Incremental Value (Part 4)

I’ve been discussing the incremental value I would provide to an investment adviser (IA) as a result of outperformance.

The numbers get more interesting if I am able to outperform by 3%. Last time I discussed the incremental value (in terms of the 0.8% management fee) were I to return 7% or 8% (11% or 12%) rather than 6% (10%). If I were able to return 9% or 13%, though, then my incremental value over 25 years would be $102K or $196K, respectively. While still apparently low, my average management fee has now increased to 0.11%.

At some level of outperformance, I feel the management fee should be increased. From the perspective of trading as a business, annual losses are anathema. In the event this accompanies improvement over the benchmark drawdown, I still feel payment should be postponed until a new highwater mark is established. The caveat, as mentioned in Part 1, is that only qualified investors* can be charged performance fees per SEC rules.

Whether clients pay performance fees is up to the IA but I feel it’s fair for me to be paid more as a trader. This goes back to my Part 2 mention of getting more than 50% of the incremental fees. Number and size (AUM) of client referrals may always be proportional to relative performance. Although hard to definitively measure, the value of this may be significant.

It has gone without saying that some benchmark for performance comparison would have to be agreed upon before any of this is finalized. I would also make a case for risk-adjusted returns. Clients who sleep easier at night will be happier than those who are more stressed and fearful. This can be measured by Sharpe [Sortino] Ratio or volatility of monthly returns. As discussed above, I strongly believe this has value albeit difficult to make tangible. One never knows when new referrals might be the direct result of a happier, stress-free clients. One also never knows when a more linear equity curve might directly result in the decision to remain invested during a market correction that would otherwise have sent them screaming for the exits to lock in large losses. These are two extremely valuable possibilities.

If I had 25 million-dollar clients then I would be earning $29K/$63K/$102K or $55K/$120K/$196K per year for relative outperformance beyond 6% or 10%, respectively. While I would not expect to manage $25M immediately upon hire, contemplating numbers like these makes a trading gig more enticing—especially if the IA can persuade me that more assets are available contingent upon solid performance.

What I’m talking about is doing exactly what I do now—executing a trading strategy in which I strongly believe—with 26 accounts rather than just my own and having a good chance of being paid [well] over $50K per year for my efforts.** I could probably get on board with something like this.


* Qualified investors have a net worth, excluding primary residence, of at least $1 million or an annual [spousal combined]
   income of at least $200K [$300K].

** All calculations taken from “IA(R) fees and earnings (hypothetical) (10-12-17).”

Incremental Value (Part 3)

Last time I presented some initial calculations to determine the incremental value I might provide to an investment adviser (IA) as a result of trading outperformance.

To isolate the impact of outperformance, I reran the analysis assuming 10% (rather than 6%) annual returns without me and 11% or 12% (rather than 7% or 8%) returns with me. Invested as previously described, $1M now becomes $8.86M, $11.11M, or $13.91M, respectively, over 25 years. The incremental value to the IA is now $110K or $240K for 11% or 12%. In splitting the difference I would earn $55K or $120K over that time.

Interestingly (to me), although outperformance is important, absolute performance plays a more significant role. Outperformance is identical on a gross basis in both simulations (1-2%). On a percentage basis, 7% or 8% vs. 6% is a 16% or 33% increase whereas 11% or 12% vs. 10% is a 10% or 20% increase. The significantly larger percentage increase is accompanied by a roughly equal ratio of incremental value share [($63K / $29K) = 2.18 ~ 2.17 = ($120K / $55K)] whereas the incremental value itself is almost double that for the 10%-12% versus the 6%-8% scenario.*

Note a similarity in calculated numbers for my share. I would earn $63K (over 25 years) by returning 8% instead of 6%; I would earn $55K by returning 11% instead of 10%. I would prefer a conservative estimate and project 2% outperformance over 11% returns. I can comfortably imagine annual returns of 11%, though. I will also do quite well when the overall market is moving moderately higher. While I will [profit but] underperform when the market is screaming higher, history has not presented many such episodes (e.g. second week of March 2009 onward and following the 2016 presidential election). I almost want to say that I can comfortably imagine 2% outperformance and 11% returns per year.

Past performance is no guarantee of future results. Time, as always, will tell.

I think outperformance would provide more value to an IA than higher absolute returns. It’s great if the IA makes 13% one year unless the benchmark returns 14%. One case where I think outperformance might not be good would be when the IA loses money for clients. Being down less than the benchmark is a marketable accomplishment, but clients may still be upset. Hopefully a conversation about the importance of minimizing drawdowns would correct their perception.

Next time I will talk more about my cut.

* If you are someone who spends modest time doing daily computation then you might be laughing at me just now for a failure to recognize basic arithmetic properties. Admittedly, I am a bit rusty with the mathematical proofs but believe you me, I still crunch numbers quite well!

Incremental Value (Part 2)

The time has arrived to break out the spreadsheets and start dissecting exactly how much I might earn as an investment adviser (IA) representative trading AUM.

I need to begin with some assumptions. Suppose the IA charges an annual management fee of 0.8%, which is assessed at the beginning of every year. As a conservative projection, let’s also assume the IA generates annual investment returns of 6%. A $1M account would therefore grow to $3.51M in 25 years.

Upon joining the IA, what if I were able to generate 7% or 8% per year?

Instead of $3.51M in 25 years, the account would now grow to $4.44M or $5.60M, respectively. That’s a significant boon for the client! This also brings incremental value to the IA in terms of management fees: an additional $58K or $126K, respectively, over 25 years. If I were to split that incremental value with the IA then I would make $29K or $63K with disproportionately more being earned as the years go by.

Keeping in mind that this trading gig must also be worthwhile to me, from a monetary standpoint I see some things not to like. First, my cut of the management fee ranges from 0.01% to 0.08% (or 0.14%). This seems minuscule. Second, that “incremental” detail is a killer. While I could make $29K or $63K over 25 years, if the client leaves the firm earlier then I will be effectively starting over with someone new. This feels like a mortgage where significant equity doesn’t start to build until later in the term. Although the incremental approach would keep me motivated to do well, I would rather be paid the average annual fee of 0.04% (or 0.07%). Besides, I don’t believe my history suggests a need for any additional motivation.

I could make a case for keeping all the incremental fees from my trading outperformance. The IA would benefit by earning more in fees as a result of my employment. My potential reward needs to be large enough for me to take on the challenge, though. If all the incremental fees went to me then it might represent a more acceptable wage (still small at an average of 0.08% or 0.14% over the 25 years) and a much happier client. That could lead to a larger book of business for the IA.

For now, in the spirit of keeping positive I think the bottom line is that I would make some money as a representative without having to do many of the back-office tasks required to launch my own IA. I wouldn’t have to file all the paperwork, come up with Form ADV, have legal work done, establish a new entity, hire a compliance team, deal with E/O insurance, cover all the overhead, or be forced to raise assets—the latter, especially, being no small feat.

Incremental Value (Part 1)

In contemplating transition from personal trading to wealth management as an investment advisor (IA) representative, I have struggled with fee structure. Thankfully the incremental value I bring to client accounts may buffer my cut as an intermediary.

What can I charge that is fair to the client and worthwhile to both myself and an IA that I represent?

In my opinion, “fair to the client” implies fees proportional to performance.* Consider this: if average annual hedge fund returns since 1970 are 12% while US equities have averaged 10% (approximations based on data from Bloomberg and Barclay Hedge) then does it make sense for the former to charge 2/20 (management/performance percentage fees) when the latter usually incurs a 1% management fee or less? I believe standard deviation is a second essential performance component and I would therefore be interested in comparing risk-adjusted returns. However, starting out with such a narrow edge in absolute return makes me skeptical that hedge funds will be able to justify a fee structure so extreme in comparison.

“Worthwhile to me” means my benefit must at least equal the cost. Working as an IA representative would require me to meet and speak with clients and with the IA, to be accountable to the IA, and perhaps to regularly commute to an office outside the home. These are big sacrifices to make especially when family is involved; much flexibility in my life would be lost. On the flip side, I would be associating [and hopefully collaborating] with co-workers and clients rather than operating in solitary confinement all day long. I would also be paid wages.

“Worthwhile to the IA” means the incremental value I provide is sufficient because a portion of IA revenue (management fee) would be redirected to me.

My initial thinking about the last two paragraphs was somewhat disappointing. I recently read about an IA charging 0.80% annually on the first $1M of assets under management. Thinking minimally, if I wanted to be paid anything more than 0.80% then the IA would be losing money to have me around!

Hope springs eternal when I consider the possibility of outperformance. Wouldn’t 11% annually be the same historical equity return mentioned above plus my 1% management fee or am I blinded by confirmation bias?

I will break out the spreadsheets next time.

* Per SEC rules, only qualified investors can be charged performance fees.