Date: Fri, 28 Jan 2005 04:07:09 CST
From: Joe Weinstein 
Subject: Re: How to better align an advisor's interests with their customer's
 interests?
Newsgroups: misc.invest.financial-plan
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Andy wrote:

> I agree with you that there needs to be a good way to align the
> advisor's interests with the clients.  However, I don't think your idea
> will fly.

No, not as baldly stated, but maybe there is something that can be built
from it with enough banging on it by a bevy of motivated intelligents.

> With equities, bonds, and mutual funds there is no capital gain (or
> loss) until you sell/withdraw, and I am not sure advisors are going to
> be willing to wait 20+ years to collect their percentage of the gains
> when an investment is liquidated. 

Well, there is precedent for brokers waiting for their money. Class
C shares typically spread out the payment to the broker, but there is
no reason why the agreement could not include periodic liquidation or
transfer of enough shares to pay the successful manager.

> Before the day the client cashes out
> of an investment all "gains" (other liquidated dividends and interest
> payments) are hypothetical and subject to change. 

True. One could agree that advisor payments would be quarterly or yearly,
whatever customer and advisor wanted, and be based on the gain since
the last payout. At any such time the customer would be as free as the
advisor to realize gains. Yearly would probably be better, to avoid
paying out on short term swings... I am not claiming anything workable
in detail, just that such a big-picture goal is doable in principle.

> The reason contingent fees work for lawyers is because the fee is not
> paid until the lawsuit is finalized and the payout is liquidated.
> Andy

And the same can work here. A yearly partial liquidation or transfer,
specifically to pay the winning manager. Let's say the agreement was
that a manager would get 25% of the gain, and a $20,000 portfolio
of 200 shares grew to $30,000. The manager gets $2,500's worth, about
17 of the fund shares.

There are more real-world issues that would complicate this idea...
For instance, one would have to quantify one's desired degree of
risk/volatility, and perhaps peg it to some broad market index, to
be able to judge whether a manager was overly risky in trying to make
gains. For instance, (and again this is a first hack at the idea),
I could say I want approximately the same volatility as the S&P
for my stocks. I could simply get this by buying an S&P index fund
and checking back in a year, so I would like to pay the manager 33%
of any gain *beyond what the S&P achieved* in the investment/payoff
period, but if he gets more risky than the S&P index, in some agreed-on
quantifiable way, and loses, he pays some penalty.

I'll bet the free market itself would naturally generate a better
arrangement if the relevant information was public. If the
average portfolio yearly gain vs. volatility exposure ratio was
published for every professional investment manager, competition
would hone the costs and performance of those folks. However, it
might also show that just like mutual fund managers, that unmanaged
index approaches beat active financial advisors too. Warren Buffett
said, "The market is a mechanism for the transfer of wealth from the
active to the patient"...

Joe