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Incremental Value (Part 4)

I’ve been discussing the incremental value I would provide to an investment adviser (IA) as a result of outperformance.

The numbers get more interesting if I am able to outperform by 3%. Last time I discussed the incremental value (in terms of the 0.8% management fee) were I to return 7% or 8% (11% or 12%) rather than 6% (10%). If I were able to return 9% or 13%, though, then my incremental value over 25 years would be $102K or $196K, respectively. While still apparently low, my average management fee has now increased to 0.11%.

At some level of outperformance, I feel the management fee should be increased. From the perspective of trading as a business, annual losses are anathema. In the event this accompanies improvement over the benchmark drawdown, I still feel payment should be postponed until a new highwater mark is established. The caveat, as mentioned in Part 1, is that only qualified investors* can be charged performance fees per SEC rules.

Whether clients pay performance fees is up to the IA but I feel it’s fair for me to be paid more as a trader. This goes back to my Part 2 mention of getting more than 50% of the incremental fees. Number and size (AUM) of client referrals may always be proportional to relative performance. Although hard to definitively measure, the value of this may be significant.

It has gone without saying that some benchmark for performance comparison would have to be agreed upon before any of this is finalized. I would also make a case for risk-adjusted returns. Clients who sleep easier at night will be happier than those who are more stressed and fearful. This can be measured by Sharpe [Sortino] Ratio or volatility of monthly returns. As discussed above, I strongly believe this has value albeit difficult to make tangible. One never knows when new referrals might be the direct result of a happier, stress-free clients. One also never knows when a more linear equity curve might directly result in the decision to remain invested during a market correction that would otherwise have sent them screaming for the exits to lock in large losses. These are two extremely valuable possibilities.

If I had 25 million-dollar clients then I would be earning $29K/$63K/$102K or $55K/$120K/$196K per year for relative outperformance beyond 6% or 10%, respectively. While I would not expect to manage $25M immediately upon hire, contemplating numbers like these makes a trading gig more enticing—especially if the IA can persuade me that more assets are available contingent upon solid performance.

What I’m talking about is doing exactly what I do now—executing a trading strategy in which I strongly believe—with 26 accounts rather than just my own and having a good chance of being paid [well] over $50K per year for my efforts.** I could probably get on board with something like this.

* Qualified investors have a net worth, excluding primary residence, of at least $1 million or an annual [spousal combined]
   income of at least $200K [$300K].

** All calculations taken from “IA(R) fees and earnings (hypothetical) (10-12-17).”

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