Posted: May 15, 2009
Investing lessons from “The Godfather”
Understanding money manager motivationsStephen Mauzy
Don Corleone's “I'm gonna make him an offer he can't refuse” is the most memorable line from the 1972 movie "The Godfather," but it's not the most perceptive; that distinction is reserved for Corleone's retort to Virgil Sollozzo when asked to invest in a potentially lucrative heroin business: “Why do you come to me? Why do I deserve this generosity?”
It’s inspiring in both its candor and skepticism (and if you remember, Corleone refused the solicitation), and it's the first question that should spring to mind when someone suggests an investment, a business proposition, a sale – any scheme that involves your money.
Too many of us fail to ask “why me?” Perhaps we are ruled by the need to believe we are unique. Perhaps we lack the confidence to vet the offer, likening the process to grilling a doctor about the intricacy of removing that cerebral cortex aneurysm from our brain. It's too complicated, and we lack the confidence to do it intelligently. Do it anyway! It's important to understand any medical procedure, but it's even more important to understand the motives of any money manager. The doctor can only kill you, but the money manager can leave you destitute.
You won't need to vet too deeply before you'll understand that self-interest is the money manager's driving motive. All money managers, be it mutual funds, hedge funds, private equity, investment banks, stockbrokers, financial advisors or whatever, are playing with other people's money. Their number one motive is to make money off the clients' money, and here's how.
First, the hedge fund industry. It markets itself with velvet-rope exclusivity through recondite black-box investing and high-minimum investment amounts, but it's a velvet rope that can just as easily be used as a hang-man's noose.
Then there's that odious fee structure, which disproportionately rewards hedge fund managers in good times, while disproportionately hurting their investors in bad times. The manager collects 2 percent of their money per year (which can go has high as 3.5 percent if itemized charges such as audits, account administration and trader bonuses are added) and 20 percent of their winnings from the comfort of a Greenwich, Conn. home office.
Now imagine slathering on another layer of expenses, courtesy of our good friend the fund-of-hedge-fund manger. His bailiwick is investing in either a portfolio of hedge funds or a highly acclaimed fund, such as Ascot Partners, which had all its $1.8 billion of assets under management invested with Bernie Madoff. Neither strategy is cheap. A 2002 fund-of-hedge-fund fee-structure study by UBS found the most common fund-of-fund fee structure is a management fee of 1 percent and an incentive fee of 10 percent, with virtually no hurdle rates.
The second most common structure was a 1 percent management fee and a 15 percent incentive fee, with a hurdle rate ranging from Treasury bills to S&P 500 returns. Heads the fund-of-fund manager wins, tails he really wins.
Motivations in the mutual fund industry are often equally at cross purposes with clients' motivations. Accumulating assets under management is the name of the game. The more assets, the more fees the mutual fund collects. But a large influx of capital causes administrative stress. The cost of coordinating the portfolio managers grows along with the complexity of overseeing a larger universe of stocks. But rare is the fund manager who can consistently beat the market.
Just 14 percent of active managers beat the market by a statistically significant margin in 1990, according to a 2006 study by economists Laurent Barras and Russell Wermers of the University of Maryland and Olivier Scaillet of the University of Geneva in Switzerland. By 2006 the figure had plunged to 0.6 percent after fees, thanks to the rising fees levied by mutual funds.
What about the professionals you intimately know? Are the motivations of the investment professionals whose calling is to hold your hand more selfless?
They should be. After all, anyone managing client accounts for profit is told by the state or the SEC to comport himself from "fiduciary duty," or the obligation to put his clients' interests first.
Color me skeptical, especially when examining the motives of the traditional stockbroker. Stockbrokers earn commissions peddling investments recommended by their brokerage's research and marketing departments. Fiduciary duty isn't the first term that comes to mind.
Brokerages, are, if anything, masters at developing commission-reaping investments. And few brokerages could out-commission Prudential Securities. Prudential was one of Wall Street's biggest peddlers of oil and gas and real estate limited partnerships – two of the hottest investments of the 1980s. Prudential peddled $8 billion worth of these illiquid, grossly expensive “investments.” Limited partnerships were veritable gold mines for Prudential and its brokers, who shared fees of 20 to 30 percent of the money raised. These partnerships were touted as high-return, steady income investments, comparable in safety to certificates of deposit.
Bad press has turned the word stockbroker into a pejorative. Marketing dictated that it be displaced by the gentler sobriquets financial planner and financial advisor. The so commissioned-based stockbroker has become the commissioned-based financial planner.
What's in a name? That which we call a turd by any other name would smell as noxious. The financial planner is still compensated by the investments he sells. The original motivation remains.
The fee-based model
One step up from the commission-based financial planner is the fee-based financial advisor, a combination of a traditional commission based financial planner and a fee-only financial advisor. The fee-based advisor might charge a flat percent of investment assets under management, say 1 percent. The fee-based advisor is also compensated for any investments he sells. If the advisor pushes a mutual fund with a 5-percent front load, the sales charge, then only 95 percent of the money is invested. Fee-based advisors push their services on the premise and convenience that the client isn't writing a check directly for the services, so it feels free. But it's only free in the sense cocktails are free when gambling at a Las Vegas casino.
The fee-only model comes closer to aligning the advisor's interest with the client's.
Clients pay for the services of a fee-only financial advisor in a number of ways, including hourly fees, yearly charges and fees for money management. The good news is fee-only advisors don't derive income from commissions on the products chosen for their clients, eliminating the conflicts of interest that can arise with commission-based financial professionals.
Performance-based models, a close off-shoot of the fee-based model, are gaining traction with more advisors. Under this scheme, advisors are galvanized to seek the best investment vehicles for their clients and constantly monitor capital growth and returns.
No conflicts of interest exist, so the argument goes, as advisors are forced to actively manage their clients' portfolios and treat clients' money as if it were their own because their pay is linked to clients' returns. Professional competency is putatively fostered through performance-based pay.
Proponents of performance-based models argue they are a superior alternative, limiting conflicts of interest while honing investing skills. Detractors note the obvious: The model encourages investing in risky assets or strategies in order to maximize possible returns. Proponents retort that if money is lost, advisors not only lose their pay from the clients but the clients as well. Detractors respond that reasoning hasn't stopped hedge-fund managers from risking and losing clients' money.
Always be skeptical like Don Corleone
I'm a detractor of most advisors, regardless of compensation model. I disdain the idea of handing money to someone else to manage. I'm paranoid. The advisor could have the best of intentions, but we all know where the best of intentions lead – Social Security, corn-based ethanol, Bernie Madoff and hell.
Keep your money under your purview; keep your money in your name and under your discretion. If you need advise, pay for it like you'd pay for services from any other professional, such as a doctor or a lawyer. Yes, it could easily cost $200 an hour for the professional's time, but it's worth it and $200-an-hour might just be a bargain.
Stephen Mauzy is a CFA charterholder, a financial writer and principal of S.P. Mauzy & Associates. He can be reached at firstname.lastname@example.org.