You Get What You Pay For: On Fees and Incentives in Investment Management and Advice
BY KEVIN E. MEIER, CFA
No one with a brain in their head who does not have a vested interest could possibly think that a commission based fee structure and suitability standard is better for investors than a fee-only structure and fiduciary standard. For banks and brokers? Yes. For investors, not a chance. Josh Brown of Reformed Broker fame has written on this extensively, and I can hardly add more to the argument. Instead, I will link to just a sampling of his passionate and cogent writing on the topic:
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And while I agree that fiduciary standard should be the standard for all whom offer investment advice and management, it is important to realize there is no perfect fee structure. Inherent in any fee arrangement are incentives that may bias participants in that arrangement. We hear all the time that “You get what you pay for,” and though hackneyed, there is truth in it, especially when you examine exactly what it is you are paying for and what you are not paying for. This statement is decidedly from the consumer’s point of view, and to make it more applicable we might rephrase that to “In any organization, you get what you incentivize”, which came from Peter Diamandis in Tim Ferriss' book "Tools of the Titans". That statement really struck a chord with me, echoing my own belief (which I have told anyone who will listen) that "If you want to know someone's REAL job, find out how they get paid."
These three aphorisms are really nuanced ways of saying the same thing. People can say that they “do” whatever they want and make it sound as noble as they want it to sound, but if we strip it down to how they get paid, where there incentives are, what you are actually paying them to do, it becomes very revealing as to what they actually do for a living and what you as a customer are going to get. So let’s look at three types of fees charged for investment management and advice and what they incentivize.*
Commission based fees: This gets to the heart of the debate against this fee structure; financial planners, advisers, and managers who get the majority of their compensation via commissions and transaction fees are incentivized to choose products with higher commissions (that might not be in the best interest of the investor), and to maximize the number of transactions. There is an obvious, inherent conflict of interest for the manager; he or she is getting paid to sell, not to manage. The investor, then, is going to get what he/she pays for: high priced products and high frequency transactions.
Management/Advisory Fees: Based on a percentage of assets under management, many advisors and managers have gone or are going to a “fee-only” structure in which they do not charge commissions and try to minimize transaction costs. This does reduce or eliminate conflicts of interests, but it also adds a different type of incentive. Managers and advisors are paid on AUM, and therefore, they are paid to collect assets. Marketing and distribution, then, becomes their primary jobs and their advice and management becomes secondary. For asset allocation and passive investment strategies, a low cost, fee-only model is probably the most appropriate fee structure, but the possibility of above average returns, based on anything other than the reduction of fees, is eliminated. Indeed, innovative and alternative strategies are dis-incentivized, as deviation from average is not rewarded.
Performance/Incentive Fees Some managers/advisors charge a performance fee as a percentage of the profits or out-performance of a bench-mark that they earns for investors. Their job, then, is to manage investors’ assets and seek optimal performance. This fee structure can attract innovative and talented managers, and align the interests of managers and investors. On the other hand, it may also incentivize and encourage excessive risk taking. For this reason, the SEC has restricted performance fees to accredited and/or qualified investors who understand the incentives and can withstand the perceived higher risks.
Conclusion Of course, nothing exists in a vacuum, and often there are combinations and layers of fees to consider. Most importantly, investors should look at each level of service and ask what the primary source of compensation is. For instance, most hedge funds, fund of funds, and a growing number of portfolio advisors and managers are charging a performance fee in combination with a management fee. This may promote excessive risk taking if the primary compensation is the management fee, and the performance fee is looked at as a bonus for out-performance (but remember the majority of managers who do this still have a fiduciary duty to their investors). On the other hand, managers who only or primarily charge a performance fee (like us) may actually be more risk averse as they are incentivized not to risk their businesses on riskier investment practices. Instead, the performance fee incentivizes innovation and risk management, while attracting top managerial talent. In the end, for some investment is is critical to minimize fees, and for others, it might be beneficial to have a different type of model. In any case, the key is to understand what you want out of each of your investments, managers, and advisors, and to ask yourself if that is what you are actually paying for.
*It is important to note that we are talking about investment advisors that offer advice and/or management services. These professionals can and do use or recommend products such as stocks, bonds, mutual funds, hedge funds, ETFs, funds of funds, etc. and there are always additional charges, commissions, and management fees for each.