Balancing Client Risk with Manager Reward

//Balancing Client Risk with Manager Reward

One of the catchy phrases that has come down to us from the ancient Romans is “Cui bono?” – literally, who benefits? When buying financial services, as with any other commercial transaction, this is a good question to ask.

At Baskin Wealth Management we charge our clients a management fee in exchange for providing investing and retirement advice, and what we try hard to make a great client service experience. We build thoughtful, customized investment portfolios and plans designed to help our clients reach their goals and objectives. We don’t do it for free, but we believe that our transparent fee structure is fair, and that it aligns the long-term goals of the firm and its employees with the goals of our clients. We charge a flat percentage annually on a client’s assets entrusted to us to manage. We try very hard to avoid any conflicts of interest.

Conflicts of interest between a client and a service provider arise when one party works for its own benefit, at least in part, and not exclusively for the benefit of its client. For example, at most car dealerships the salesperson who helps the car buyer through the process is strongly incentivized to steer the buyer in the direction of a more expensive car and costly add-ons. The salesperson is usually paid on commission, and will get paid more money if the buyer is persuaded to buy a more expensive vehicle, or one with lots of optional extras. In this case, it’s easy to see how the buyer’s preferences and concerns can be swept to the side in favour of a bigger paycheque for the salesperson.

Wealth management as a service has seen a number of fee structures over its history. The oldest and most well-known is the commission model, still used by many full service stockbrokers. The stockbroker generally does not have discretion to trade directly on the clients’ behalf; instead, she or he recommends purchases and sales, each of which incurs a trading charge, and the client decides whether or not to follow through. The stockbroker earns a commission only when trades take place, and as a result the broker is strongly incentivized to convince clients to make as many trades as possible. Some of these trades, and particularly the resulting commissions, will not be in the clients’ best interest. Should the client choose not to make the trades, the stockbroker may stop making recommendations to that client altogether and ignore the account, leaving the client to fend for him or herself. This is a strange relationship, and one in which the stockbroker is less incentivized to recommend good long-term investments to the client as opposed to many short-term quick flips. Certainly it is the rare broker who recommends a “buy and hold” strategy, even if it is the best solution for the client.

A second compensation model is the mutual fund fee structure in Canada. In Canada, advisors sell mutual funds to clients, and the advisors are paid in two ways. First, they earn a commission (usually from 5% to 7% of the invested amount), either from the client directly, or from the fund company in exchange for recommending its funds (this option results in a fee being charged to the client – but not the advisor – if the client sells the fund before a set number of years have elapsed). Second, the advisor earns an annual “trailer fee” for keeping clients in those funds; usually 1% per year. Often, in this fee structure, the most lucrative payout for the advisor is to switch between different fund companies in order to collect the 5% commission, while the best outcome for the client would usually be to select an appropriate fund to hold for the long-term. We view the trailer fee as little more than a bribe paid by the mutual fund company to induce the advisor to leave the client’s money in its funds, even if this is not in the best interests of the client.

A third compensation scheme is the “two and twenty” fee structure which is common in the hedge fund world and at certain wealth management firms that charge based on performance. The manager earns a fee equal to 2% of invested assets per year regardless of performance. However, if returns surpass a given benchmark (the “hurdle rate”), the manager also charges 20% of the excess profits as a performance fee. The performance fee can incentivize the manager to take big risks in order to boost its fees, since the payout to it would be so large. Importantly, the performance fee is a one-way street. The performance fee does not go into reverse to reduce client losses in bad years. It is a true “heads I win, tails you lose” situation.

Some firms have experimented with other fee structures in an attempt to correctly align the incentives of the firm with their clients, but as far as I can tell, these experiments only introduce other issues. For example, another firm in our space has a policy which reduces its fees during any year following a year of negative returns. The reasoning goes that if the manager loses money for its clients, it deserves to earn less in fees. But this actually creates incentives similar to that of the hedge fund performance fee. The manager is incentivized to avoid losing money; this could easily induce it to invest mostly in extremely low-risk/low-return investments – to ensure their returns stay above zero. Managers’ incentives should encourage them to invest in their best investment ideas – the investments with the best expected returns which are suitable for each client’s individual needs and goals.

We believe the best way to align the interests of our clients with those of the firm is to charge a flat percentage fee on assets. If we are able to grow our clients’ assets, and if they choose to entrust us with more of their funds, we earn more in management fees. If our performance is strong, our assets under management grow and so do our fees. If we perform poorly, we make less money and share in our client’s disappointment. In this way, we feel that we’ve best aligned our interests with that of our clients, and we hope to continue to build long-lasting, mutually beneficial relationships with them. Success for our clients means success for us.

By | 2018-07-18T16:56:41+00:00 July 3rd, 2018|Blog|