Paying advisers based on performance may present a conflict of interest. This is because the adviser might be tempted to chase higher returns for clients in order to collect additional performance fees. This could potentially put clients in situations where their portfolios are more risky than what is ideal for their individual needs. As such, Registered Investment Advisers are generally prohibited (although there are certain exceptions) from accepting performance fees as they are required by law to always put their clients' interests first.
It's a timely and interesting question. Many RIA firms, including mine, charge primarily through a fixed percentage of assets .More than one person has opined that I should receive that % in the year (or quarter) when account goes up, but not when it goes down. I think these folks miss the point of what I am charging for. Their view implies they want the account to go up EVERY year. - Which of course it won't (Except Madoff's. In hindsight Madoff was just giving investors what they were demanding, but I digress)
We are charging for ADVICE; to help investors make a plan and stay on track even - and especially - when the account is going down. Hope that makes sense. Regards, Evan
Registered Representatives and broker/dealers(ie. Stock Brokers) are not allowed to participate in their client's gains. It is seen as a conflict of insterest as a broker would be tempted to go for a risky gain in order to get more themselves than what may be in the client's best interest. Registered Reps and "Stock Brokers" compensation is based on "Suitability" and providing a product or service, not advice(even though many offer advice). RIA's charge a fee for their advice, not for the product or service that is used. The reason some investors think that it would be a good idea is that they believe it would lead to better performance, but it also would lead to a lot of potential problems. Hedge Fund managers can accept a percentage of the gain but remember their job is manager a pool of assets, not working for you specifically.
The answer is simple: you're paying someone else to be lucky. Michael Maubossin points out that in a field where the difference between the least skillful and the most skillful is low, then luck plays a bigger factor in explaining high or low performance. Given the proliferation of information about stocks - you can look on Google, Yahoo! Finance, Motley Fool, CNBC, Wall Street Journal, etc. for current information about any company you can think of - compared to a long time ago, even the "average" investor isn't too far behind the "professional" investor when it comes to knowledge and awareness. It's not like the financial planner who takes a percentage of assets under management is going to go walk the floors of the 20 companies he'd invest in for you, talk to their customers, talk to their vendors, talk to the management, sit in on board meetings, etc. The informational edge is slight (he knows a Sharpe ratio! Ooh!), he suffers from the same cognitive biases that you do, and, therefore, his performance compared to yours is going to be based much more on luck than skill. You can find out more here: http://www.hullfinancialplanning.com/do-you-have-to-be-lucky-to-beat-the-market/
You can expect to get a LOT of responses to this question! You have hit a hot button with many of my colleagues. There are a number of different compensation schemes when hiring an advisor:
1) Commission - Generally an upfront charge for the advice given, and could be in the form of a mark-up or mark-down, a commission on a securities trade, a load charge on mutual funds, etc.
2) Hourly Fee - Generally a charge for advice based upon the time spent.
3) Asset-Based Fee - You pay an annual fee for continuous portfolio supervision based upon the assets supervised.
4) Performance Fee - Often in conjunction with an asset-based fee, rewards the advisor with a percentage of the profits.
Some advisors may have a combination of the above, or charge differently for different activities.
The issues with a performance fee are; (1) you could be paying a lot of money for performance that might be actually market-driven and not really a result of the advisor's exceptional acumen, and (2) you might be providing incentive for the advisor to take exceptional risk with your money.
Personally, I believe there is a place for all of the above. I am a fee-only advisor (#3 above) but I think there are great advisors in all these channels.
Good question. I believe that paying based upon performance may pose the potential for conflict of interest. Let's use an example of someone who is deep into retirement and very risk averse. Let's assume that their portfolio is all in bonds. In today's low interest rate environment The yield on that portfolio would be about 2% or 3%. If an advisor was paid by performance the fee would be very low. There may be some advisors who would find themselves tempted to add stocks to the portfolio in an attempt to increase their compensation through higher long term expected returns. This shift would make the portfolio riskier than it should be for the client.
I agree with Evan. We charge a fee based upon the value we add for our clients through our advice regarding investments, but also in the areas of tax, insurance, estate, etc.
There are several good answers here. I would like to add a couple of comments.
-being paid a percentage of assets is performance based when you think about it, the more the assets grow over the long run, the Advisor and client benefit, if the assets decline then they get paid less. In that way there interests are aligned in seeking competitive long-term performance.
-another issue with performance based fee arrangements I have seen is that if the portfolio under-performs its benchmark, the manager gets paid some minimum fee. If the manager outperforms the performance fee is usually higher than a typical advisory fee. If we are talking about the stock market, and one assumes that the market is going up at say, and annualized rate of 10% per year (like large cap stocks since 1926), the performance fee can be higher than than a basic percentage of asset fee.
The only advisors that get paid on performance are hedge fund managers. They charge a 2% management fee and share in 20% of the profits.