Stewardship and the Commercial Imperative

“Show me the incentive and I will show you the outcome.”¹

If we could internalize this quote, we’d go a long way to understanding the behavior of others. Turns out it’s a tall order, even for someone like Charlie Munger (to whom the quote is attributed) who spent much of his career studying the topic:

“Well, I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther.”²

Understanding the power of incentives may be a tall order but it offers wisdom to those willing to make the effort.

Consider incentives in the financial world. The problem with commissions is easy enough to spot, but there’s a lot more going on under the surface. For example, RIAs love to tout their fiduciary responsibility – the legal obligation to put investor interests first. Yet the industry standard fee model is “assets under management” (or AUM).  That’s a good thing, RIAs say, because it means that when you do well (the value of your account grows), they do well (the dollar amount of the fee increases). Interests are aligned!

What RIAs don’t tell you is how this fee model also incentivizes asset gathering. Adding more AUM becomes the overriding objective, the holy grail. Anything that increases AUM is good and anything that jeopardizes AUM is bad.

But this dynamic can put RIAs at odds with their clients.  Here are 2 examples:

1. A business owner takes a distribution from their business…we’ve offered this scenario many times as an example of the AUM problem in action including here

2. Overvalued stock market

But why would an overvalued stock market be a problem? The answer is incentives. AKA career risk. AKA if you don’t keep up with the crowd you get fired. Jeremy Grantham, co-founder of investment firm GMO, described this dynamic recently in reflecting on GMO’s experience³ in the wake of the tech bubble/bust of the late 1990s/early 2000s:

“…and I started to ask the question, what was going on? What was the meta-message? And the meta-message is, if you're a big company, you can't fight a major bull market. It's ridiculous. It's terrible business. You have to roll with the punch. Try and be more persuasive on the way down and up, and get back in quicker, get out faster on the way down. Just execute and talk a good game, and you will not be in any serious danger. But if you fight a bull market, you better expect to lose tons of business. You will never hear a Goldman Sachs or a JP Morgan, tell you to get out of the market because it's ludicrously overpriced. Everybody knows today it's ludicrously overpriced, but no one can tell you, and they never will. I completely get that.”⁴

[As an aside, Grantham went on to say that this is one area where independent investment firms and individuals have an advantage – they can avoid overpriced stock markets because they don’t have to fight the commercial imperative.]

So how could we solve this problem? Are there better incentives that improve alignment of interest with clients?

I think it depends. It’s not obvious that there are better fee models per se - every alternative has pros and cons. But there are two key things to consider that can help someone identify the right people and the right fee model for them:

A. What are my needs?

B. If I’m going to engage an investment manager or advisor/consultant, can I find indicators of stewardship…is stewardship clearly baked into the DNA of the organization?

As to needs, here’s an example: we serve business owners, and we use a fixed fee model to do that because we think it is best suited to the needs (diverse, frequently changing, with a strong need for integration) of that audience. That may not be the best fee model for someone with simpler needs.

What about stewardship? Well, for investment managers, strong stewardship might include caring more about performance than fees; due consideration given to AUM capacity and a demonstrated willingness to close strategies if AUM gets too high; and the discipline to avoid stocks if and when the manager’s process says they should be avoided. You want someone who is aiming for the returns hall of fame – not the assets under management hall of fame.

For advisors and consultants, strong stewardship might be caring more about long-term relationships than short-term fees; diligently running down client priorities (not just the things that are easy for the advisor); and a willingness to avoid what’s popular if the advisors’ process says those assets should be avoided.

Understand incentives. And verify behavior. Then you’ll have a pretty good idea about what to expect from your financial professionals.

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1. https://fs.blog/bias-incentives-reinforcement/

2. Ibid.

3. GMO refused to buy the dot com and technology darlings of the day and, as clients grew increasingly frustrated and pulled their money, the firm’s AUM declined materially between 1995 and 1999 at a time when most investment firms reported large gains in AUM, according to Grantham⁴.

4. https://www.capitalallocators.com/podcast/bubbles-value-investing-and-the-long-game-at-gmo/

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