Tad Borek wrote:

- quote -

I do understand that most don't have the basics to even judge, but that
is their concern.

- quote -

To a degree. For instance, my current 401k was started empty in Oct '98.
I have contributed the max for each year. I focused on the S&P fund and
the money-market options. To date it is at about $147k, comparing favorably
with a full S&P plan, at a very low beta of less than .3 (if the S&P = 1.0).
I did this by being fully in the S&P from inception till Jan 2000 when I
went all to cash and stayed there till now. I calculate the beta by the
portion of the time it was in S&P divided by the whole time. This 'bucket'
has languished in the money-market since March 03 when I could have
reinvested in S&P, as I did elsewhere, but fully as deep as I was comfortable
in another account. This is not a sterling gain, but very good for it's
safety and neglect.

And thank you for your other answers. I will do that google search and
read.

Joe Weinstein wrote:
- quote -

Hi Joe-
Well I'm sure if you asked the direct question, a lot of people would
say that portfolio performance - maximizing returns - is the top
priority for them. But then ask the follow-up question, "what have your
returns been, and how does that compare to a relevant benchmark?" and
you'll find out that it's a very, very small group that can even begin
to answer that (can you, for example?). They may know the ratings for
their mutual funds (at least, when they first bought them), or what sort
of long-term returns different types of investments have had, but they
don't know what returns they've actually gotten. And they probably don't
know what a good bechmark might be. For good reasons: it's hard to
figure this stuff out, and it certainly isn't on the average account
statement.

So that's a real disconnect isn't it? It's like saying your top health
priority is losing some weight, but not knowing what you've weighed in
the past, and not having a scale.

And really, in practice, a lot of people don't say that - they don't
come in asking to get high returns or if they do, they back off after
discussing the basic risk/return trade-offs ("how about emerging market
small-value stocks?"). Usually it's more something vague like "grow over
the long term". And with wealthier clients it's just not necessary to
shoot the lights out...tax questions can predominate a lot of the
investing decisions, or just "preserving wealth".

I'd also stress the value of talking people out of making the silly
little mistakes that can hurt things over the long term. One difficult
part of building wealth is that you need to keep staring down an
ever-increasing pile of money without tapping into too much of it at the
wrong time. And you need to resist the mindset that it's OK to throw
some of it at the investment du jour, in the name of "taking on some risk".

And getting back to your original post...this is the kind of stuff
that's hard to quantify in your incentive scheme. You'd need to recreate
that imaginary portfolio with all the hot-stock-tips you talked your
clients out of, and the early IRA withdrawal that didn't happen because
you talked them into keeping enough money in accessible cash. And I
think you'd find that being 80bps ahead of the S&P 500, or generating
consistent positive returns, aren't necessarily the best criteria for
setting an advisor's pay.


- quote -

I don't know exactly how many advisors work only under an AUM
arrangement. I think it's fair to say that most who do, and who use
mutual funds, will stick to no-loads. I suppose there's another group
that bills AUM and using load-waived products, different share classes,
that kind of thing, but I put that in a different category, because a
lot of those folks refuse to take on fiduciary responsibility, and
aren't providing comprehensive investment advice. [If you're really
interested in this stuff, Google MERRILL RULE and read away. If you want
to hear my thoughts on it, add in the term BOREK.]

As for whether every load fund has a no-load counterpart that is likely
to do as well...that's kind of a loaded question. I focus on passively
managed mutual funds and everything I use is accessible at no load (at
least in the typical sense of "load"). I imagine there are people who
genuinely believe that certain "superior" managers or mutual funds are
available only by paying a load. Which is fine, but I just don't think
that, so I don't need to use them.

-Tad

Joe Weinstein wrote:

- quote -

There's really no good way to do this unless you are willing to MM
your account with the clients' account. In order to be compensated
for a spent decision, you will have to bear the risk along with the
client - otherwise, you're hitching a free ride.

Tad Borek wrote:

Thank you *very* much for your reasoned comments. See below.

- quote -

Absolutely. The only reason I had mentioned 1-year performance was
because no advisor would stand for *that* much delay in payment,
let alone the true timeframe of the appropriate performance of the
portfolio.

- quote -

Yow. Interesting. Do tell me more. This thread is the most one-on-one
involvement I have had with a professional advisor, so I would have
naively guessed differently. If portfolio performance isn't the usual
overriding concern of your clients, what is?

- quote -

Sure, I can imagine. My hope is that a few serious days of education
would do much to normalize most peoples goals and expectations. The
value of comparing individual portfolio performance to a broad market
index is that 'market return' is easily and cheaply attainable, and
easily defineable. I would interact with the customer to define success
based on getting them to self-discover their actual risk tolerance/awareness,
and what is historically possible/probable given their real timeframe(s)
for their money. I have seen people with low risk tolerances but with such
low risk awareness that the intolerance never kicks in. My mother-in-law
had 50% of her wealth in pension and annuities, and 50% in a random
lightly-churned assembly of bond funds and inherited stocks that were
'managed' by an advisor that periodically did stuff after 'selling' her
over the phone, without her ever being asked to consider any quantifiable
information. She was distantly and detachedly bemused by whatever happened
with the stocks during the 2000 crash, and sort-of dismissed their real
value with "they don't pay a dividend, do they?".

- quote -

Nope. You're right about the short-term focus. I wish there was a long-term
metric that was applied to, and publicized about the success of various
investment styles and stylists. Unfortunately, the long-term prospects and
info *isn't news*. It doesn't change enough to make anything new to print
on the cover of a magazine someone wants to sell.

- quote -

My half-baked scheme would have already given you some of the appreciated
stocks. Compensating you for the tax optimization you provided is left as
an exercize for better students than me....

- quote -

That is certainly fair. My elementary-school umbrage is directed more at
loads as an obfuscated way of taking money. There's no connection between
the load payee and value. For instance, if I read the National Inquirer
and they are talking up the "Dewey Cheatham and How Optimally-Loaded Fund",
and I call Schwab to buy some, Schwab gets and keeps the load/kickback.
I guess the 'advisor' would be the news-rag that comes closest to earning
the load. How many advisors work under a straight AUM agreement, and does
that implicitly or explicitly mandate avoiding loads wherever possible?
Am I right in my rule-of-thumb that for every loaded investment there's
likely to be another that does as well, with no load?

- quote -

True. I get the sence that some advisors think they can predict the
unpredicatable, to the extent that they believe they can trustably beat
the market over the long term on an equal-risk basis.

Joe


======================================= MODERATOR'S COMMENT:
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Joe Weinstein wrote:
- quote -

Hi Joe-
Let me throw out some comments - I'm an investment advisor that has
tried to think these things through for my practice. I've ended up with
hourly fees for project work, and percentage-of-assets fees for most
"ongoing" work including asset management. To me that's about as good as
you can get, and it's preferable (for a client) to the percentage of
earnings approach you propose.

The fundamental problem I see with "win the horse race" type
compensation, like that a hedge fund might use, is that it doesn't
reflect the fact that a lot of advisory work has nothing to do with
that. Using your lawyer analogy, most lawyers don't do trial work, they
do transactional work, where it's pretty hard to define "winning" or set
a contingency fee. I have clients where the actual portfolio management
is almost an afterthought because the tax and planning questions
predominate. And if anything, a lot of the help I give is getting their
focus off short-term performance (including one-year) and onto the big
picture. I think many individual investors fall into this category -
most people have a lot of Money 101 kinds of questions, and they're
ongoing. That's work and somebody needs to be paid for it, if the client
isn't doing it themselves.

Let's say though that you were isolating just investment performance.
Again, this would be unusual for an individual investor, but let's say
it's there - a pot of $150k that you want to grow over the indefinite
long-term, that's it, no other questions to address. The issue becomes,
how do you define success? Is it going to be "the account goes up every
quarter" (that's what most indv investors would define it as, though
it's completely unrealistic). Is it going to be "beat the S&P 500"
(which can easily occur through factors tied much more to chance than to
skill) or "beat the NASDAQ composite" (which I don't think is a valid
investment goal). You mention a volatility-based standardized metric,
but I can't think of a single client who really views their money that
way, or that would be able to sort out the validity of, say, a
regression analysis based on the three-factor model. There's a big
problem here and realize that clients have very different (and often
unrealistic or ignorant) perceptions of what is possible.

Let's say it were standardized somehow - like you use some standard
benchmarking methods...would that be better? I don't think so because
human nature will lead to some bad manager-assessment decisions, because
it just won't allow for the long view. I'd argue that this is a core
problem with the investing world as it is now. If you don't believe
this, open up a personal finance magazine and look at the ads. You'll
find all the funds-du-jour that people are buying for silly, short-term
reasons. In effect we already have a horse race compensation system
where being Morningstar five-star over the past five years attracts the
assets (and boosts the management fee). Once you set horse-race
compensation at the account level, advisors are going to chase
short-term returns, because that's the way human clients are going to
assess them. And you know what'll happen? Some accounts will "win" and
be profitable. The losers will just slide away. In the same way that
"winning" funds pop out of incubators, build assets for a few years,
underperform, and then are quietly liquidated or merged out of
existence. Is that preferable?

And as you said, taxes complicate the benchmarking issues tremendously,
and I'm not sure you can really factor that in accurately - you'd need
access to many years of tax returns run under various scenarios. Nobody
has time for this - I certainly don't. I have a client where we've done
charitable giving using highly-appreciated stocks. They give that way
because I advised them to, and the appreciated stocks are there (instead
of funds) because years ago I advised them to buy them. How should that
factor into my pay? Just the tax benefit of one of those, instead of the
old cash donations they were giving anyway, would cover a few of my
invoices.

So at the end of the day I don't think it should factor in - not tax
efficiency, not short-term horse race success. You'd end up with
hopelessly complex and somewhat abitrary methods of defining success and
compensation. A straight "AUM" fee (percentage of assets under
management) rises and falls with the portfolio value, so has that
alignment aspect to it. More important, I think, is that it can be shut
off at any time, so in effect you're constantly put in a position of
proving your value. You do a poor job....well, your client walks, and no
more fees are owed. It's up to you to show that you're doing an OK job
and for all you know, they're being pitched by alternatives all the
time...the market is at work. They didn't make a big up-front payment to
you either, as would be the case with some commission arrangements.

And of course if someone decides to fly a couple planes into the WTC,
well my paycheck isn't going to get shut off as a result - and why
should it? Clients don't pay me to claim that I can predict the
unpredictable - why should compensation be based on that?

-Tad

- quote -

My answer would be 'a'. As a practical detail, the broker needs to get
paid, and won't wait for 30 years to start getting a fraction of your
monthly retirement distribution. A yearly agreed-on specific date is enough
distance that the percentage of gain in a typical portfolio is due to
relative asset performance, as opposed to daily/weekly volatility.
I am mainly talking about mutual fund investments, which would never
be as volatile as a single stock. No client/advisor would have a significant
portion of the customer's portfolio in a single stock. For a customer with
an initial $20,000 I would expect a portfolio of mainly a few broadly
diversified funds. I say again that the desired degree of volatility
should be one of the fundamental starting agreement points in the
management contract. If a portfolio was big enough to support adequate
diversification owning individual stocks, the swings of an Enron-type
stock would affect a typical diversified portfolio by single digit
percentages.
I do see another issue to consider. Somehow, we should include the
tax efficiency of the fund management. A manager's returns should be
affected for better or worse to some degree in the same direction as
his/her actions affect the customer's tax consequences.

Joe Weinstein wrote:
- quote -

Hi Joe: I don't think you understood my point. My concern was that
all "growth" of a portfolio is illusory unless and until you liquidate
the entire portfolio, so if you pay the manager based on the illusory
intermediate "growth" with real dollars you are going to be kicking
yourself when the portfolio falls back to earth and you realize that
the gains you paid the manager for no longer exist!

Lets use your example. A $20,000 portfolio of 200 shares in, lets say,
Enron "grows to $30,000." You cheerfully liquidate $2,500 worth of
shares to pay your manager his 25% commission. Then, literally the
next day, the newspapers say Enron was cooking the books and is
actually bankrupt. Your portfolio experiences negative "growth" over
the next few days to the point where it is worth $1,000. Under your
system, does the manager:

(a) Keep the $2500 commission and thank god it was calculated when
it was?

(b) Return the $2500 commission?

(c) Return the $2500 commission and also pay the client a negative
commission of $6625?

Under scenario (a) the client is going to be disgruntled. Under
scenarios (b) and (c) the manager is going to be disgruntled.

As a side note, here is why I put "growth" in quotes when it comes to
stocks. Words like "growth" and "worth" are misleading when it comes
to equities; they imply that the stock has undergone some change in its
intrinsic value. The only thing one day's stock price means is that it
happens to be the price that the miniscule percentage of shareholders
who sold today were able to negotiate. A rise in a stocks price
doesn't mean the stocks are intrinsically worth more, its just a
measure of the gain you would realize if you chose to sell today. If
you are not planning to sell on a particular day then that days stock
price may be entertaining to watch, but it doesn't determine anything.

This is why you pay income tax on interest earned but not on the
"growth" of your stock portfolio. Its all just black squiggles on a
piece of paper (or computer screen) until you sell.

Andy

Andy wrote:

- quote -

No, not as baldly stated, but maybe there is something that can be built
from it with enough banging on it by a bevy of motivated intelligents.

- quote -

Well, there is precedent for brokers waiting for their money. Class
C shares typically spread out the payment to the broker, but there is
no reason why the agreement could not include periodic liquidation or
transfer of enough shares to pay the successful manager.

- quote -

True. One could agree that advisor payments would be quarterly or yearly,
whatever customer and advisor wanted, and be based on the gain since
the last payout. At any such time the customer would be as free as the
advisor to realize gains. Yearly would probably be better, to avoid
paying out on short term swings... I am not claiming anything workable
in detail, just that such a big-picture goal is doable in principle.

- quote -

And the same can work here. A yearly partial liquidation or transfer,
specifically to pay the winning manager. Let's say the agreement was
that a manager would get 25% of the gain, and a $20,000 portfolio
of 200 shares grew to $30,000. The manager gets $2,500's worth, about
17 of the fund shares.

There are more real-world issues that would complicate this idea...
For instance, one would have to quantify one's desired degree of
risk/volatility, and perhaps peg it to some broad market index, to
be able to judge whether a manager was overly risky in trying to make
gains. For instance, (and again this is a first hack at the idea),
I could say I want approximately the same volatility as the S&P
for my stocks. I could simply get this by buying an S&P index fund
and checking back in a year, so I would like to pay the manager 33%
of any gain *beyond what the S&P achieved* in the investment/payoff
period, but if he gets more risky than the S&P index, in some agreed-on
quantifiable way, and loses, he pays some penalty.

I'll bet the free market itself would naturally generate a better
arrangement if the relevant information was public. If the
average portfolio yearly gain vs. volatility exposure ratio was
published for every professional investment manager, competition
would hone the costs and performance of those folks. However, it
might also show that just like mutual fund managers, that unmanaged
index approaches beat active financial advisors too. Warren Buffett
said, "The market is a mechanism for the transfer of wealth from the
active to the patient"...

Joe

Joe Weinstein wrote:
- quote -

The problem with that is that you can't do it without introducing a risk
bias, as risk and return go hand in hand. So an adviser would always
come out ahead if he pushed riskier investments if you had a "you don't
get paid unless I make money" method of compensating the adviser. As
well, you also would end up pulling the client out of the decision
making process--after all, is it fair to "penalize" an adviser if a
client balks at making an investment that ends up performing well? But
do you really want to remove your veto power over the advisers actions?

The problem is that what most customers *WANT* is high returns with no
risk--that is, the impossible dream. And I say that as someone who
doesn't deal in investment advice.

Consumers have to be realistic and realize that *no* compensation
mechanism could ever perfectly align the interests of the two parties,
largely because two parties never have perfectly aligned interests to
begin with. Full disclosure of compensation mechanisms is the best
answer, largely because it now puts the ball back in the consumer's
court--*you* have a responsibility to evaluate the advice you are given
and to determine if the adviser is truly acting in your best interests
or not.

In most investment matters, there's no way to get a guarantee of the
"optimal" return, since guarantees by their very nature imply that risk
shifting of some sort is going on--and insurance is, and should be,
compensated for, whether it's explicit insurance (the charge on an
annuity that provides a guaranteed rate of return) or implicit risk
shifting (the lender taking a guaranteed return rather than
participating in the profits, as the equity holder does).

As well, basing your mechanism on return itself introduces a risk
bias--return generally rises with risk and, all things being equal,
higher risk equates with higher average return, though greater variation
in that rate of return.

--
Ed Zollars, CPA
Phoenix, Arizona

Joe Weinstein wrote:
- quote -

I agree with you that there needs to be a good way to align the
advisor's interests with the clients. However, I don't think your idea
will fly.

With equities, bonds, and mutual funds there is no capital gain (or
loss) until you sell/withdraw, and I am not sure advisors are going to
be willing to wait 20+ years to collect their percentage of the gains
when an investment is liquidated. Before the day the client cashes out
of an investment all "gains" (other liquidated dividends and interest
payments) are hypothetical and subject to change. The only way an
advisor could logically be paid for increases in an investment's value
before it is liquidated is if the advisor is willing and able to return
his commission when and if the investment loses value. And the only
way the advisor could be sure of being able to pay refunds if the
market crashes is if he doesn't spend any of his earnings *and* he
supplements those earnings from somewhere else to cover the portion
earnings that went to paying his income tax.

The reason contingent fees work for lawyers is because the fee is not
paid until the lawsuit is finalized and the payout is liquidated.
Andy

Hi all.
In the Jan. 31 Newsweek there is an article that describes the SEC's plan to require
a new disclosure form for securities brokers, specifically to help prevent the abusive
selling practices by some financial advisors.
A broker would have to fill in this form and give it to the customer as a part
of any fund/security purchase. This form would list *in plain English* any up-front
charge, the first year's fee, and whether the fund paid the broker extra to make the
sale. A first test form was tried with a group of typical investors, and had copies
of the relevant prospectus chapters, but the 'road-test' proved that the prospectus
legalese went right over the usual client's head, so the SEC is mandating simple
English.

I wonder how much lobbying against this will occur?

Could we design a system that more closely aligns a typical financial manager's
interests with their typical client? For instance, there are many successful lawyers
who will work on commission, taking a portion of the award. These lawyers are
optimally motivated to do their best.
I would like to discuss a way to have advisors to be paid primarily from productive
portfolio net gains, to motivate them optimally to produce them. And this should be
explicitly qualified by the customer's chosen level of risk. Otherwise an advisor
might push the higher risk to gain more when it succeeded.
Is there a public ordering of advisor success (from a customer point of view)?
For instance, it could list the highest average percentage portfolio earnings for
low-risk portfolios, 'balanced portfolios', all-stock portfolios, etc. These
portfolio types would have to be defined, but I hope I convey the idea sufficiently
for a discussion starter...

Joe