Noland recently shared his frustration over how difficult it is to run a comparison of fee structures against performance net of fees. He was conversing with fellow attendees at a conference sponsored by Private Client Resources (PCR), an information services company in Wilton, Conn., that helps clients compile all of their financial data in one place and benchmark it against that of other ultra-affluent investors. “Some 75 heads suddenly began nodding in agreement as I spoke,” he says.

TOP VIEW Few advisors advertise that they will negotiate performance-based fees, but many will do so. These compensation agreements have some important advantages over simple flat fees and those based on a percentage of assets under management; primarily, when properly structured, they can align the advisor’s and client’s interests more optimally than other schemes. However, they are arduous to negotiate, and private investors must ensure they choose the right benchmarks on which to base their advisor’s compensation.

One of those who is in agreement is Chris Snyder, who became a cofounder of PCR because he thought there should be a mechanism for pulling together investment information and determining the value received for the fees paid. The firm is trying to develop a database over the next year or so that will allow clients to compare managers’ and advisors’ fees, with a goal of eventually linking fee arrangements to performance.

Such improved clarity could also provide impetus for change in the way fees are calculated. When investors can analyze their fees in the context of performance, they may have more incentive for demanding performance-based fees. Until it becomes crucial to attracting and retaining top clients, a change in status quo, for the advisory community, makes poor business sense.

However, that time may be nearing. “It seems clear that investors are beginning to get frustrated—both private and institutional—with the level of fees and the alignment of client/manager interests,” says David Blood, the former CEO of Goldman Sachs Asset Management who in 2004 cofounded Generation Investment Management, with offices in Washington, D.C., and London. Blood has been in the unusual position of creating an investment firm from scratch at a time of increased regulatory scrutiny and growing concern over conflicts of interest and transparency within the industry. As such, he and his partners considered their timing an opportunity to rethink traditional fee structures, and have made performance-based fees their standard practice.

However, from the perspective of most investment firms, a performance-based fee structure requires calculations that are so complex they would make the eyes of the average client glaze over. Fees based on assets under management, on the other hand, are both easy to calculate and to explain to investors: a predetermined percentage, often scaled to offer discounts on larger balances, multiplied by the client’s account balance as of a specific date. Such a fee structure is often sold to clients with the assurances that “if you do well, we do well.” If the company’s strategies work, the account balances of the clients will rise, leading to increased fee income for the advisor. It appears to be a win-win arrangement. However, while the AUM fee structure rewards an advisor for increasing client assets, it does so regardless of whether or not those assets increased because of outstanding performance on the part of the advisor. The assets under management may grow simply because of client deposits, reinvestment of investment income or even a rising market. It makes little difference whether the advisor is tracking, exceeding or trailing that market.

“...It isn’t exactly rocket science. It’s basic math. The incremental complexity is well worth it.”

For advisors who excel at gathering assets—that is, landing new business—it is a very winning arrangement. It has been argued that the AUM fee structure can inadvertently lead an advisor to focus more on marketing than on delivering the superior asset management services clients contracted for in the first place.

This potential for conflicts between client interests and those of the advisor contributed to the SEC’s gradual loosening of previous restrictions regarding the use of performance fees by registered advisors. In 1998, the agency even removed contract terms and disclosure restrictions with the goal of enabling any advisor of any size to introduce performance fee structures, as long as the client has at least $750,000 under management with the advisor or a net worth of at least $1.5 million—enough to ensure sufficient sophistication to enter into a negotiated fee agreement.

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.