The world runs on incentives. Often, the challenge in investing is to figure out how to entrust your money with people whose incentives are aligned with your own.
Case in point, studies have identified high ownership by a fund’s managers as a main ingredient in the preponderance of funds that beat their benchmarks. It’s not that the managers of non-high ownership funds are not incentivized; they are taking career risk. Yet seemingly the subconscious power of personal gain makes a profound difference.
As an aside, this is why we charge fees (i.e. a % of assets under management) rather than commissions. By having our compensation tied to the value of our clients’ accounts, we are incentivized to have that value grow, which means we want to keep fund fees low, increase tax efficiency, and maintain a properly diversified portfolio. Advisors who work on commission (while they may have their clients’ best interests at heart) are incentivized to sell the products that pay higher commissions.
The opposite of aligned incentives is where “advice” primarily seeks to benefit the advisor. Case in point, the SEC’s case against Tobin Smith, a former long-time Fox News commentator and market analyst. In sum, a company paid Smith in cash and stock to promote it in hopes of raising its stock price. And Smith turned around and did just that on TV, calling the company “a perfect tech stock.”
Smith may have genuinely believed the company was a great investment. Nonetheless, by not disclosing his conflict of interest, he inhibited the audience’s ability to properly audit his recommendations. Without considering an advisor’s incentives, you simply cannot judge his advice.
