The Investment Scientist

Why financial advisors should not charge incentive fees

Posted on: August 24, 2012

Golf ball

Is a round of golf all the value you get from your financial advisor?

Why do you charge me 1% every year regardless how well you do for me? I would rather not pay you anything for the first 5% return and split anything above and beyond that.

This is a question a prospective client of mine asked me. Let me explain why this fee arrangement is not in the client’s best interest.

Historically, the mean return of the market is 10%, and the standard deviation of return is 15%. This means the market is equally likely to go up 25% in one year and go down 5% in another.

Despite what they want you to believe, financial advisors have very little control over the market.

If incentive arrangements are in place, the advisors will get nothing in the down year but a 10% incentive fee in the up year.

Worse still, even though financial advisors cannot predict or control the market, they can amplify risk. For instance, they can use leverage to make the portfolio go up 35% in the up year and go down 15% in the down year. With this easy maneuver, they still get nothing in the down year, but now get 15% in the up year.

Incentive fee arrangements induce financial advisors to take excessive risk. Because of this reason, the Securities and Exchange Commission does not look on these arrangements favorably and requires extensive disclosure to clients before advisors can set one up.

Now you may ask, if financial advisors have very little control over market performance, how do they add value to justify the 1% fixed fee.

Some advisors get really busy spinning the wheels. Seeing how busy they are with your portfolio, you feel reassured.

Other advisors admit to you that they can’t control the market, but they can play golf with you at their expense. If they are good players, that’s value.

Since I don’t play golf, I deliver value to you, my clients, in three ways:

  1. I help you avoid conflict of interest; this alone saves you about 2.5% on average.
  2. I help you avoid emotional investing; this probably saves you 3% to 4%.
  3. I watch over your overall financial health and help you connect to the right people who can help you financially; the value of peace of mind is priceless.

Get my white paper: The Informed Investor: 5 Key Concepts for Financial Success.

1 Response to "Why financial advisors should not charge incentive fees"

This is an issue of great concern. Securities investing is such a complicated affair the average person doesn’t feel qualified and secure in their ability to manage their portfolio.

I have known several unsophisticated investors that have stated openly to their advisor, “I don’t understand that stuff and I am leaving the decisions to you!”

In my own case it has been the lacking of confidence in my own ideas.
Because of that I have divided my holding 4 ways and each year we have a contest to see which ideas work best.

When I retired from the Post Office I opted to roll my FERS account, tax deffered, into a self directed traditional IRA. It is in an online brokerage account that I personally manage.

I inherited an IRA from my late wife, also tax deferred. That is in the same system she used to build the nest egg. It is institutionally managed and over the years has done well.

I also inherited money from an aunt. She was an unsophisticated investor that had done very well with a professional advisor. I left that money in his hands.

As Michael knows, the rest of my investments are in local residential real estate. My wife and I have taken cash and purchased foreclosed or distressed properties, fixed whatever was wrong with them, and rented them to well qualified families.

This may seem complicated and multi-layered. I confess at tax time there is quite a bit of paperwork. The benefit is not only are the ideas diversivied, the management techniques are diversified too.

Nobody can be right all the time. Even Warren Buffet freely admits he has made “bonehead” plays. If I get off in the weeds with my stock picks, the professional manager and the institutional management are going by their plan. If the rising tide they count on to lift all ships is waning, perhaps my trend following ideas add enough to keep the over portfolio moving forward. Finally, people will always need a nice, safe, and convenient place to live; so the rental income adds to retirement income every month.

When the market turns down, or even goes sideways, the incentive paid investment advisor is the only one that makes money. Up or down, if there’s anything in the account he get’s his share. That’s not a happy time. The upside is if you’re up 25%, as in Michael’s example, you still pay the agreed management fee. If you were partners you would split the profits, and on bad years share the losses.

That’s life. If you’re making a big run you don’t need a partner to split the profits. In bearish times we may all wish we were handing off the losses to others, but there are never any volunteers to take that part of the deal.

So for me, having things I can work at and an income stream not tied to the advisor offsets the cost of professional management. I have been very fortunate in recognizing human trends and buying stocks to take advantage of the momentum. What if I’m wrong?

If I’m wrong I need the institution and the professional doing what they do.

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.


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