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Investment advisers managing portfolios typically receive a flat fee. Maybe they charge 1% of the assets, which provides incentive for the adviser. One percent of $150,000 is nice, but one percent of $200,000 is even nicer. So, the percentage stays flat, and the adviser’s compensation only grows if the customer’s assets grow.
Some advisers would prefer to take a share of the paper gains or the profits made from trading the account. Every time the adviser buys at $10 and sells at $18, the adviser gets a piece of that capital gain. What about the rest of the stocks?
That is the problem. If a client were to pay an adviser with a share of capital gains, the adviser could make a profit on one lucky stock pick even if the rest of the account goes down to zero. Say a client invested $100,000 with an investment adviser who said they were not going to charge any ongoing fees. Rather, they would just take half of any “trading profits.”
Let’s say the investment adviser puts the client into 10 stocks with $10,000 invested in each. One stock goes up from $10,000 to $18,000, and the adviser sells it for an 80% profit. The client makes a short-term capital gain of $8,000, and the adviser takes $4,000.
Now, the adviser tells the client to be patient, just wait until those 9 other stocks go up. Only, they never do. The account drops from $90,000 to $60,000 in a hurry, then slowly drifts down to $36,000, at which point the client tells the adviser to sell everything and send a check for what’s left.
So, how did the client do in this case? After putting down $100,000 the client is left with $36,000 plus a pre-tax profit of just $8,000. How did the adviser do? They made a fast profit of $4,000 with no risk to the firm.
Ouch. Or, maybe dependable, blue-chip stocks are suitable for a client’s portfolio. Unfortunately, if the investment adviser is paid on a share of capital gains/appreciation, why bother with the slow-and-steady stocks that might not go anywhere for a while? Regardless of the client’s risk tolerance, why not pick 20 of the most speculative stocks trading through the non-NASDA OTC?
Offering to share the gains or capital appreciation with an investment adviser entices the adviser to take on bigger risks and often puts the adviser’s interests in conflict with those of the client.
That is why advisers cannot be compensated as a share of capital gains or “paper gains” as a general rule. Advisers managing a portfolio, typically, are compensated as a percentage of assets over a specified period.
The Uniform Securities Act then clarifies that this rule, “does not prohibit an investment advisory contract which provides for compensation based upon the total value of a fund averaged over a definite period, or as of definite dates or taken as of a definite date.” That means that while an adviser cannot share the gains on individual stocks or take a percentage of the amount that the account “went up,” the firm can bill the client based on the average account balance over a certain period or bill a percentage of assets as of, say, the end of each financial quarter, or on the last day the market is open for the calendar year.
As we said, this is the general rule for compensation. However, if the adviser has a contract with a qualified client, performance-based compensation is allowed. A qualified client includes certain institutional clients and individuals with either $2 million of net worth (excluding the value/equity of the primary residence) or—more typically—at least $1 million of assets under the adviser’s management. Advisers to mutual and pension fund portfolios typically earn performance bonuses based on matching or beating an index that represents the portfolio’s makeup.
So, although performance-based compensation, or compensation based on the capital gains/appreciation of the account, are generally not allowed, the Uniform Securities Act includes the caveat, “Except as may be permitted by rule or order of the Administrator.”