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| Best Practices: Bankers Agenda |
Performance Enhancers
Gayle B. Ronan
12/01/2005
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Benchmark Bluffs
However, an investor cannot assume that a
performance-based fee structure automatically means his financial advisor is
trying harder. When the concept emerged within the institutional market,
articles began appearing in industry publications such as the Journal of
Portfolio Management and Financial Analysts Journal describing how advisors
could manipulate the structure to their advantage by basing their fees on
performance benchmarks that are easy to beat. Investors therefore need to pay
close attention to how the incentives are structured. The underlying benchmark
needs to be consistent with the agreed-upon investment goals and with the
advisor’s strategy.
One of the arguments against using performance-based fees
is that they encourage advisors to take greater-than-appropriate risks in order
to push returns into their incentive zone. However, that behavior represents a
violation of the Investment Advisers Act of 1940. That act requires advisors to
distinguish between suitable and unsuitable investments and take a client’s risk
tolerance into account whenever they offer advice or invest on a client’s
behalf. If advisors take undue risks, they may run afoul of the Securities and
Exchange Commission. Given the hassle an advisor faces from a routine SEC audit,
an actual complaint to the agency is something an advisor would want to
avoid.
Zachystal stresses the nature of his fiduciary duty when discussing
performance fees with Individual Asset Management’s new clients. “We assure them
we are legally bound by the investment policy that we prepare for each client,”
he says. However, structuring the fee agreements is difficult, he points out.
“The explanation isn’t straightforward. We find that people who want other
people to manage their money often don’t want to think that hard about the fee
structure.” As such, many do opt for the asset-based fee schedule over the
performance-based alternative, although all are given both options.
Blood
says his clientele is more receptive. “Certainly, it is more complicated than an
assets-under-management fee calculation, but it isn’t exactly rocket science,”
he says. “It’s basic math. The incremental complexity is well worth
it.”
“Performance fees are a valid structure,” Zion says. “It isn’t all or
nothing, but a matter of hiring managers willing to strike a fair economic
relationship with clients, and managers who are equally willing to match our
objectives to fair compensation.”
Illustration by Ken Orvidas.
Gayle Ronan is a freelance journalist and former private banker and advisor
who writes frequently on wealth management topics.
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