In Part I and Part II, I looked at some money manager characteristics beyond performance that should result in an overall positive client experience, and used Warren Buffett as the classic example. In Part III, I conclude my thought experiment with three final characteristics.
Buffett is diversified, but not over-diversified. He has most of his money in his top 10 ideas, but these ideas are in different industries and have different strengths and weaknesses. One besetting problem a lot of people have is that they select too many managers, or that they have managers who own far too many things. If you want to be highly diversified, you shouldn’t select a money manager at all, you should own index funds or index ETFs.
Another advantage Buffett has is that he is low cost. He pays himself $100,000 a year and builds his wealth through investing alongside you. Money manager fees are a big deal, especially where you pay a high annual fee and a performance fee on the positive returns. In my opinion, it is virtually impossible over any long period of time for a money manager to add value with a 2% base fee and 20% performance fee with no hurdle. It is a great thing for the money manager who can expropriate huge amounts of client money and get rich very fast if some risky or leveraged bets work out for him, but it is not a good situation for the client.
Lots of managers worsen an already egregious situation by allowing so-called “resets” on their performance fees. This means that they can start the clock over again after some period of time, and you can find yourself paying a “performance fee” even when they have lost you money longer term. That is an outrageous practice that should not be allowed. A reputable money manager should always have a permanent high water mark for performance fees so that situation cannot arise. They should also have a hurdle rate so that some substantial amount of money would have to be made in any given year before the performance fees kicked in.
So, our next rule will be: pay attention to your fees. As your annual fees go past 2% of assets, your chances of making value-added returns fall dramatically. If you give the manager a fee schedule that rewards him lavishly on the upside and leaves you all the downside, your long-term returns will almost certainly be disappointing.
Another great thing about Buffett is that he is tax efficient. If you never sold your Berkshire stock, you never paid any capital gains taxes. Even if he had been structured like a traditional pooled fund, the taxes would have been very low because of his buy-and-hold strategy.
For investing taxable family wealth, taxes can be a very heavy cost. Hyperactive money managers can generate a lot of capital gains income in a bull market so that your after-tax returns are actually pretty low. Beware of managers who turn over their portfolios at a high rate – they are probably charlatans anyway.
Here’s a complete recap of my criteria for a manager who has set himself up to give clients a good experience beyond the returns:
- The manager has most of his net worth aligned with you through direct investment in the same products in which you are investing. He takes the same risks you do and receives the same rewards.
- The manager has a simple and effective investment approach which he explains to you in clear and understandable terms. You know what he is doing with your money.
- You can see what your money is invested in, and you understand the investments. The manager admits and explains mistakes.
- The manager has a good record of protecting the downside in poor markets and a proven ability to capitalize on opportunities at these times.
- The manager is diversified, but not over-diversified. If you want broad diversification, consider index strategies.
- The manager’s fees are reasonable and he can demonstrate that he has added value well in excess of the fee. Make sure he is not taking a big chunk of the upside and leaving you all the downside.
- Make sure the manager is not generating excessive taxes.
If your manager combines all of these characteristics, I believe you will protect yourself against some of the most frustrating and frightening aspects of dealings with money managers. The alignment, simplicity and transparency will protect you against fraud and error; downside protection and adequate diversification will ensure that your losses are reversible; reasonable fees with symmetrical rewards and tax efficiency will ensure that the lion’s share of the value added ends up in your pocket rather than that of the money manager or the government.
Best of all, you will have the basis for a fruitful long-term relationship, and you won’t find yourself doing a manager search every five years.