“Show me the incentive and I will show you the outcome. I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives and all my life I’ve underestimated it.”
-Charlie Munger (Vice Chairman of Berkshire Hathaway,
Warren Buffet’s long-time partner)
“Never ask the barber if you need a haircut.”
-Cliff Asness (Founder of AQR Capital Management)
The longer I live, the more I believe incentives make the world go round. If you understand someone’s incentives, you likely can predict his or her actions. Having worked in the world of asset management and wealth management my entire career, I have seen firsthand that incentives drive behavior. When we meet with an investment manager, we always ask questions to try to ascertain the incentives present. Here are a few examples:
- If an investment firm pays an equity portfolio manager (PM) based on risk-adjusted returns, these funds will likely deliver lower risk investments. The PM will optimize to whatever will increase compensation. If the risk-adjustment is “volatility,” the PM will decrease volatility; yet if the risk-adjustment is “tracking error” (deviation from an index), the PM will likely track the benchmark closely. Compensation drives behavior.
- If an investment firm receives performance fees on their investment strategy, meaning they get to keep 20% (“promote”) of their return above a certain threshold (usually 8%), the manager has an asymmetric compensation model. If they lose money, they receive only the management fee (which is often 2%), but if their performance exceeds their minimum (i.e., 8%), they receive incredible compensation. At first glance, this structure seems to align interests, and in many cases, it does. But we are certain that the investment firm will be willing to take outsized risks to ensure they hit their hurdle rate and get paid their 20% “promote.” These managers also tend to employ other tools to help improve their performance results by using lines of credit before capital is called (this is a well-known trick in the private equity world). This will increase their IRR (IRR vs. TWRR for another topic) to get them closer to their hurdle rate of 8%, at which point the huge compensation kicks in.
When we interview investment firms, we try to get straight to their incentive system. It’s important to know as much as possible about conflicts of interest and incentive structures before investing. Incentive structures will at times lead us to pass on opportunities. Understanding incentives allow us to set our expectations for underlying risks. Alignment of incentives is paramount to successful capital allocation and to successful partnerships.
When it comes to finding a financial adviser, incentives absolutely matter. When we have a chance to analyze a portfolio managed by a financial adviser, we can largely predict what will be in a portfolio based on which type of firm advises the client. To be 100% clear, there are exceptions, but I would estimate these exceptions are few and far between (less than 10%). In the same way we ask probing questions to our investment partners, we think everyone should ask key questions of their adviser. If your adviser becomes defensive, you know it’s time to run! Likely, your adviser will answer the questions honestly and the answers will give you a lot of good information about their incentives. Here are a few probing questions I would ask a financial adviser if I were a client or a prospective client:
- Are you held to a fiduciary standard of care in all activities? You are asking the adviser if they are legally required to do what is in your best interest. If they answer that they are not, it is a red flag. It likely means that they are operating under a brokerage model and are held to a suitability standard. The difference is that a broker will happily sell you a suit or a dress, but a fiduciary must make sure it looks good on you and fits you appropriately.
- Are you compensated by any products? Examples of product compensation include commissions and incentives from the sale of brokerage mutual funds and closed-end mutual funds, commissions from selling banking products such as asset-based loans or margin lines, insurance products such as life insurance, annuities, or disability insurance.
- Can you list out for us all of your firm’s lines of revenue by percentages and list out the percentage of your (and your team’s) compensation by business line? Let’s face it, large financial services firms (banks, insurance companies, and brokerage firms) have used their financial advisers as a sales arm, not an advice arm. Financial advisers, in some firms, are paid on commissions from individual bond purchases, money held in cash accounts (banks make a lot of money on sweep accounts), and cross selling insurance, mortgages, loans, credit cards, and other products.
- Do you receive up front compensation for placement in alternative products? Many brokerage firms will advise clients to invest in private equity or hedge funds but that “advice” comes with a pay-to-play model in which a large private equity firm (which may have even had trouble raising money from more sophisticated investors) decided that they would pay the brokerage firm to then push the fund through their advisers. The client then pays upfront fees (2-5%) – and in some cases additional ongoing fees – for the privilege of being sold a fund, often one that sophisticated investors passed on. Let’s face it, why would a private equity fund be so happy to deal with tiny investors and pay to raise the money if they could get the same capital from a large endowment?
- Explain, in some detail, the compensation structure of the advisers at your firm? If an adviser is strictly receiving a percentage of the gross revenue that they manage, it isn’t inherently a bad thing. But it means the firm you are working with doesn’t operate as a team. They likely operate as a siloed operation. Your adviser may be a great person, but just know you are paying for them and them alone. Siloed operations tend to lead advisers to hoard clients. Essentially the adviser is managing their own small business inside of a bigger one. We think a team-based model is the right one. At Verum Partners we strive to create a team-based approach by ensuring that all team members have a vested interest in the well being of your family and of the business. All five Verum Partners employees own a portion of the business.
- Who will service our relationships if something happens to the adviser? You should know the team on the front end. For folks who are in retirement or approaching retirement you understand that managing your finances successfully over the next 30 years is paramount. What happens if your adviser retires or has a health incident? Who will be taking care of you and your family? Do you know and trust these people? Ask these questions on the front end so you have comfort with the people who step in for you and your family.
In short, incentives will always drive behavior. Incentives and conflicts exist in every single industry, but are notoriously egregious in the world of financial services. We encourage everyone to probe a little bit to uncover potentially costly conflicts they may not have considered. This allows you, as the investor, to assess how much risk you are willing to take. I am inherently conflicted in the following statement, but it doesn’t change my belief that it is true: Financial advice is best delivered by someone who is held to a fiduciary standard, who charges fees transparently, who has a succession plan in place, and who is surrounded by a team who has a vested interest in the financial success of your family and of the company they work for.
Here is a great blog post by famed investment blogger Jason Zweig on the same topic: https://jasonzweig.com/the-19-questions-to-ask-your-financial-adviser/