Alignment of Interests

Recently, someone argued to me it’s not good if your personal portfolio looks too different from what you recommend to clients as a financial advisor. Generally, I disagree. However, there are certainly limits. If you are selling your ability to “pick winners” to clients and your portfolio is all index funds, for example, that is a problem.

If I am acting as a fiduciary, I am to act in clients’ best interests. Most clients will look nothing at all like me in terms of their goals, financial circumstances, risk tolerance and level of financial sophistication.

The biggest difference between me and a client would probably be our relative tolerance for tracking error. That is, our tolerance for investment performance that is very different from the broad market indices and our neighbors, who are inclined to chase momentum and do stupid things like borrow money to buy Bitcoin at the top.

Everyone wants to be +20 when the market is +10, or breaking even when the market is -10. No one likes being -5 when the market is +5.

Oddly, the pain of being -5 when the market is +5 seems more acute for clients than being -10 when the market is -10. For the client, the right thing to do is minimize tracking error and the pain of relative underperformance to make it easier for him to stick to his asset allocation and financial plan more generally.

What is more important than the optics of my portfolio is the alignment of interests in the advisor-client relationship. My financial incentives should be structured such that I am at all times incentivized to make decisions in my clients’ best interest.

Two And Twenty

Some people claim the hedge fund two and twenty (that is, a two percent management fee and twenty percent of profits) fee structure aligns the managers with their clients. This, too, is nonsense. It is a totally asymmetric payoff for the manager. The manager suffers nothing if performance is poor. The compensation structure is a free option that encourages excessive risk taking. That’s why it’s extra important for hedge fund managers to be personally invested in their funds and “eat their own cooking.” It creates symmetry in the incentive structure.

A financial advisor is not a hedge fund manager.

A hedge fund manager should be entirely focused on investment performance (here I am including risk management under the umbrella of performance). For a financial advisor, investment performance is at least two or three lines down the list, well below things like cash flow management and asset allocation. If a client is not generating free cash flow even Buffett’s returns won’t save him. Likewise, a client who is inclined to whipsaw herself to death trying to time the market will not benefit from clever security selection.

Increasing clients’ saving rates and dissuading clients from market timing have nothing whatsoever to do with the composition of the advisor’s investment portfolio.

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