Thoughts on Starting the Global Asset Management Firm
A few of you have expressed interest in the behind-the-scenes process of launching the global asset management business Aaron and I are establishing to provide a mechanism to take on outside funds alongside our own; a natural extension of what we’ve been doing for so many years privately. Sharing it will help me clarify my thoughts, too, so consider this the first installment in a series that will probably cover a lot of ground.
As we work on getting the firm up and running either by the end of this year or the first half of next year, I’ve spent the past few months reading through thousands upon thousands of pages of regulatory filings for financial institutions in the United States, throwing myself into it with the obsessiveness that is a core part of who I am. I want to understand who is already managing money, on what terms they are doing it, how much they charge, the structures they employ, the business models they prefer; all of it. Even last week, when Aaron and I went to visit his parents at the lake, I showed up carting a stack of 500+ pages of SEC forms and a pocketful of highlighters, off in a chair and muttering to myself, pen flying across the page with notes.
It’s led me to three realizations.
First, Aaron and I are in a wonderfully unique place compared to nearly everyone else who has gone down this path. Having already achieved financial independence early in life, we don’t have any of the same considerations most people do when they jump into the industry. We have, as Charlie Munger might say, the luxury of operating according to our core principles and ideals because we don’t need the income. We can take on people we like, turning others away if they aren’t the right cultural or temperamental fit. Not having to sing for our proverbial supper changes the ballgame entirely. We are selecting the client as much as they are selecting us.
Secondly, it made me realize how immoral some major players in the industry are by preying on the ignorance of investors. By the end of the first thousand or so pages, I probably sounded like Elizabeth Warren on a stump speech about Wall Street regulation, apoplectic about the need for major reforms. God help the RIA industry if I ever sit on a regulatory board because it will be like the Red Wedding. I think it would be an extraordinary public service to metaphorically burn some of these firms to the ground. It makes me appreciate the honest, good ones even more when I come across them. And they do exist. Though they are a rarer breed, there are people out there who truly care about their clients, who are rich themselves (and in many cases, much richer than their clients), and who always appear to be doing the right thing, even if it means their firm isn’t as profitable or large as it could be.
Thirdly, I have arrived at the conclusion there are really five types of firms operating in the United States today. The layperson throws all of them under some generic title like “portfolio manager”, “investment advisor”, “broker” or what have you but the differences are meaningful.
- Honest-to-God asset management firms (falling into one of two, or both, services)
- Private individualized asset management, often for high-net worth individuals
- Pooled asset management (sponsoring mutual funds, private equity funds, ETFs, hedge funds, etc.)
- Honest-to-God wealth management / financial planning firms
- Sales firms masquerading as either of the first two categories
- Asset gatherers serving as counselor and extracting a toll to steer people to the first two categories
- Stock brokers
Some firms incorporate more than one type of operation into their business model, blending the lines. However, if you start to separate the divisions, you see this is the real layout of the land. Things become a lot clearer.
Let’s look at each.
Category One: The Honest-to-God Asset Management Firms
These are businesses that employ security analysts and portfolio managers to study disclosure documents, analyze financial statements, look at capitalization structures, and ultimately decide whether or not to buy or sell a stock, bonds, piece of real estate, private operating company, or other asset. When Benjamin Graham setup his firm back in the early 20th century, this is what he was doing. Clients and shareholders came to him, bought into his business, and he, along with his analysts, found specific securities to acquire with the client money, earning income from the activity. The asset managers are the brains; the decision-makers upon whose work everyone else depends and without whom, most of the others would starve.
Typically, asset managers offer their services in a handful of ways. Here are some common examples:
- They setup a mutual fund so that other investors can buy shares. The money used to purchase the shares gets put into a single pool and they charge the pool a fee.
- They setup an ETF, license the rights to use a certain stock market index (e.g., creating an S&P 500 ETF and paying S&P for the intellectual property), taking it public and earning a small management fee, hoping the volume makes up for the low expense ratios.
- They setup a hedge fund and take on partners who fit very specific requirements, allowing exemption from regulatory rules.
- They setup private equity funds, buying entire businesses, improving them, making them more efficient, then selling them or taking them public.
- They allow affluent or high net worth clients to come directly to them, building individual portfolios in private custody accounts; sort of like a mutual fund, only for a single person or family who holds all of the underlying securities directly or in a street name.
- They offer other firms their services at reduced fees so the other types of firms can outsource the asset management function.
Asset management firms can run the gamut from old-school, disciplined, fundamental value investors who buy shares of great businesses and have their clients sit on them for generations to momentum junkies dumping money into dot-com stocks during the height of the 1990’s.
Fees for real asset management services scale. There’s almost no way to make them affordable for smaller investors (hence the focus on pooled mechanisms or high-net worth requirements). Fees are unique and not comparable, too, making it extremely important to read the fine print.
For example, one revered asset management firm charges a flat 1.50% on all account account balances, with a minimum opening requirement of $5,000,000. It doesn’t matter if you have $5,000,000 or $100,000,000, you’re paying them 1.50%. The actual effective fee, however, is much lower because it excludes cash in the calculation of the fee and, as a matter of practice, the portfolio managers almost always have 8% to 20% of client portfolios in cash reserves. Client portfolios are typically fully paid for, in cash, with no margin debt. Clients hold the portfolios themselves in a custody account at a bank trust department so the firm doesn’t even have access to the money. The international scope of the service – clients end up owning shares of operating companies around the planet, collecting dividends in dozens of currencies – ends up costing, under most conditions, a mere 1.25%, which is fantastic for the tax harvesting and risk reduction it permits. They can even do custom mandates (e.g., “I’m ready to stop working and want to collect at least 3% to 4% spendable cash per year without a risk of running out of money, so can you only find companies around the world that have strong balance sheets, low bankruptcy risk, stable political operating environments; make sure no more than 2% of assets are put in any one firm, and have the dividends direct-deposited into my checking account once a month as they pile up?”).
Another, in contrast, charges 0.75%. It looks much cheaper. However, they then turn around and put client assets into underlying securities and proprietary hedge funds with significantly higher fees, some of which – I kid you not – in turn invest in other third-party funds and securities with their own layer of fees! It is impossible to tell but it very well could end up being 2% or even 5% or more by the time one got to the bottom of it all depending on the performance. Worse, you didn’t even know what you owned or how much debt was being employed. No sane person should be working with this firm, yet they have billions of dollars under management.
Some asset managers are generalists, hiring specific experts to oversee certain categories (e.g., Vanguard or American Century). Some asset managers are specialists, focusing on a single type of investing strategy, such as value investing or investing in timber, minerals, or energy. Some follow the low-turnover, tax-efficient, long-term approach while others employ strategies like triple-leverage, high-speed computer trading.
The more successful and wealthy you are, the more likely it is you have a direct relationship with an asset management company no one but other rich people have ever heard of; no intermediary between you, just two people sitting down at a table and arranging a deal. Many of the best have no website, do not advertise, and only communicate by word of mouth from existing clients. The founders can make millions of dollars a year and, over several years of operation, reinvest sufficient profit alongside clients so that they become one of the biggest accounts themselves (in more than one case, the founders only started the business after divesting a family company and deciding to take on other investors alongside their own capital allocation activities). Almost all charge fees ranging from 0.50% to 2.00% + 20% of profits depending on the complexity of the mandate and service level required. For example, international and global asset management specialists rightfully charge more than domestic asset management specialists because it’s a lot harder to do the former well; to appreciate the risks and variables that go into maintaining a portfolio of shares pumping out Swiss Francs and Japanese Yen.
Asset management firms are frequently misunderstood by the general public, even those interested in investing. Case in point: I recently read a post on the Boglehead forums by an investor who approached one of the better-known asset management firms. He said he didn’t hire them because they “wouldn’t invest his money in mutual funds” or something along those lines. That tells you how big the disconnect is. The notion that he would have contracted with these people, presumably, had they pooled his money with others but not if they took him on directly tells you how clueless folks can be. He would (and probably does) gladly pay significantly more than they would have charged him and be happy about it because he doesn’t see it directly. It’s crazy if you stop to think about it.
Category Two: Honest-to-God Wealth Management / Financial Planning Firms
Let’s say you have a successful career and amass a good amount of money. Or maybe you win the lottery. Perhaps you end up with a huge inheritance. Not only do you need to invest the cash, there is a lot of other stuff you might require, such as comprehensive estate planning, tax services, insurance audits, and liability protections (e.g., do you think it is an accident that your favorite Hollywood star doesn’t own his or her house outright, but instead, has it titled in the name of some random limited liability company that is almost impossible to trace?).
This is where wealth management and financial planning firms come into the picture. They often bring asset management, legal advisory, estate planning, trust services, and tax preparation under a single roof. You might approach one and say, “I want you to serve as co-trustee for five trust funds I’m establishing for my children, watching out for my interests long after I’ve died. I want you to manage the trust principal, too, by only purchasing stocks with dividends that have been increased every year for 25 years, and rebalancing once per year on August 15th.” The costs are going to be significant, but the peace of mind is worth it. You might say, “I have this enormous block of Microsoft I acquired over the years during my time with the firm. There are huge unrealized capital gains and I’d like to diversify while lowering my tax bill as much as possible.” You might say, “I have this block of apartment buildings I want to donate to my alma mater but I want my grand niece to receive a private pension from the income for 12 years following my death.” All of this can be done.
Some of these firms charge flat rates – e.g., a minimum retainer of $10,000 or $100,000 per year. Some charge as a percentage of assets. Some do both. For example, I saw one major practice in the United States that charged what appeared to be a jaw-dropping 2.25% to 2.55% annual fee on the first $5,000,000 in assets under management plus certain hourly charges. For those who aren’t exposed to the complications that come with having a high net worth, that might look insane. Why would someone – and not just someone, a lot of people with a lot of money as this was a major institution – invest with a business they knew would construct a portfolio that, after fees, is all but guaranteed to significantly underperform a comparable index fund? Simple. Comparison to the benchmark is wholly, inexcusably inappropriate because the fee is not just for asset management services in this case.
Rather, the client is buying so much more. This firm specializes in comprehensive risk and estate management strategies, including sitting down and passing judgment on things like long-term care insurance contracts to make sure a person’s life’s work isn’t eaten up by hospital expenses. They created protected structures to stop disaster scenarios from playing out (e.g., keeping your daughter’s drug-addicted husband from ever having access to her inheritance or providing for a wanton child so they don’t go homeless and, at the same time, making sure most of the wealth ends up in the hands of your responsible, productive grandchild). They setup tax mechanisms, such as family limited partnerships with liquidity discounts, to drain your estate faster than would otherwise be possible so more money ends up in the hands of your heirs instead of the government. They can provide family services and things that don’t easily fall under any given category (I recall one private wealth manager checking on a client’s elderly mother when he was abroad since he couldn’t get in touch with her. He found she had fallen and needed to be taken to the hospital, getting to her in time to save her life. Another arranges private military personnel to drop in and save you if you are abducted abroad or will secretly chip your children so they can be tracked anywhere from satellites.)
This is one of those areas that the division between lower / middle classes and the upper class become painfully evident. As I explained in an older post, you’ll hear people who have no idea what they’re talking about suggest lottery winners forgo financial advisers to save on fees, buying Vanguard funds instead (mistaking the advice of some intelligent people to avoid “helpers” – which is not what the original authors and commentators were talking about only they don’t know the difference). As I said then, and reiterate now, it’s moronic; indicative of a person attempting to take the most rational situation for a reasonably successful office worker making $50,000 a year and scaling it to amounts he or she neither understands nor comprehends. To try and save themselves 1% to 3% per year over the index fund, they could cost themselves 10x or 100x that in opportunity cost on an after-tax, inflation-adjusted basis. The sticker-rate performance relative to the benchmark is not what matters.
The grand irony, of course, is that it takes a degree of sophistication to be able to spot which wealth management / financial planning firms are fair deals, adding significant value. I saw some that were pathetic – the managing directors were clearly former stockbrokers who slapped “wealth management” on their door and started raising assets due to their ability to charm people, not actually look out for the clients’ best interest – but I came across others that earned their fees in spades.
Had General Johnson paid a bit for these services, the nightmare that became the Johnson family wouldn’t have turned out like it did. They would have likely foreseen a lot of the structural errors in the trust documents due to an understanding of human behavior; perhaps been able to emotionally contain some of the heirs due to their experience working with similar situations. Relationships between parents and children, cousins and spouses, uncles, aunts, nieces, and nephews could have been salvaged. By refusing to pay up in the beginning, he and his heirs paid exponentially more in legal fees down the road.
If a wealth management firm isn’t employed by the third generation, it’s highly probable the shirtsleeves-to-shirtsleeves proverb is going to play itself out, again.
Category Three: Sales Firms Masquerading as Either of the First Two Categories
If I were to say the names of some of these firms, you would know them instantly. These are the people who take non-experts, put them through a quick regulatory exam, some sort of in-house training program, and then turn them lose on society to cold call, selling everything from annuities and insurance policies to mutual fund shares and unit investment trusts. You go to them and they give you big speeches on stocks, bonds, or annuities. They explain why [XYZ] fund is the best or how this one magic equity-indexed variable annuity will “protect you from stock market crashes while giving you the upside”. Meanwhile, whatever they get you to “invest” [read: Buy] involves a kickback, typically of at least 5% of the principal value, directly into their pocket as if they were selling you carpet or a used car. They often don’t have a bloody clue how the underlying investment itself works. They are warm bodies paid to get you to sign on the bottom line.
In effect, they are nothing more that the distribution arm of the first two categories. Sometimes, this works out well for the investor. There are many, many millionaires in their 70’s, 80’s, and 90’s who are only rich because a good salesman convinced them to buy shares of certain American Century funds decades ago, all so he could take the commission to go buy a new car or put a down payment on a house. Even if they would have ended up richer had they found the funds themselves and not paid the load, it wouldn’t have happened otherwise so, in the real-world, they owe a debt of gratitude. More often, it seems the incentives motivate the most lucrative products being pushed.
There are two reasons I find this revolting:
- Personally, I don’t have the constitution to do it. I’m incapable of it. I’d starve. I could never look at someone and tell them to buy a financial product that I didn’t think, deep down in my heart, was the ideal fit for them, nor could I suspend my own disbelief long enough to convince myself in order to cash the commission check. It puts me at a massive disadvantage and is one of the reasons I avoided Wall Street in the first place. Perhaps it’s all the Sunday School my parents sent me to during childhood but I can’t help but think, “Would I be selling my own grandmother this product?”. If the answer were no – which it inevitably is in this sort of arrangement and the compensation has to be built into the distribution model – I couldn’t go through with the sale. It would be a horrible professional disadvantage were I to attempt to be successful in this arena. Avoidance is the only rational strategy.
- There’s something in my personality that allows me to sell if people come to me – I could build a McDonald’s, open a movie theater, or sign another book deal – but that instantly turns me off if I have to go to them. I like being on a certain side of the table; the one with the power to turn them away. I like being the one in control. I like being the one who sets the rules. I’m sure it’s a strategic defense mechanism from my childhood when I never wanted to be at the mercy of others to protect myself because I didn’t know if everything I worked for could be taken away simply because of who I was. It’s served me extraordinarily well, so I’m not particularly keen on changing it, but I have to admit it’s there when I stop to examine my own motivations.
I’m morally torn on the good asset managers that opt to employ these people, too, because if they refrained from doing it, it would result in only the bad ones remaining, causing more human suffering and damage in the long-run.
Category Four: Asset Gatherers Serving as Counselor and Extracting a Toll to Steer People to the First Two Categories
Being a private investor who handles the capital for many of the people around me, I never looked much at the state of the non-institutional or non-high net worth money management industry up until the past year or two. It simply wasn’t relevant to my life nor did I particularly care. Once I did, I was astounded by the size, scope, and ubiquity of this sort of firm. I’m also severely torn on their existence because there are two powerful arguments, one for and one against, that cannot be reconciled easily in my mind.
These firms call themselves asset managers / wealth advisors / financial planners. They have it on their door and it’s printed on their letterhead. They are nothing like the ones we’ve already discussed. Rather, they are in the business of serving as coach, emotional counselor, guardrail, and asset gatherer.
Here’s how it works. Like true asset managers, they tend to operate on a fee-only basis. They also tend to appear to offer low fees; often much lower than true asset managers.
A client comes in, but instead of the firm managing the money itself (there are no annual reports, Value Line tear sheets, Bloomberg terminals, 10-K filings, or other documents piling up as they construct private portfolios), they sit down and put the client funds to work in a portfolio of mutual funds, exchange traded funds, or other pooled structures. “Yes, Mrs. Smith, I think we should allocate you 10% to this fund, 25% to that manager …” They are paid watchers and helpers. They put themselves between you and the folks making the real decisions, charging you a fee. They either 1.) pay the asset managers a smaller fee, pocketing the difference, 2.) acknowledge that the asset manager will apply its own fee on top of what the client is already paying, or, 3.) in the case of pooled structures like mutual funds, ETFs, or hedge funds, issue a disclosure that the pooled structure itself will be subject to a management fee.
With pooled structures, the client never explicitly sees the fees deducted from their account and, thus, doesn’t realize that the actual cost he or she is incurring is 2x, 3x, 4x higher without any of the benefits of a direct portfolio, such as the ability to tax harvest, tilt the dividend yield to match income needs, or arrange the bond duration to line up with major life events, maximizing risk/income/liquidity. I saw one firm down south that actually created intermediary structures itself so it could outsource the asset management and have the fees charged to the structure, avoiding the client seeing them, then had the audacity to advertise itself as a low-fee firm! A lot of people were actively falling for it, too. They were huge.
The worst I saw was a large firm that bragged about watching the outsourced managers and recommending their hiring/firing to the client based on monthly performance relative to a benchmark. I don’t care if a place like that showed up with $10 billion tomorrow, hell would freeze over before I signed a contract on those conditions. I think it remains, in my entire career, one of the stupidest things I’ve ever read in a financial disclosure. Mathematically, you can’t really isolate randomness from talent on a basis of less than five years, especially if you hold a cross-selection of blue chips that include things like commodity businesses. It tilts the entire incentive system to tax-inefficient closet indexing. You get someone who buys a firm like Facebook not because they think it is a good investment, but because by not holding it and being compared to the S&P 500, they’re effectively short Facebook in their performance calculations. It discourages long-term passive holding. It’s a monstrosity. It’s hard for me to accept that people want these helpers to lie to them; to give them an illusion of control that they are masters of the universe and can predict where the stock market is going tomorrow or even next year. Then again, I’m the sort that would prefer the brutal truth to the comfort of a lie. I want the information, as it is, ugly as it may be.
But – and there’s always a “but” in life, isn’t there? – here’s the thing. Whenever you look at investor behavior, the typical person sucks at managing his or her own money. There’s this constant refrain, “Lower fees and buy Vanguard or Fidelity index funds”. Only, when most investors actually do that, and you start looking at the real-world performance they experience, they end up blowing it because they don’t have someone holding their hand. You get this insane outcome where over longer periods of time when the underlying index grew 9%, 10%, or 11%, the actual fund investors made only 2%, 3%, or 4% because they could not overcome their desire to act. Sure, it’s ideal if you aren’t rich and can’t or don’t want to evaluate individual securities (hence my long-term support for indexing) but it only works for a certain type of personality, with a certain level of discipline.
If – and it’s a big if, but an important one nonetheless – if one of these asset gatherers can calm your Great Uncle Bert down as he starts panicking, watching CNBC with the flashing red numbers; if they can encourage him to have faith when the market is tanking in 1973-1974, 2001, or 2008-2009; if they can keep him regularly buying, without exception, and acquiring only good, fundamental-based assets that ignore things like market timing or derivative tradings, then the value added is worth every single penny. To compare the under-performance to the index fund is both intellectually dishonest and downright stupid because it never would have happened; it was never in the cards as they were incapable of behaving in such a way. Were you to convince the client to move to a firm like Vanguard, he’s going to lose everything eventually or end up compounding at far lower rates than the underlying funds. Some people are not rational. They need the handholder. They need the helper. The theoretical perfect is an impossibility in their case.
[Side note: There are times a true asset manager or wealth management company from the earlier categories might employ something like industry or sector-specific ETFs despite the double-layer of fees. If they agreed to take on a smaller client, who they normally wouldn’t accept, and who doesn’t have sufficient assets to achieve diversification but with whom they are working to create a comprehensive wealth plan, it can be rational as an intermediary step to, say, significant earning power in the future (if they were working with a rising star in some industry) or an expected inheritance (they were the child or grandchild of an existing client). The absolute fees are somewhat meaningless in terms of real-world utility and it begins the saving, accumulating, and investing process. Likewise, Charlie Munger once talked about how he was unable to evaluate individual pharmaceutical stocks due to it being outside of his circle of competence so the most rational course of action would be to use a low-cost basket approach. If the industry as a whole were cheap, buying an equal-weight ETF as a method to gain ownership of an entire swath of the economy could end up being less expensive than developing dozens of individual positions, justifying the practice. You could also buy them when they traded significantly below their net asset value due to short-term liquidity problems, like the ones seen in the market the other day (one ETF I saw traded at around 2/3rds its underlying holdings, which were incredible businesses), but that is more of a special operation. Additionally, you might want to employ them for speculative purposes if you were running money and had a side bet on some particular event. Let’s say you thought oil prices were going to spike and/or the probability of a terrorist attack were high. You might effectively short the entire airline sector by purchasing a put option or something, though I think I’d still prefer derivatives on the actual underlying components so I could weight the overall bet toward the weakest. I do not consider these situations comparable to placing client funds in open-ended mutual funds representing stakes in managed pools.]
Category Five: Stock Brokers
While there are a few exceptions, these days it seems that regulatory changes and competition from other types of firms have resulted in traditional full-service stock brokers becoming the Frankenstein-bastards of industry, combining almost all of the other models in a terrible, godawful abomination of a final institution. They train armies of salesmen to go out and knock on your door, open offices in your local town, try to get you to buy their proprietary funds (steering money to their real asset management affiliates while earning a kickback for themselves) and even operate affiliated brokerage houses so they can charge you if you want to execute trades through them (e.g., you call and tell your broker you want to buy $25,000 worth of Coca-Cola shares, he’s going to apply a 2% commission).
I know one older gentlemen in a little town here in Missouri. He has a penchant for real estate but when it comes to securities, he invests exclusively in tax-free municipal bonds. Though you’d never know it by looking at him, he has enough money he could get most doors opened to him at most asset management or wealth management / financial planning firms. They could give him institutional pricing. They could make sure his holdings pass to his heirs without probate by setting up a living trust. His returns, and estate, would be much improved.
He won’t do it. For as long as I can remember, he has used a local Edward Jones representative to acquire his bond inventory in, I believe, a plain-vanilla brokerage account owned outright by him, personally. The bond duration was so obscene at one point, so wildly inappropriate for his life expectancy and the fact he will need to liquidate them as, statistically, he doesn’t have much time left, I wanted to grab him by the shirt and say, “You have no idea the risk you are taking onto your children and grandchildren’s books nor are you getting anywhere near the yields you should be getting on the purchases you are making!” It’s gone on for years. I wasn’t surprised to see the SEC settlement last month. It’s the most disgusting moral failure imaginable and you’re talking about tens of billions of dollars under management. How do these people sleep at night? I mean, my God, when the former head of your municipal underwriting desk is barred from the securities industry for at least two years, you’d think that would cause some introspection about your ethics. Then again, I’ve written about their mutual fund practices in the past. Suffice it to say, I’m not a fan of their behavior.
Thoughts on the Money Management Industry in General
A few things have become clear on the journey so far. These are general observations that are currently guiding our planning process:
- Aaron and I are only interested in building one of the first two types of businesses. The latter three hold no appeal, in any capacity.
- The focus will be on global value investing. Our activities will not be restricted to the U.S. stock market unless the client specifically requests a domestic mandate. Roughly half of the world’s publicly traded companies are outside of our borders, in places like the Canada, the United Kingdom, Germany, France, Japan, Switzerland, etc. Why restrict our universe of potential attractive acquisitions?
- We both abhor the money management industry as it now exists and refuse to participate in distribution systems, practices, and commonly accepted behaviors that we find morally unacceptable. We would rather build a smaller, boutique firm that shares our values and of which we can be proud than go after size.
- We should codify our values into written form, penning a firm Credo in the same spirit of Johnson & Johnson’s; a document that simultaneously serves as a compass and lantern; that guides our behavior and illuminates who we are and what we believe. It must become a core part of the firm’s identity.
- The firm will practice extreme forms of simplicity and transparency to the degree it is possible and legally prudent. While fine print always has to exist (e.g., you have to explain to people who have no experience that if they buy shares of a foreign stock, like Nestle, they will experience additional risks such as currency fluctuations, for example), there is no need for dozens of pages breaking out complex calculations, compensation systems, and charges. In nearly every instance I’ve studied, this has been little more than a charade used to extract more money from the client as if they were a goose to be plucked rather than a co-venturer on a journey where you are both investing your own money. I would not want someone treating me that way so I won’t treat others that way even if they insist upon it (too many billions of dollars are allocated to firms that hide their charges so there must be those who demand such abuse). Rather, the substance of our entire arrangement should fit on the front side of a business card, in a legibly-sized font. The heart of it will come down to:
- We manage your assets on a value basis for [x]% per year.
- We provide one-on-one consulting services if you want us to work on something specific for [$x] per hour.
- We only want to run a firm where we would be happy to swap places with any client. That means we want to buy securities at prices and on terms that we, ourselves, would be willing to accept for our own portfolios or the portfolio of one of our family members were we or our family members in similarly comparable situations with similar goals, risk tolerances, and preferences. This could put us at a terrible competitive disadvantage but we’re not willing to compromise on it. From time to time, there is a lot of money to be made as misguided investors throw cash at portfolio managers who will tell them what they want to hear, playing off their hopes and dreams of getting rich. We can’t do it. We cannot buy something we don’t think the probabilities favor, even if it means missing out on the rare outcome where it does make owners wealthier. We also cannot buy certain businesses that possess what we consider unacceptably high levels of wipe-out risk (e.g., in years like this one, it means missing out on airline stocks nearly doubling). This is going to make us extremely unpopular from time to time.
- Over the years, we want a significant portion of firm earnings reinvested alongside clients. I’ve seen situations where portfolio managers have generated millions and millions of dollars only, at the end of a quarter-century, you discover they have practically none of their own money invested in the structures they are managing. Neither of us understands this behavior, nor why anyone would trust someone who engages in it. (I, personally, feel this way about corporate executives who don’t have large holdings in the businesses they run. It’s gotten better in recent years with insider ownership requirements but I can’t, quite, bring myself to fully trust a long-tenured Vice President or director who has almost no equity exposure to the business he or she presumably knows more about than anyone else.) Though it can’t guarantee protection against loss, it can align the interests of both parties. Do you think the people emailing each other about the junk collateralized debt obligations they were rating for clients back during the last crisis would have done so if they were required to put 100% of their own retirement into those securities? I doubt it.
- Edit: This point has caused some fantastic discussion, which I very much appreciate. For now, I’m going to clarify it to reflect the intent, which is now much-expanded upon in the comment section. In that same spirit, I want to require employees to maintain a significant portion of their liquid net worth in portfolios containing securities similar, and in some cases identical, to those we construct for clients, adjusted for the suitability of the particular situation; the same value philosophy and risk management practices. If a client is going to entrust us with his or her entire net worth, then the employees should – as one firm puts it – “eat [their] own cooking”. I need to talk to some people about how, if, and to what extent this can be done under the existing laws and regulations, but if there’s a way to pull it off, we intend to do it. It goes back to that “do unto others” guideline. One mechanism is establishing minimum account values as a multiple of salary, perhaps funded to some degree by bonuses or profit sharing, the same way McDonald’s requires certain positions to hold ownership stakes so they are in the same boat as owners.
- Even if it means lower profits for us, we want the compensation system for future employees to be among the best in the industry, with the people helping us perform our duties sharing in the prosperity. We would like to build a company where, if a secretary or data entry person works for us for over an entire career, he or she almost can’t help but retire a multi-millionaire if they do exactly what we say. Neither of us has any idea what this will look like in the beginning – it could be some sort of ConocoPhillips-like arrangement where they match the first 1% of your salary by 900% so you get this huge tax-efficient bonus or it could be a profit sharing arrangement, just to name two possibilities – but it’s important to us the firm be a blessing to everyone it touches. We already have enough. It’s okay to let others take an extra piece of pie sometimes.
- We want to attract the right kind of client, who shares our conviction that stocks are really ownership stakes in businesses that should be measured over long periods of time and who understands why we consider it a good thing if there are years during which the turnover rate of their portfolio is lower than even a passive index fund. This means finding ways to actively discourage so-called “hot money”.
It’s hard to express how grateful I am that I’m undertaking this project at this point in my life. I don’t know how a young person starting out with no money or no experience could launch a firm with these sorts of guidelines and still put food on the table. Even the luxury of taking our time, waiting until we feel like we’ve gotten it right, is wonderful. The difference between what many others go through (“we need to raise assets to keep the lights on”) and what we’re doing (“we’re already successful and engaged in this activity, anyway, so if you want to throw your hat in with us, you can)” is radical in the independence it affords. It changes the game entirely because we approach the clients as equals; metaphorical partners with a shared purpose, strategy, and vision. It suits us. We also think it’s a better deal for the client.
For now, more information on the soon-to-exist firm can be found here. It’s been fun, and humbling, to watch the contact database grow each day as people call, requesting to be put on the information waiting list so they are notified when we launch. We review it almost every night.
If any of you have any questions about the process, resources you think I’d enjoy, or suggestions for things you’d like to see, let us know. I’m looking forward to walking you through the legal structures we’ll be using, the way standard advisory contracts work, the limits put in place by the regulations in the United States, and all the other interesting (at least to this crowd) stuff you don’t really see since it’s behind the scenes.