How to Better Align Money Managers With Their Clients

I believe my skills as an investor (along with most investors) will improve over time. Each year I learn about more companies, more industries, and a wide variety of topics that aren’t directly related to investing. That knowledge compounds over time. I am a far better investor than I was three years ago and I expect to be able to say that same thing at any point in time going forward. Thus, the below chart gives an idea of what my investing skills should look like over time.

investingskills.png

If I somehow managed a fixed amount of money over my entire life (say $1 million), I would expect my returns to slowly increase over time, maybe plateauing around 20% or something like that. But managing a stable amount of money isn’t realistic. The amount of money I manage will slowly increase over time as well (either by getting new clients or by growing my own net worth and current assets under management). Managing lots of money acts as an anchor on returns because the opportunity set becomes smaller when managing more money. An equally skilled investor will earn higher returns managing $1 million than another managing $10 billion. Thus, below is the chart showing return potential as AUM increases over time.

returnpotential.png

When you combine the increasing investing skills chart with the decreased return potential that comes from managing more money over time, the result looks like this:

combined.png

There should be an optimal point in a money manager’s life where their skills have evolved (but their AUM hasn’t become too large) and that is when their return potential will peak (in fancy terms, they will generate the most alpha). Theoretically, that would be the middle point on the above chart (which if of course not drawn to any scale, but you get the point). Before this midpoint, increasing investing skills results in increased returns, but beyond that point, increased investing knowledge isn’t enough to overcome the AUM anchor that drags down results.

A money manager who truly has his clients’ best interests at heart should want to close his doors before he gets to that optimal point (so somewhere on the left side of the chart) to let his current clients benefit for as long as possible from his increasing skills before the AUM anchor takes over. Unfortunately, two things make that uncommon.

  1. Optimistically, many managers don’t attract much capital until they start approaching that midpoint on the chart where their results are peaking. This means managers raise most of their money just as their best results are behind them.
  2. Pessimistically, some managers are greedy wannabe billionaires and will raise money until the day they die because they care about their own bank account more than anything else. If they can raise money way past the point of when they could generate alpha—all the better. Scraping 1-2% in management fees to follow the market doesn’t sound so bad.

So what’s the solution? Capping AUM is a good start, but it’s still impossible to know when that midpoint on the chart is. Can my current strategy scale to $50 million? $500 million? $5 billion? I highly doubt it’s the last number, but I don’t know. I’ve never managed that much money before so I can’t predict what that’s like. If I think $100 million is where my return potential starts to noticeably drop down, then I actually want to close my doors at maybe $50 million. This would ensure my clients at the time benefit from a long runway of good returns (in that goldilocks zone near the middle of the above chart). But still, this is a complete guess and probably something I would only know for sure in the rearview mirror. When a manager starts to feel the AUM anchor affecting their decisions and investments, they probably should have closed their doors three years ago.

Another solution is to scale down fees as AUM grows, which I think is fair to clients and aligns the manager’s incentives better. If a current client pays me 2% per year and then I go out and raise $100 million dollars next year, it’s really not fair for that client to keep paying me the same amount for worse service. In this case, worse service = lower return potential. That client’s returns get dragged down because I decided to bring in a large investor. As the return potential (i.e. expected value) of a money manager decreases, I think it’s only fair that clients pay less for that.

2 thoughts on “How to Better Align Money Managers With Their Clients

  1. How about structuring a partnership like Buffett. No fees and you are only paid with a share of profits above a long-term risk free rate.

    You are aligned with customers assuming you have most of your wealth in the fund. You eat your own cooking.

    INSTEAD, most HFs do 2 and 20%. Those days are over.

    Like

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