Advisers Ditch 'Buy and Hold' for New Tactics

On Apr 29, 7:14 pm, Ron Peterson wrote: [snip]

Yes, may I add "increasing earnings," and "grasp the basis of the business," and "sell when revenues show signs of flattening." (Or, to reminisce about the happy days of Calculus 101 before I started to get bonked on the noggin but such things as EMH and Random Walks, sell when the second derivative has been negative for a couple of years.)

The truth is often right in front of one's nose. Seeing it is an entirely different matter, requiring the strongest of virtues.

I think many advisors chase new fads so you have to pay them more to move your money around.

This brings up the recurring thought that I have when I ask financial advisors a question?

Why don't financial advisors use the "agent" model for reimbursement? That is, accept 5-10-or even 15% of MY financial gain as compensation. If I lose money on your recommendations, you get $0 (not negative). This model has worked quite well in the entertainment and sports world, why not the financial? Makes the agents really hustle to get gigs for their clients! If I win, you win. If I lose, I get a more competent agent. Sounds like the free market to me.

All I hear is a tap dance of chase the tail arguments about fiduciary integrity and other balderdash.

Does any advisor work on this model? Or are they all bookies that don't care if you win or lose, just so they get the vigorish?

Chip

Because this approach ignores risk. If I were such an advisor, and lacked ethics, I would put each of my clients into a different high risk, high reward investment. Some would win and I would make money. Some wouldn't. That's OK, I lose nothing. Of course, I use my winning clients for references.

Although some hedge funds compensate their managers with what's called a 2/20. The managers get 2% of the net assets each year and 20% of the gains.

-- Doug

Thank you, that simple explanation makes more sense than all the blather I have heard from various advisors.

Chip

Also, there would be certain time periods, like today's serious decline, when very few of the high risk, high reward investments would be profitable, let alone the conservative ones, so an advisor would very likely receive nothing or very little income from most clients, perhaps no income at all for as long as a year or more. Somehow, I suspect that possible outcome explains the absence of the approach, more than the risk of fraud.

More blather:

1. it's illegal under federal securities laws, unless you meet some high-net-worth criteria (see Rule 205 of the Investment Advisers Act of

1940). For reasons like those Doug mentioned.

1. it implies a "worth paying for" adviser is one who can consistently predict impending drops in the stock market, thereby avoiding losses. That's not just being a good adviser, that's divinity.

2. ideally advisers do things that deserve compensation even if the stock market happens to drop. Not always the case of course.

-Tad

Recently in Missouri, we had a sitution where the state fund managers got bonuses even though the funds (like pretty much everything) lost value. However, they'd beaten the reference benchmarks signficantly. So there's debate about whether they deserve bonuses for not losing as much as they might have.

Of course, there's debate it should be a bonus system at all.

Brian

Of course, I would have some of the clients on the short side, thus making money if the market went up or down. -- Doug

Let's remember one thing.

The things that cost much less now than they did 2 years ago, are actually less risky now than they were 2 years ago, for a simple reason -- they are a lot cheaper and properly recognize (if not over-recognize) the possivbility of loss.

Our perception of risk went up, but the actual risk went down.

i

It's generally a violation. See section 102 of the Uniform Securities Act:

(c) Except as may be permitted by rule or order of the Administrator, it is unlawful for any investment adviser to enter into, extend, or renew any investment advisory contract unless it provides in writing (1) that the investment adviser shall not be compensated on the basis of a share of capital gains upon or capital appreciation of the funds or any portion of the funds of the client;

Why, you ask, might this be the case? Consider the scam artist who goes out and tells half his clients to invest in a stock. And then goes and tells the other half of his clients to short it.

There are exceptions to this rule, of course. It doesn't apply to advisors to investment companies (ie. managers of mutual funds), it doesn't apply to a contract relating to the investment of very substantial assets (ie. rich folks - theoretically "sophisticated" investors who would know whether their advisors was scamming them, etc), and a few others.

But, no, generally, an Investment Advisor may not participate in the cap gains.

Think, also, of what incentives that sort of thing gives aside from just the scam suggested above. Such an advisor has every reason to plow loads of money into the most risky stuff. If it goes south, no skin off his back -- it's not his money to begin with. But if it does well, he's rich. Sound anything like the "risk management" at certain wall street firms?

This model is precisely to keep it from being what you describe.

Probably the model with the least likelihood for the sorts of shenanigans we're trying to avoid is either simple fee-for- service -- either by the hour advise, fixed-length projects, fixed retainer fee, or a percentage of assets under management. And there are many investment advisors who work with exactly those models.

This is one of my criticisms of the hedge-fund compensation model so it's kind of ironic to see it viewed as desirable. There are thousands of hedge funds and hundreds of them close up shop every year (Hedge Fund Research, quoted in Forbes, said 693 closed in Q3 2008 alone). Those that close shop aren't the winners, but it's not as if they're giving back the fees they earned. And every year new ones crop up that are for whatever reason able to attract money and charge fees at 2-and-20.

Another way this can play out is on the conservative side. If the only way to lock in a paycheck is with gains, it motivates the manager to produce only gains. The only way to assure that is with low-risk investments (blatantly circular here..."low risk" meaning "unlikely to drop in value"). You won't have the blowout comp years that 2+20 can provide, so instead just gather a larger pool of money, and "make it up on volume". To give the appearance of activity, purchase long and short positions with part of the portfolio that effectively cancel each other out, and call it something like "proprietary long-short total return model" in slick marketing materials. Some financial products and strategies aren't really too far off of this, when you think about it.

These are extremes of "gaming the comp scheme" though and it doesn't need to be so bad. But share-of-profits is better suited to a pure money manager tasked with "beating the benchmark" rather than what I think the OP was referring to (an adviser to an individual). And even that money manager probably wouldn't agree to "profits only", instead making it "performing better than my benchmark" - just because the stock market (and other markets) do go down, no fault of the manager.

-Tad

< beaucoup snippage to appease our esteemed moderators>

YES - BUT

It isn't quite a simple as it sounds. This is known as "a performance based fee arrangement" and it is allowed, though under very strict circumstances.

First, the advisor has to be allowed to do this through his broker/dealer and many B/Ds won't approve such things. The hoops for the B/D with the oversight boards are extensive so many shy away.

Secondly, the client must be an 'Accredited Investor" which usually means that they must have a certain amount of investable assets or a history of significant income.

Thirdly, most advisors and most B/Ds don't like the concept of not getting paid when the portfolios take a down turn. After all they still have to do the same amount of work, even if the portfolio fell in value. So they're working for free and they don't like that.

Fourthly, even if the B/D allows a performance based fee arrangement, the advisor has to jump through a ton of regulatory hoops to get it to fly with the regulators.

Lastly, many clients don't like the idea of having to turn over what they perceive as a significant amount of their gains to the advisor when the media is telling them that advisor did nothing and the gains are the result of the market.

For example, I am licensed for securities sales and advisory work with a B/D that allows a performance based fee arrangement. BUT my B/D does not directly offer this nor do they allow ME to offer it. Instead, my B/D requires me to use a third party money manager that has already jumped through all the hoops and has everything in place to make sure none of the regulations are breached.

I'm a small fish in this game, I have about 125 financial clients, my brother is also a licensed advisor with about 150 clients. Additionally, I know quite a few other advisors and I've lurked and participated in this NG for years. AND STILL I have one client on a performance based fee agreement and I know of NO OTHERS.

Personally, I think performance based fee arrangements are a great option for the reason you've stated. If I make you no money then I get no payday. In fact, with the program the I use the fee is not only performance based but it high-water marked as well. So if I start out with $500K of your money and it goes down to $450K, I get no fee until I get your account back past the $500K mark - adjusted for withdrawals of course. And the fee is

10% of the gains calculated on a monthly basis. So some months I make nothing while other months I do pretty well. The interesting thing is that when I compare the performance fee to a regular managed account fee the difference is negligible.

You'll hear a lot of negative comments about performance based fees causing advisor to take more risk than normal, which I think is bunk, for several reasons:

First, the investment still has to be suitable for the investor or we risk getting sued; Second, most advisors live on client retention and client referrals. If we do something that causes the investor/client pain, their don't keep their money with us and they surely don't refer us new clients.

I wish I could give you list of performance fee based companies, but I cannot - first I don't have one and secondly, even if I did this is NOT the forum to release such information. If you search around you should be able to find some.

Good luck, Gene E. Utterback, EA, RFC, ABA

Sounds exactly like a bookie!

Chip

I keep thinking, well why not use the same model for physicians and auto mechanics? I think the difficulty is that real-world problem solving, including finding the most appropriate investments for a client, is so far from black-and-white and one size that fits all that it is just not fair to pay a person only if the outcome is a "success."

(What do we do with advisors like joetaxpayer who tell their around 80- year-old clients to keep a large allocation in high grade bonds and CDs? How is he going to make money in a bull market giving advice like this? And yet, don't we want advisors to counsel most of our senior citizens towards conservative allocations?)

This sub-thread also seems to look at investing and financial planning as though it were a short term phenomenon. AFAIC prudent advisors understand it is a long term phenomenon for most of the population and convey the same to their clients.

Igor Chudov wrote: On Warren Buffett as a financial sage --

NY Times reporter Andrew Sorkin will be attending the annual Berkshire Hathaway meeting that starts tomorrow. Sorkin wrote that the format for the annual meeting this year is that two other reporters and he will ask Buffett questions. He has invited readers to submit questions for him to ask. One reader posted that his BH shares had declined in value by about 33% since October when he bought them, whereas his overall portfolio was down quite a bit less. What happened? Specifically in the last six months BH is down about 21% vs. the S&P

500 being down only about 9%. See ^gspc;indicator=volume;charttype=line;crosshair=on;ohlcvalues=0;logscale=on;source=undefined I do not think either your stats or my stats above say much of note about Buffett's abilities.

^gspc;indicator=volume;charttype=line;crosshair=on;ohlcvalues=0;logscale=on;source=undefined>

Buffett manages Berkshire Hathaway. He outperformed the S&P by 27% last year. That is a fact that is fully separate from the price of Berkshire shares.

Decisions to buy and sell the Berkshire shares, and prices of same, are set not by him, but by individual investors. For any reason, they decided to pay less for the company than they were willing to pay a year ago. (similarly to how they decided that various other assets are worth less now than they were a year ago).

i

You were comparing stock prices, the S&P 500, which as you say individual investors dictate, to a company's performance. Then you condemn my comparing stock prices to stock prices? If you want to disregard my point then I have to disregard yours, too.

Comparing a manager's performance against S&P 500 is a standard benchmark. Note that S&P 500 performance is free of all costs and taxes, whereas Beskshire pays all costs and taxes. Despite that disadvantage, Buffett managed his shareholder's equity to beat S&P by

27.5%.

In the long run, stock price follows business performance.

As for the last year, Berkshire stock price outperformed S&P 500, as can be seen here:

^GSPC One year, of course, is not a long enough period to reach any solid conclusions.

i