A few clients and potential clients have asked why we can't structure their Asset Management Agreement in such a way that I'm compensated by a % of their profits, rather than a % of the assets under management. In short, the reason is because it's illegal. But, I think it’s worth responding to why it's illegal, b/c many misunderstand the purpose for the law.
Under the pressure of making money
solely on the gains of other people’s portfolios, the unscrupulous advisors out
there (and they're definitely out there, I've interacted with some of them)
would be incented to take substantial risks that might not be in the best
interest of their clients. Here’s an example… you give advisor X 30k and
agree that he gets 10% of your gains each year. Seeing that he’s only
compensated by upside, and doesn’t lose anything on downside, he could easily
shoot for the moon in your portfolio and one of two things happens: 1) the risky
investments pay off and you both make money or 2) the risky investment fail,
your account is cut to 15k, you fire your advisor, and he finds another client
to replace you by using the “pay for performance… I only win if you win
argument”. In other words, he loses nothing. This is clearly not
what the average client wants as the advisor's incentives are not aligned with
your interests. The government is VERY concerned that’s what they would
get from some advisors if the % of gains method of compensation were allowed.
Now, it may seem unfair to have to pay for financial service that might not return any money. And it might seem like your advisor doesn’t have the incentive to go the extra mile for your portfolio if there isn’t a % of gain arrangement. Here I’ll give you the alternate argument, and it happens to be one I believe, not just textbook. By paying an advisor a % of assets managed, the advisor is definitely incented to make you money. 3 primary reasons:
1) The only way he can keep you as a client is to keep you satisfied. He doesn’t want to lose you as a client b/c without the “pay for performance, I only win if you win” argument, it’s pretty hard to get new clients. A lost client is essentially lost revenue, and lost referrals. Not to mention bad word of mouth publicity, which is kryptonite to a planning business.
2) The only way for the advisor to make more money is to make you more money so that his management fee grows when your assets grow. It’s slower than in the % gain scenario, but it’s more lasting too. If your portfolio loses money, his business takes a hit the following year.
3) Under this method, you really have to trust your advisor. You need to know him personally, or get recommended to him by someone you personally know and trust. If you trust him, you know he's not going to lazily take your money without giving anything back.
Now, it’s possible that you do lose money, especially short-term. No denying that. But, that’s the reason why I want my business to be more than a stock-picking service. If I get to know what’s important to each client and help them set goals for their future, then I can help them set up a plan to achieve them. The focus becomes achieving the returns that are required by the client’s goals and making sure you’re not taking any more risk than you must to achieve them. Short-term gains and losses, even for a couple of years are irrelevant when you look at goal-based planning. Over the medium and long term, exposure to the market will earn you money. And in the meantime, you get all the other services like making sure you’re tax efficient, getting your taxes done, knowing you’re insured for the case where something terrible happens, having your 401k in the right place, etc.
I’m convinced this is the right model and that if everyone who didn’t have the time and inclination to do this all themselves would find someone who can do it for them, starting when they graduate from school, there would be a lot more “financially independent” or “perpetually wealthy” people in the world. Paying a few bucks each year to get back your life’s goals sounds like a pretty good plan. That’s what I want to provide for people.
Feedback on this argument is welcome. My business depends partly on the fact that I can make this clear to prospective clients. And I truly believe the existence of my business will help each client be more successful, which is as important to me as my own success.
President - Perpetual Wealth Advisors, L.L.C.
Tom Nardozzi is President and Founder of Perpetual Wealth Advisors, L.L.C. If you have questions or comments on this publication, please email firstname.lastname@example.org or call 404-380-1977.