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.