How to Pick a Money Manager
from
September/October 2006
by John J. Curran
You’re bright, successful, and quite good at dispensing advice to others—which is why you’re on a board. But when it comes to your personal wealth, are your talents as keen?
Probably not, which explains the booming industry of wealth managers who are out there to help you. But their broad array of offerings—and marketing blitz—can leave you more confused than enlightened. Whether you’re an accomplished, self-directed type or want to hand off your portfolio to a “we’ll take care of it” manager, you need more to go on than a company’s literature, slick television ads, or even a colleague’s recommendation.
Fortunately, ethics among investment firms are a bit less chancy than they once were, thanks to beefed-up compliance departments and a newly watchful Securities and Exchange Commission. But all this doesn’t guarantee a fair shake. That can only come from a goodly amount of homework on your part.
What’s available today from money-management firms is exciting in many respects, with newly expanded investment menus offering commodities, real estate, private equity, and hedge funds of many stripes. Then there are the in-vogue financial-planning tools such as the so-called Monte Carlo analysis, which runs your portfolio through hundreds of thousands of possible scenarios to deliver a comprehensive assessment of your prospects. Higher up the financial-jargon ladder is portable alpha, a complex way to isolate a manager’s ability to deliver returns that are exceptional.
If you’ve been in business your whole life, you’re not likely to be too impressed by jargon, even if it’s Greek. What you do like, though, is buying a product or service that delivers value. This is nearly impossible to achieve when you’re paying up to 3% of your portfolio every year in fees, as some wrap-account managers would have you do (they “wrap” their advisory fee around the fund manager’s fee). Yet even in the realm of reasonable fee structures you’ll find a dizzying array of compensation arrangements, many with breakpoints (the percentage the adviser takes goes lower the more money you invest), profit-sharing programs, and even loyalty points, which resemble frequent-flier miles.
The key to surviving in the maze is this: Know your annual all-in cost in dollars and as a percentage of assets. That can be tricky if you have performance-contingent fees, as most hedge funds do. Even if you have to go back and recalculate the fees you paid six months after year’s end, do it. And as you grapple with that unfriendly paperwork, keep this in mind: On the other side of the money-management curtain is a hardworking team of M.B.A.’s coming up with ingenious new ways to extract more revenue from your account. Ignore them at your peril.
A difference of a percentage point or two in annual costs may not matter much when you’re logging 20% annual returns, but in the current environment, where most agree that the annual return will average around 6% to 8%, a one-percentage-point difference in fees can dramatically affect your portfolio’s long-term growth. Consider: For a $10 million portfolio managed over 15 years, the difference between a 5% return and a 6% return is $3.2 million. Are you really willing to kiss off that extra percentage point?
The other reason to stress fees is that they are known. Future performance is not. A soup-to-nuts annual fee should not exceed 1.5% of your portfolio each year. You can do it for less, provided you have enough invested. Vanguard, for example, will manage $5 million for roughly 0.55% of assets, or about $28,000 annually. And a new report from Cerulli Associates, a financial-services market-research firm in Boston, notes that larger accounts—$25 million and up—can now get bare-bones asset-management fees as low as 0.2%. If you’re paying closer to the top end of the fee range, you should be doing so only if you are receiving some valuable services, such as high-powered tax consulting and filing, estate planning, or useful philanthropic guidance.
Further, a 1.5% fee ceiling doesn’t mean that your financial adviser gets 1.5% and the money managers he or she puts you with take another fee—it means 1.5% for them to share. If you’re talking serious money, and surveys indicating that our average reader’s net worth is $12.6 million suggest that you are, expect to lower that fee to less than 1% without sacrificing service. Bessemer Trust, which manages large sums ($10 million and up) and dispenses personalized advice on related issues like charitable giving and estate planning, averages about 0.8% with its clients, according to senior managing director Robert Elliott. “We charge 1% on the first ten million and 0.75% on the next ten,” he says. That covers a broad range of services, from dealing with a CEO’s concentrated stock position to advising on trusts. But, says Elliott, there are some things that aren’t included, such as the fees associated with hedge fund investments or drawing up legal documents to establish trusts.
The good news on fees is that the wealth-management business has lately become more competitive and your ability to negotiate is stronger than ever, especially if you don’t use all the services for which you are paying. “There’s a trend toward unbundling of fees,” says Benjamin Poor, a senior analyst at Cerulli. “Many high-net-worth clients have their own attorney, their own accountant, so they really don’t avail themselves of the full range of services.” This means that all those extras—the tax filing, legal services, philanthropy guidance, and, yes, even dog-walking—if not of value to you, should be put on the table.
Before you do any negotiating over fees, take a moment to read Warren Buffett’s letter to shareholders in the 2005 Berkshire Hathaway annual report (BerkshireHathaway.com). On page 19 (of the PDF file) he sets forth the real cost of financial “help” with a biting tale about the fictional Gotrocks family, which is overly served by the investment community. Buffett’s bottom line is that individual American investors, large and small, are getting clipped by too many layers of pricey advice. At the very least, it will put you in the right frame of mind for a fee negotiation.
The first thing a professional money manager can bring to your portfolio is an objective eye on diversification. If you don’t spread your wealth widely enough, you’re shortchanging yourself. Reason: Your concentrated positions are probably exposing you to more risk—that is, volatility—than the returns you’re getting justify. You may feel that your portfolio is of sufficient size to weather any storm, but that might be because you’ve never tasted the market’s worst. If you were heavily invested in NASDAQ when it took a 39% plunge in 2000 (and another 46% over the following two years), you know the real meaning of the V-word—getting knocked down so badly that it takes you years or decades to get back to where you were.
Most money managers and advisers not only have the software and expertise to guide you to a savvy diversification but also bring the added benefit of regular reviews—an important service, since market movements like NASDAQ’s 86% rise in 1999, or the charging bull in emerging markets over the last few years, can quickly turn a balanced portfolio into one flashing “Tilt!” Consistent diversification can’t do away completely with risk, but it can smooth the growth of your portfolio without an offsetting reduction in return. That incremental boost to risk-adjusted performance may sound a bit theoretical, but it is a compelling reason to use professional money management, because it improves the prospect that you will reach your goals.
It’s common for Wall Street firms to have legions of securities analysts scrutinizing individual stocks; what is of more value to most wealthy individuals is a company that has such teams devoted to maximizing the benefits of diversification or improving after-tax returns—things that truly affect personal wealth. You can often gauge a firm’s relative strength in these departments by the quality of its literature, its white papers, and ultimately its financial advisers. For example, does the financial adviser have a detailed, statistically validated justification (long-term returns, intermarket correlations, and the like) explaining why he or she recommends 25% international exposure instead of a number that is higher or lower? The response can often tell you whether you’re dealing with a true investment adviser or a conservatively dressed salesperson.
The expanded menu of offerings available to high-net-worth investors today, from private equity to commodity funds, is part of a big push by Wall Street to bring institutional offerings to individuals. Many firms have new departments dedicated to “alternative investment products,” in which they research and package such nontraditional offerings. It’s sophisticated, it’s cutting-edge, and it raises the question: Do I really need all this stuff?
To be sure, there is truth in the idea that you’ll benefit from portfolio exposure to more than just U.S. stocks. Different stock sectors may make you feel diversified, but they have a fairly high correlation; if one tanks, another is likely to sag as well. Real estate offers a lower correlation, so it has become a popular addition to high-net-worth strategies, particularly since real estate investment trusts (REITs) trade on stock exchanges, offering the same liquidity as stocks. Indeed, a study performed by Bernstein Investment Research & Management, a division of AllianceBernstein LP in New York City, compared the growth and volatility of an all-stock portfolio with one that was spread widely, with 55% in stocks, 35% in bonds, and 10% in REITs. It found that over the 20 years from 1981 to 2001, the diversified portfolio was far less volatile than the all-stock portfolio, yet had a similar return.
Commodities like gold, oil, and soybeans also tend to lower overall portfolio volatility, but there’s some concern that the lack of growth (a gold bar doesn’t throw off cash, nor grow into two gold bars) greatly limits the long-term contribution to return. Says Steve Wood, a portfolio strategist at Russell Investment Group in Tacoma, Washington: “I really don’t consider it a bona fide asset class.” Hedge funds, all the rage in recent years, are another alternative, although their steep fees and paltry returns of late have cast doubt on their benefits too (see the box on page 57).
Few outfits do more work on the challenges facing high-net-worth individuals than the wealth-management team at Bernstein. The firm is a veritable university on the subject of wealth management, and it goes to great lengths to educate its clients. The better-known Wall Street corporations like Goldman Sachs and Merrill Lynch also have deep talent benches and far-reaching capabilities, from credit facilities to trust and estate planning. But at such sprawling organizations, it ultimately comes down to the quality of the company’s individual representative. Notes Alyssa Moeder, a private wealth manager at Merrill’s Private Banking and Investment Group, which handles clients with more than $10 million to invest: “Our job is to provide the level of service of a boutique and the resources of one of the largest financial firms in the world.”
The finances of clients in this league are usually complex, with multiple homes, multiple custodians, a labyrinth of trusts, maybe even a leased jet. Coordinating those assets takes expensive technologies, plus a softer touch. “There is a lot of concern among the ultra-high-net-worth clients about instilling the right values in their children, of not leaving all the money to them without the right guidance. It’s far more complex than just setting up a trust,” Moeder says. Concurs Robert Elliott of Bessemer, a firm that also tends to the $10 million-plus crowd: “CEOs will often be so focused on their business that they fail to develop an investment plan. They may just have an odd mix of hedge funds and the like that their friends sent them into. It’s a considerable effort to put that right.”
Between $5 million and $10 million in assets is the client territory most coveted by regional brokers and independent financial advisers. Here clients’ lives are still relatively simple, but there is a need for value-added investment insight and personalized service. Supporting financial advisers like those from AG Edwards or Raymond James are investment think tanks like Russell Investment Group. Russell, which got its start decades ago advising pension funds, doesn’t deal with individuals directly but instead works with client firms’ financial advisers, helping to identify the most talented money managers and pooling client assets to get the lowest fees. If you are considering a regional or independent broker, you should know what kind of intellectual firepower is behind it.
In the $1 million to $5 million bracket, clients come with a different set of anxieties, says Gail Graham, senior vice president of Fidelity’s Private Access service, which caters to this group: “At that asset point, people are primarily concerned about the risk that their money will run out, and secondly that brokerage fees will quietly eat away at their wealth.” There’s nothing irrational about those worries. Clients at this level are most acutely in need of achieving the highest return, but they have significantly less bargaining power over fees; standard discounts, or breakpoints, generally apply to their commissions. That’s no problem for knowledgeable do-it-yourselfers, who now have an ever-improving list of Web-based tools, thanks to heavy investments in technology by the large financial houses. Fidelity, for example, offers sophisticated income-planning tools, even the ability to build a staggered bond portfolio that will automatically generate e-mails when bonds are maturing. “While most firms focus on hand-holding, we focus on technology and tools,” Graham says. Fidelity also offers Private Access clients a flat $8 commission on stock trades. Once a client’s account surpasses $5 million in portfolio assets, Fidelity will typically refer him or her to an outside financial adviser.
In the realm of investing, one word both excites and motivates the professional. The word is “alpha,” which refers to the excess return that is earned beyond the market, the excess that points to true stock-picking talent. Indeed, the reason clients choose active money management over a dirt-cheap index fund is the prospect of achieving alpha.
But there are some reality checks against this notion. Alpha isn’t just the professional’s Holy Grail; it is what every money manager promises but very few can deliver. David Hsieh, a professor of finance at the Fuqua School of Business at Duke University, for example, recently presented a research finding that there is roughly $30 billion of alpha available in the market each year—think of it as exploitable market inefficiencies. Given that $85 trillion is invested in funds worldwide, that’s a tiny piece of excess return to spread among the hopeful masses. If you’re still optimistic, take a gander at the hedge fund returns of the past few years (see the chart on page 57), which more closely resemble the return you would get from supersafe bonds as opposed to a high-risk, highly illiquid investment, which is what hedge funds are.
As Leslie Ainslie, manager of the Maverick Capital hedge fund, with $10 billion in assets, recently opined in a Q&A with McKinsey & Co., “If you look at the pricing of all assets, financial and real, one could argue that there is simply too much liquidity chasing too little return.” That is, dwindling alpha isn’t a bad cloud passing overhead; it’s the direct result of money flows from institutions and high-net-worth individuals who, guided by advisers, have funnelled massive sums into the most successful money managers and strategies.
With financial markets tamed, alpha dwindling, and competition for your money heating up, it seems likely that your best way to boost returns is to find good management and negotiate reasonable fees. Of course, after all is said and done you may be happy with your current money manager for reasons that have nothing to do with his or her financial insights or low fees. Perhaps your adviser is among your best friends, or you’re in one of those programs that reward you with loyalty points for your business, which can be redeemed for things like a flight in a combat jet or a pseudo state dinner served by a former White House chef. These are quality-of-life perks that may overwhelm financial considerations in your mind. If so, enjoy them fully. But also set aside time each year to tally your returns—and your fees—so you can put a dollar figure on those intangibles and see how you’re really faring. Maybe after that, you’ll hire your own chef and get a new money manager.
