10 billion in retirement assets for more than 38,000 current and former county employees. 

Last June, the SDCERA board of directors hired Houston-based Salient Partners LP to be the asset manager of the pension fund. During the past month, some SDCERA board members have become disenchanted with Salient and its founder, Lee Partridge, claiming their management has taken too much risk for too low performance at too high a cost in management fees. 

Here’s the backstory. Salient had served as a paid consultant to the SDCERA pension fund since 2009. During that time, according to a recent Salient statement, the pension fund generated “a 10.1% annualized net return, which delivered $4.4 billion to SDCERA plan members at a lower cost and with less risk than 80% of similarly sized pension plans. The average SDCERA plan beneficiary realized more than $111,000 in gains under Mr. Partridge’s stewardship for a total fee over five years of $414 [per beneficiary].” The release also pointed out that “Mr. Partridge was awarded Small Public Fund Manager of the Year by Institutional Investor in 2012 for the outstanding results achieved with SDCERA.”

According to an October 2 posting on the local newspaper U-T San Diego Online, the SDCERA board was sufficiently impressed with Salient’s performance that “In April, the board unanimously endorsed [ Partridge’s] complex strategy.” And in June, according to a Sept. 11 article, the board approved full outsourcing of its $9.9 billion portfolio to Salient Partners.

The new contract sets Salient’s annual fee at 11.5 basis points on AUM for the first six months and 10 basis points after that. Salient agreed to employ SDCERA’s three investment staff members as part of the deal, and all have accepted the offer.” 

But things have soured since then with some of SDCERA’s board members who had become uncomfortable with the leverage Salient was using, even though the firm’s tactics here the same as it had been using for the past five years, and which had received that vote of confidence last April.

Yet the same story quoted one of Salient’s leading critics, trustee Samantha Begovich, (who joined the board in July, following its signing of the new contract) during a September 4 meeting: “At a time when pension managers are getting paid less and less across the board, it is well documented that we’re paying exorbitant, outlier-type fees with no incentives except to grow the fund.  Why is the contract fixed without any correlation to performance?” Perhaps I’m missing something here, but doesn’t performance “grow” the fund? 

Fortunately, according to the CIO article, some of the trustees had a better handle on the risks involved: “Other board members stood by their agreement with Salient. One noted that performance-linked compensation had been ‘extensively discussed’ but dismissed because ‘the cons— the behavior it might induce—outweighed the pros.’”

U-T San Diego Online wrote: “Partridge has argued that his strategy has performed almost exactly as planned, and exceeded the county’s goal of 7.75% average annual return. Because the portfolio is diversified through derivatives into bonds, real estate, commodities and other assets, its relatively small portion in stocks will cause the overall fund to lag during the kind of equity boom we’ve seen since 2009. The payoff, he says, will come in the next crash, when the county’s fund will be hurt less than others. Diversity is safety.” 

What’s more, in a Pensions & Investments story posted last July, Kevin Olsen writes about a study conducted by the Maryland Public Policy Institute and the Maryland Tax Education Foundation of the highest and lowest fees paid by state pension funds: “The 10 states with the highest fees had a median rate of 0.61% of total assets, compared with 0.22% for the bottom 10 states.” This seems to suggest Salient’s 10 bps a year is pretty competitive, and I’d think most state pension funds are quite a bit larger than San Diego County’s $10 billion. 

What’s the takeaway in this tale for independent advisors? First, let’s hope that your fees and/or risk management won’t be called into question in the press. But you never know.

Whether you find yourself reading about your firm in the local newspaper or you’re fielding questions from clients or prospective clients, it’s important to keep in mind that they don’t really know anything about advisor compensation or investment risk (and have probably picked up some misconceptions on the Internet).

So, as in most other aspects of client relationships, it’s an advisors’ job to teach them what they need to know. 

For these situations, I’m a big fan of formal documents. In Salient’s case, as a pension consultant, it was contractually constrained in what it could say publicly. Advisors, too, are limited by compliance departments or SEC regulations. But educating clients is usually permissible. The goal is to provide a context for clients to understand what they may read or hear. How do your fees compare with other advisors who offer similar services? Why are those services important? 

On the investment front, I know that most advisors do spend a lot of time trying to educate clients about risk management and its relationship to investment returns. But the research that I’ve seen indicates that most clients don’t really get it. The problem seems to be that advisors often use technical terms that clients don’t understand. It’s a complex subject, but if you’re clients don’t really understand what you’re doing for them, and why, that confusion can lead to problems—particularly in today’s environment. 

Such appears to be the case with Salient. It may be hard to believe that pension fund trustees can be confused about fees and performance, but clearly, it happens. In this case, there was a happy ending, at least for now: “The SDCERA board declined to terminate its contract with outsourced-CIO Salient Partners at a meeting on Thursday,” reported last week. “As predicted by those close to the $10 billion fund, the vote came down to the wire. After nearly five hours of discussion, a motion brought by trustee Dianne Jacobs to fire Salient was blocked by five trustees, and backed by four.”


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